June 19, 2014
By Richard Epstein
At present the United States is embroiled in litigation with Fairholme Funds over the so-called Third Amendment to the Senior Preferred Stock Purchase Agreement (SPSPA) that it entered into on August 17, 2012. It did so through the Federal Housing Finance Authority (FHFA); the latter in its role as conservator of both Fannie Mae and Freddie Mac. At issue in that and other cases is the full dividend sweep, whereby FHFA agreed to hand over to the United States Treasury all of its net earnings, forever, so that the underlying advances could never be re-paid, no matter the future condition of Fannie and Freddie.
I have written about these issues on multiple occasions as an outside consultant for several institutional investors. The central point of this message is that there is no intelligible reason why FHFA should hand over all the income of Fannie and Freddie in exchange for nothing at all. This transaction is not a foreclosure, and it’s not because Fannie and Freddie are not in default. It is an outright transfer of wealth under the terms of the Senior Preferred Shares Agreement.
In dealing with this case, the federal Government in its motion to dismiss took the position that the Third Amendment was justified because of legitimate fears about the long-term financial viability of both Fannie and Freddie. In so doing, it made the conscious decision to challenge the factual accuracy of Fairholme’s complaint, which asserted that both Fannie and Freddie had returned to financial health. The federal government’s motion to dismiss thus put into issue the financial prospects of both entities. Fairholme promptly obtained from Judge Margaret Sweeney an order seeking discovery of relevant material on that question prepared before and after the adoption of the Third Amendment, as clearly relevant to the matter at hand.
On May 30, 2014, the government sought a protective order claiming that the production of this information would “Interfere With The Operation Of The Conservatorships In Violation Of HERA And Impermissibly Intrude Into The Deliberative Process” [of key government officials]. In support of that contention, FHFA Director Watt insists that “The disclosure of any plans relating to ongoing and future operation of the conservatorships, including the projections of the future profitability of Fannie Mae and Freddie Mac (or lack thereof) under a range of economic, business and policy scenarios can be anticipated to have a destabilizing effect on the Nation’s housing market and economy.”
On June 10, 2014, Fairholme filed its response. I admit to a partisan interest in this case. But this case is not even close. The Affidavits of key government officials, including the passage quoted from Director Watt, have a cookie-cutter quality about them. Their abstract assertions give no explanation as to how the release of this information can have the deleterious consequences that they claim. The most obvious explanation for the federal government’s reticence is that it will be embarrassed by some revelation that its own internal deliberations will show that the Government’s public face is an elaborate ruse to divert all of the wealth that would have gone to the private shareholders of Fannie and Freddie under the SPSPA.
At the very least, as Fairholme points out in its brief, the documents could be turned over to the plaintiff with an order that they not be published or used outside the litigation. Yet even that remedy seems extravagant in this case given that the government on multiple occasions made its own projections on the financial status of Fannie and Freddie or various scenarios. It does not help the Government’s case that many of the documents sought were prepared close to two years ago, and thus have little if any direct relevance on today’s market in their shares, whose only value is that of the lawsuits brought against the federal government.
Nor does the current law back the federal government’s position. A similar contention was made by the federal government in the very different litigation of Starr International v. United States, where the Court held that “[b]y choosing to put the Government’s knowledge of its own authority under Section 13(3) of the Federal Reserve Act [relating to the Federal Reserve Bank to issue an emergency loan to AIG) at issue, questions of the Government’s intent and understanding of the scope of its authority to enter into the loan commitment are directly relevant to this litigation.” That same conclusion applies to this case as well. These documents should be produced, and they should be published as well, unless the federal government can offer a far better justification for their concealment than it has offered to date.
Richard A. Epstein is the Laurence A. Tisch Professor of Law at New York Univerity, a senior lecturer at the University of Chicago, and the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution.