The Courts Can't Oversee Us! FHFA's Extraordinary Argument Before The U.S. Court Of Appeals

Includes: FMCC, FNMA
by: Wayne Olson, CFA

The GSEs are essentially public utilities. The FHFA’s duties as a regulator of the GSEs are essentially the same as those of a public utility regulator.

As argued by FHFA’s attorney before the U.S. Court of Appeals, the FHFA as regulator has extraordinary authority, with no judicial oversight of its actions. This is regulation on steroids.

That is not how public utility regulation ordinarily works. Public utility regulators should be subject to oversight by the executive branch, the judiciary, and the courts.

It is hard to imagine that a court would think that government actions to expropriate assets from investors and de facto nationalization cannot be overseen by the courts.

This case is very important for GSE common and preferred investors. Investors should do their own due diligence.

Q1. What is the purpose of this Seeking Alpha article?

A1. I discuss selected issues raised in the oral arguments before Judges Brown, Ginsburg, and Millett at the U.S. Court of Appeals, D.C. Circuit on Friday, April 15, 2016.

I will focus primarily on responding to the arguments of the attorney that argues on behalf of the Federal Housing and Finance Agency (FHFA).

Note that while this case is very important for Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) common and preferred investors, I do not provide detailed analysis of the investment prospects of FMCC, FNMA, and the GSE preferred stocks in this article, although I have discussed those issues here and here.

It is hard to imagine that a court would think that government actions to expropriate assets from investors and de facto nationalization cannot be overseen by the courts. But that is (arguably) the issue before this court. Therefore, it is particularly important that investors in these government sponsored enterprises (GSEs) do their own due diligence.

Q2. Please discuss FHFA's argument.

A2. During oral argument, FHFA's attorney, Howard N. Cayne of Arnold & Porter, made a remarkable argument (audio of the oral argument in Perry Capital LLC v. Jacob Lew is here). FHFA's attorney argues that the agency as regulator can replace the traditional regulation of the GSEs' capitalization levels with support from the Senior Preferred Stock Support Agreements (SPSPAs) without any scrutiny by the courts. [This article will be updated to quote and cite the transcript once that transcript is available.]

This truly is regulation on steroids. The courts, as Judge Millett noted during oral arguments, generally give the courts considerable discretion as to the details of regulation-and this seems to be especially true with respect to the actions of a conservator. Nevertheless, it is remarkable that FHFA's attorney would so aggressively assert a regulator's immunity from oversight by the courts. [Note that under Section 4623, a regulatory action can be overturned by the courts "only if the court finds, on the record on which the Director acted, that the action of the Director was arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with applicable laws."]

Q3. Are regulators normally subject to oversight by the courts?

A3. Yes. Courts tend to be interested in ensuring that regulators act in a manner consistent with their statutory authority. Some timely examples include: (1) SCOTUS agreed to review Environmental Protection Agency (EPA) regulatory actions with respect to its Clean Power Plan; (2) SCOTUS agreed to hear a case on EPA's regulation of mercury; (3) the Court of Appeals (DC) is examining Federal Communication Commission (FCC) "net neutrality" rules; and (4) SCOTUS recently found that the Federal Energy Regulatory Commission (FERC) had the statutory authority to issue its "wholesale demand response" rule. These are just a few of the many examples of a court deciding whether or not a regulator implemented public policy in a manner consistent with its statutory authority.

Q4. Has the FHFA previously discussed its statutory duties under HERA of 2008?

A4. Yes.

In its February 21, 2012 strategic plan, FHFA identified "three legal obligations that direct the agency's activities involving the Enterprises." The first is the FHFA's conservator powers, which can be shorthanded as "sound and solvent" and "preserve and conserve." Second, there is the duty to "foster liquid, efficient, competitive, and resilient national housing finance markets." Third, there is the duty to "implement a plan to maximize assistance for homeowners... to minimize foreclosures." Thus, FHFA must implement these three public policy goals to comply with the requirements of the Housing and Economic Recovery Act of 2008 (HERA of 2008).

The FHFA's duties are not unlike those of the Federal Energy Regulatory Commission (FERC) with respect to transmission carriers in the wholesale electric and natural gas businesses or that of the Federal Communications Commission (FCC) with respect to interstate telecommunications carriers. Thus, the FERC regulates interstate electric and gas infrastructure providers and there is wholesale competition in the commodity itself, whether electricity or natural gas. In telecommunications, there is a degree of utility regulation of regulated carriers, but there is nevertheless competition in the provision of telecommunications services. Likewise, the GSEs are regulated in terms of their securitization activities, with part of their role being to improve the operation of competitive mortgage markets; they are also in conservatorship.

Q5. The FHFA's attorney argued, in essence, that FHFA and the GSEs are utterly unique. Would you agree?

A5. No. The GSEs are essentially public utilities. The FHFA is essentially a public utility regulator. Public utility regulation is not at all unusual in the U.S.

More broadly, public utilities can be viewed as public-private partnerships (PPP). PPPs are extremely common in the U.S. [See: Committee on Transportation and Infrastructure, "Public-Private Partnerships: Findings and Recommendations of the Special Panel on Public-Private Partnerships," U.S. House of Representatives, 113th Congress, September 2014.] Note that concerns are often expressed about how PPPs perform in practice and how to design PPPs to perform better, which is also the case with the GSEs.

In the U.S. public utilities are often investor-owned, as are the GSEs. This is not unusual or surprising. Investor-owned firms have the incentive to improve their efficiency and thereby increase their profits. Of course, they have an obligation to serve their customers, but, in doing so, can succeed as investor-owned businesses.

The purpose of public utility regulation is generally to assure that the consumers of public utilities' services pay rates that are "just and reasonable" based on prudently-incurred costs, while also treating utility shareholders fairly. Treating utility customers fairly is beneficial to utility customers in the long run because it reduces the utility's cost of capital. Note that FERC, FCC, and state public utility regulators are also concerned about ensuring that the conduct of infrastructure carriers accommodates competition where competition is possible. FHFA, similarly, is charged with "sound and solvent, preserve and conserve" duties, supporting the U.S. mortgage markets, and assisting homeowners' ability to own a home. There is nothing particularly unusual about the GSEs' public utility duties under HERA of 2008 relative to other utility industries.

In an article I wrote in The Electricity Journal in 2010, I noted that Hank Paulson had argued that the GSEs should be regulated as public utilities. Ben Bernanke had earlier identified the public utility model as an option to consider and Barney Frank concurred.

My argument as to whether the GSEs are essentially public utilities can be summarized as follows. First, the GSEs have made asset-specific investments that are used to help finance long-lived mostly fixed-rate mortgages and the GSEs have achieved economies of scale and scope in doing so. As such, the GSEs have become a ubiquitous presence in the U.S. mortgage markets together with Ginnie Mae (FHA), comprising over 90 percent of U.S. mortgage securitization volume since 2008.

Q6. Judge Millett seems to be hung up on the statutory language "best interests of the regulated entity or the Agency."

A6. From a public policy standpoint, it is hard to imagine that a public utility regulator could take actions that benefit the agency but not the regulated entity.

Judge Millett points to language in HERA of 2008, which states that:

The Agency may, as conservator or receiver- ''(I) exercise all powers and authorities specifically granted to conservators or receivers, respectively, under this section, and such incidental powers as shall be necessary to carry out such powers; and ''(ii) take any action authorized by this section, which the Agency determines is in the best interests of the regulated entity or the Agency.

A regulator must focus on the public interest, the common good. Not the agency's self interest. Regulation is in many ways a balancing act, but treating investors fairly is good for mortgage holders and the mortgage markets in the long run, the proverbial win-win-win situation.

Q7. How does public utility regulation balance a regulator's authority with accountability?

A7. Surprisingly, FHFA's attorney argued that FHFA as regulator should not be subjected to court scrutiny. Usually this is discussed in the context of conservatorship. While there is some tradition of allowing FDIC and substantial discretion in its actions as conservator, that would be far less likely to be the case in the context of a public utility regulator. [Note that FHFA is distinguishable from the FDIC in terms of its ongoing regulation of the GSEs, although their roles as conservator seem largely the same.]

FHFA seems to think that its role as both regulator and conservator gives it enormous protection from oversight by the courts. But, that is plainly undesirable from a public policy standpoint.

As I explained in my book on public utility regulation, an "independent public utility regulator is 'free from control from outside political and special-interest influence.'" This freedom is not absolute, rather there is a "balancing act" between a regulator's authority and its autonomy. A regulator will have "agency discretion" when evaluating issues and making choices consistent with their statutory authority, and courts do not ordinarily second guess regulators' judgment in doing so. Nevertheless, the regulator will ordinarily be subject to oversight by the executive branch (the executive nominates the regulator), Congress (which enacts the laws that the regulator is to follow) and the courts (which can determine whether the regulator follows its statutory authority).

Note that courts ordinarily can determine whether a regulator makes decisions consistent with its statutory authority and whether the regulator provided administrative due process in doing so. This is desirable from a public policy standpoint as regulator are independent agencies. Accountability requires that policy makers provide oversight to ensure that the regulator performs its assigned tasks in a reasonable manner. A regulator will be more likely to achieve good results, consistent with its statutory mandate, where there is accountability to the executive, legislative, and judicial branches of government, both in terms of achieving desired outcomes consistent with the defined purpose and tasks of the regulatory agency and in terms of the transparency and procedural fairness of the regulatory process.

Q8. How would it work if conventional public utility regulation was followed by the FHFA with respect to the GSEs?

A8. The regulator would have the authority to make independent decisions consistent with its statutory mandate, but the regulator's role would be restricted to implementing its statutory mandate, rather than making public policy.

While I can't judge the merits, I am interested in an argument recently made before SCOTUS. In a case having to do with immigration, SCOTUS Justice Kennedy argued that Obama was "defining the limits of discretion" and he went on to say that:

And it seems to me that that is a legislative, not an executive act. The briefs go on for pages to the effect that the President has admitted a certain number of people and then Congress approves it. That seems to me to have it backwards. It's as if the President is setting the policy and the Congress is executing it. That's just upside down!"

Similarly, when Treasury/FHFA agreed to the 3rd Amendment, they made public policy, rather than merely implementing public policy. Treasury/FHFA set forth a 3rd Amendment that was fundamentally "legislative" in nature, far beyond any fair reading of their statutory authority and, indeed, diametrically opposed to the FHFA's "sound and solvent, preserve and conserve" mandate.

Next, Treasury says it won't change the 3rd Amendment, instead Congress must do so.

That's just upside down! If Treasury/FHFA could agree to it they can also change it. Failing that, the courts may overturn the 3rd Amendment.

Disclosure: I am/we are long CERTAIN FREDDIE MAC AND FANNIE MAE PREFERRED STOCKS, INCLUDING FMCKJ AND FNMAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am an economic consultant and the author of The A to Z of Public Utility Regulation (Vienna, VA: Fortnightly, 2015). See: I am not an attorney.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.