Q1. What is the purpose of this Seeking Alpha article?
A1. I will discuss the rule of law, the rule of man, and the past, present, and future of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Fannie Mae and Freddie Mac are together known as the government sponsored enterprises or GSEs.
During the 2008-2016 period, it is apparent that the "rule of man," (i.e., Hank Paulson, Tim Geithner, and Jack Lew), has been followed, with Edward DeMarco and Mel Watt following along.
At present, there is significant political risk, but also significant potential upside for Fannie Mae and Freddie Mac common and preferred equity investors.
Going forward, court decisions could reshape the investment prospects of GSE equity investors. There is also the possibility of a settlement, which could lead to the restructuring and/or replacement of the Senior Preferred Stock Purchase Agreements (SPSPAs) and the related Senior Preferred Stock certificates.
In a formal sense, the SPSPAs are separate agreements between the U.S. Treasury (Treasury) and Fannie Mae and between Treasury and Freddie Mac. However, the Federal Housing Finance Agency (FHFA), as regulator and conservator of the GSEs, agreed to the SPSPAs on behalf of the GSEs. It is my understanding that Treasury and FHFA have the authority to restructure the SPSPAs without the need for Congress to act.
It is impossible to predict the future of GSE regulation and conservatorship. While I have no idea of what will happen, I am willing to state my opinions as to what should happen.
Investors in GSE common and preferred stocks should do their own due diligence.
Q2. How should the incoming administration explain changes in public policy toward the GSEs?
A2. It will be important to explain public policy toward the GSEs carefully. It is likely that journalists, housing advocates, Treasury and FHFA staff, DOJ legal staff, among others, will find the changes confusing. I would emphasize the following:
- The Rule of Law. Overturning the 3rd Amendment is necessary in order to comply with the rule of law.
- Secrecy. The incoming administration need not continue the Treasury/FHFA efforts to keep over 11,000 documents secret. These documents have been kept secret from even plaintiff legal counsel pending court review. The basic policy argument can be transparency, the peoples' right to know if the government is itself complying with the law.
- Settlement. Beyond overturning the 3rd Amendment, the incoming administration may decide to seek to settlement the ongoing court cases on a comprehensive basis. This settlement could include financial recapitalization of the GSEs, damages for the harm to GSE equity investors, and the end of conservatorship.
- Treasury warrants. It is possible that the Treasury may voluntarily agree to not seek to exercise their warrants to own 79.9 percent of the GSEs. This would reduce the risk that GSE common equity investors bear with respect to massive earnings dilution via exercise of the warrants and financial recapitalization.
The basic story has to be the fundamental unfairness of the GSEs' holders of Senior Preferred Stocks attemping to wipe out the GSEs' common and preferred stock investors via the 3rd Amendment. It is not Treasury's and FHFA's job to pick winners and losers. All equity investors in the GSEs, common, preferred, and senior preferred, should be treated in a reasonable manner, while recognizing that the common equity investors are entitled to the residual after all the GSEs' other obligations are repaid.
Q3. Has the investment proposition facing GSE common and preferred equity investors begun to change?
Q3. Possibly. It is possible that the incoming administration will be less committed to the status quo with respect to the SPSPAs including the 3rd Amendment net worth sweep. Also, it is possible that the court decision in the appeal of Judge Lamberth's decision could have favorable implications for GSE equity investors. I would continue to emphasize that GSE equity investors should do their own due diligence.
Political risk is the risk that political decisions, events, or conditions will significantly affect the forward-looking profitability and cash flows of a firm. I have discussed political risk here, here, and here. The GSE common and preferred stocks face significant political and litigation risk, but they also could have significant upside potential.
My basic analysis of the investment potential of the GSE common equity stocks is here. My basic analysis of the investment potential of the GSE preferred stocks is here. Note that while the specific facts have changed since those Seeking Alpha article were written, the basic analytical approach remains relevant.
Note that the market prices of FNMA has increased to $3.13 per share from $1.76 per share since September 19, 2016, an increase of about 78 percent. During the same time period, the market prices of FMCC went from $3.08 to $1.68 or an increase of about 83 percent. Past results do not necessarily offer a prediction of future investment performance.
The market-traded GSE preferred stocks have increased to about 18 percent of redemption value from about 11 percent of redemption value since October 19, 2016, an increase of about 64 percent. There are a number of GSE preferred stocks that are market traded. Information for Fannie Mae and Freddie Mac, respectively, can be found here and here; the GSE preferreds vary considerably as to market prices, terms, and conditions. The future prospects of the GSE preferred stocks are uncertain.
Q4. What is the rule of law? What is the rule of man?
A4. The rule of law requires that a regulatory agency act in accordance with its legal authority. Following the rule of law instead of the rule of man means that official decisions will not be arbitrary, that due process and administrative justice will prevail, and that constitutional, judicial, and/or legislative checks on the power of the executive branch will provide constraints against arbitrary action by the government.
The rule of man is the absence of the rule of law, where a person, regime, or group of persons rules arbitrarily.
Aristotle said that "for this is law, for order is law; and it is more proper that law should govern than any one of the citizens." Thus, law should govern.
John Adams, in drafting the Massachusetts Constitution, set forth the goal that the government of Massachusetts "be a government of laws and not of men." Thus, the Massachusetts Constitution states that:
In the government of this commonwealth, the legislative department shall never exercise the executive and judicial powers, or either of them: the executive shall never exercise the legislative and judicial powers, or either of them: the judicial shall never exercise the legislative and executive powers, or either of them: to the end it may be a government of laws and not of men. [Emphasis added]
Thomas Paine said "in America, the law is king. For as in absolute governments the King is law, so in free countries the law ought to be king." Thus, the government should itself comply with the law, just as its citizens are expected to comply with the law.
Three important aspects of the rule of law are procedural due process, separation of powers, and judicial review. Each of these aspects arguably haven't been followed with respect to conservatorship of the GSEs.
Q5. What are the relevant elements of the rule of law?
A5. There are four categories of elements that are relevant. These are: (1) formal elements; (2) procedural elements, (3) institutional elements; and (4) property rights.
To be consistent with the rule of law, laws must meet minimum formal elements that require that laws must at least be: (1) sufficiently general; (2) publicly promulgated; (3) prospective; (4) at least minimally clear and intelligible; (5) free of contradictions; (6) relatively constant; (7) possible to obey; and (8) administered in a way that does not wildly diverge from their obvious or apparent meaning.
Minimum procedural requirements include administrative due process, such as: (1) a right to a hearing before an impartial and independent tribunal; (2) a right to representation by counsel; (3) a right to cross-examine witnesses and make legal arguments; (4) a right to hear reasons from the tribunal when it reaches its decision; and (5) a right to appeal to the courts. I have previously discussed administrative due process issues here, here, here, here, and here.
Institutional requirements have to do with a regulator's independence. An independent public utility regulator is "free from control by outside political and special-interest influences." Thus:
Independence, defined both as freedom from control by legislature, governor, politicians, and utility interests, and as integrity and impartiality in performing assigned duties, is the result of a number of factors, some of which deal with legal and administrative structure, but many of which involve political, economic, and personal relationships varying with time and place. [J. Fesler, "The Independence of State Utility Commissions, II," Journal of Politics, 3 (Feb. 1941): 65.]
An expropriation of property rights via regulation occurs when:
[T]he value or usefulness of private property is eliminated or greatly lowered by a regulatory action without physical occupation... Regulatory takings can be separated into two classes: categorical and non-categorical regulatory takings. A categorical regulatory taking occurs when a regulatory action causes a property to lose all economic value... The complex test for determining whether a non-categorical regulatory taking has occurred involves weighing a number of factors.
Q6. Was the conservatorship, the SPSPAs, and the 3rd Amendment to the SPSPAs consistent with the rule of law?
A6. No. I would argue that the rule of law was not followed.
Since the 3rd Amendment took place well after the financial crisis period of 2008-2009 was over, I normally focus almost exclusively on the 3rd Amendment's net worth sweep to the SPSPAs, which was announced on August 17, 2012. It is worth noting that former Treasury Secretary Hank Paulsen was largely responsible for engineering the conservatorship of the GSEs and the SPSPAs in 2008 and that former Treasury Secretary Tim Geithner was responsible for the 3rd Amendment in 2012.
It is not readily apparent that any of the 12 criteria for putting the GSEs into conservatorship were met at the time that conservatorship was announced in 2008. The de facto nationalization and direct expropriation may have had more to do with "not letting a financial crisis go to waste" than it had to do with compliance with the requirements of Housing and Economic Recovery Act of 2008 (HERA). Thus, Rahm Emanuel said that "[y]ou never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things that you think you could not do before." Still, it's hard to imagine a federal judge wanting to second-guess decisions that were made in the midst of a financial crisis.
With respect to the 3rd Amendment's net worth sweep, I would emphasize that:
- Expropriation of property rights. The expropriation of GSE common and preferred investors was in a sense a "physical occupation" in that FHFA essentially "took over" Fannie Mae and Freddie Mac, largely displacing the GSEs boards of directors as the governance structure of the GSEs. However, it could also be characterized as a regulatory taking. In either case, Judge Sweeney at the federal Court of Claims may eventually have the opportunity to rule on whether the expropriation of GSEs via the 3rd Amendment's net worth sweep constitutes a taking of property without just compensation under the 5th Amendment to the U.S. Constitution.
- Independence of the FHFA. I've argued elsewhere (here and here) that the SPSPAs essentially make the Treasury a co-regulator of the GSEs with respect to the 3rd Amendment in direct contravention of the specific requirements of HERA of 2008. Thus, HERA states that "[w]hen acting as conservator or receiver, the Agency shall not be subject to the direction or supervision of any other agency of the United States or any State in the exercise of the rights, powers, and privileges of the Agency." To me, the SPSPAs are inherently inconsistent with the "separation of powers" doctrine--and therefore inconsistent with the rule of law.
- Administrative due process. Needless to say, neither Treasury nor the FHFA bother to hold a hearing before agreeing to the SPSPAs in 2008 or the 3rd Amendment in 2012. Nor have the other basic procedural requirements of the Administrative Procedures Act of 1946 been followed. I have discussed this here, here, and here. I have discussed the trouble with secrecy in financial regulation of the GSEs here, here, here, and here.
- Formal elements. I would argue, at a minimum, that the way that the 3rd Amendment has been administered does diverge from the obvious or apparent meaning of the terms of HERA of 2008 that require that FHFA "preserve and conserve" and achieve a "sound and solvent condition." Nor was the 3rd Amendment publicly promulgated.
The 3rd Amendment is inconsistent with the rule of law and should be overturned.
Disclosure: I am/we are long VARIOUS FANNIE MAE AND FREDDIE MAC PREFERRED STOCKS, INCLUDING FNMAS AND FMCKJ.
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 a consulting economist. 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.