Edward Lampert Chairman’s Letter

Eddie Lampert, as Chairman, wrote a letter to shareholders of Sears Holdings Corporation in February 2009.  Interestingly, the letter contained a detailed and insightful analysis of the situation with Fannie and Freddie.  It’s a longer letter but the section about Fan and Fred is here:

Pressure from foreign lenders and other significant participants in fixed income markets increased as concerns were raised about Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises (GSEs) that are the largest providers of liquidity to the mortgage markets. The GSEs had been for a long time a political football, with some conservatives urging their elimination and some liberals urging them to do more lending to lower income communities. As investors reevaluated their risk tolerance, a flight to quality ensued, with many investors shifting their preference to cash and to risk-free Treasury securities. The credit spread over Treasury securities for high-grade corporate bonds as well as GSE debt increased (even though the absolute level of rates was still very low), generating losses amongst many fixed income participants, including foreign lenders and large fixed income mutual funds and investors.

In July 2008, Congress was persuaded to act. Under the advice and urging of the U.S. Treasury, Congress passed the Housing and Economic Recovery Act of 2008, which increased the oversight authority of the regulator of the GSEs, ultimately giving the Secretary of the Treasury a “bazooka” to fire at the GSEs and their shareholders under certain conditions. As the Treasury Secretary explained at the time, “if you have a bazooka, and people know you’ve got it, you may not have to take it out. You’re not likely to take it out.” This gave a temporary reprieve to worried GSE investors. Immediately after passage of the legislation, however, many in the media began to call for the nationalization of the GSEs. Depending on their vantage point, people argued either about the GSE’s ability to fulfill both a social and an economic mission simultaneously, or about why they existed in the first place.

On September 7, 2008, in the largest nationalization in American history (executed expeditiously and without an obviously transparent process), the U.S. government announced that it was placing Fannie Mae and Freddie Mac into conservatorship. As part of the conservatorship, the government would provide capital support, if necessary, of up to $100 billion to each GSE through Preferred Stock Purchase Agreements. Although no cash changed hands, in consideration of this backstop, the U.S. government received 80% of the common stock plus $1 billion in preferred stock in each institution. This backstop has recently been increased to $200 billion as part of the Homeowner Affordability and Stability Plan. In the process, they suspended dividends on existing preferred stock of both Fannie Mae and Freddie Mac, eliminating approximately $36 billion in value, most of which was held by the major commercial banks in the United States.

Rather than help solve the housing and mortgage problem, the unintended consequences of this action were manifold. First, bank capital was depleted. Not only was $36 billion in GSE preferred wiped out, but the whole market for financial preferred securities went into a free fall, wiping out additional equity from financial institutions, including many large insurance companies. Second, despite the boards of directors of Fannie Mae and Freddie Mac consenting to conservatorship, neither company has ever given an explanation for its consent. For those who are sophisticated in finance, neither Fannie Mae nor Freddie Mac had a “funding” problem. Because each GSE’s balance sheet was comprised of highly liquid Mortgage Backed Securities (MBS) that pay off on a monthly basis, it should have been easy for either to pledge securities to raise money or to shrink their balance sheet and meet their financial obligations as they came due. The logical explanation for the boards of directors giving consent rests with the presumption that if they did not consent, there was some other threat that would have been even worse for those directors. As for the shareholders the directors represented, it is hard to imagine anything worse than having their investment effectively wiped out, and they had no vote on the matter.

Investors in regulated industries rely on the fact that regulators will not behave in an arbitrary fashion and, if they do, that there are due process remedies that their managements and boards can pursue. Investors in financial institutions who experienced what can happen when funding was compromised earlier in the year in the case of Bear Stearns, now experienced what can happen when a regulator unilaterally decides that the rules of the game are not sufficient or appropriate. Both Fannie Mae and Freddie Mac had capital in excess of the required levels under regulatory guidelines and accounting rules in effect, with Fannie Mae’s capital being significantly in excess of the required levels. However, if one were to use some other standard (and many were being suggested and recommended for quite a while), one could make the case that neither company had the capital desired by their critics, some of whom were not investors, while others had an academic or political interest in the housing and mortgage area that was adverse to the GSEs.

Once it became clear that regulators would act preemptively and with apparent disregard for the regulatory capital requirements and rules, it took less than one week for Lehman Brothers, AIG and Merrill Lynch to find their funding compromised. The government then made the decision to let Lehman Brothers fail, rather than to provide some form of funding bridge that would allow them to meet their short-term obligations and shrink or reform their balance sheet in an orderly fashion. Merrill Lynch agreed to be bought by Bank of America, thereby securing funding for its obligations. The government stepped in to provide bridge financing to AIG. Goldman Sachs and Morgan Stanley were allowed to become bank holding companies on an expedited basis, thereby strengthening their liquidity positions through an expansion in the types of assets they could pledge at the discount window. This provided both companies a strong boost and enabled their survival, while eliminating the last of the major investment banking firms.

The willingness to let Lehman Brothers fail, the stringent terms of the AIG bridge loan, and the arbitrary nature of helping some and not others was too much for many investors to bear. Confidence – which was already strained earlier in the year – was destroyed by this series of events, and unforeseen consequences continued. Shortly thereafter, Washington Mutual was seized and sold to J.P. Morgan, Wachovia agreed to be acquired, first by Citigroup and then by Wells Fargo, and National City was forced into the hands of PNC.

To simplify, there were two paths being pursued simultaneously to strengthen the financial system in general and individual companies specifically. First, there was the capital raising path. This path has generally not worked and has been both value and confidence destroying. Yes, it has given support to creditors (depositors, lenders and others) of financial institutions, but it has destroyed their stock prices, which for many are the primary indicator of confidence. Raising capital at any price or achieving the same effect through forced mergers, and doing so at a time when regulatory capital levels were at or higher than historical levels, made investors wary of buying financial securities and caused many investors to sell these securities. Second, there was the funding path. This path has worked very well and was buttressed later in the year by guaranteeing deposits at a higher level, allowing banks to issue government guaranteed debt, guaranteeing money market funds and providing access to commercial paper for higher rated borrowers. A business that has access to funding can continue to operate, generate earnings, and increase its capital to repair its balance sheet.

The market often has a short memory – but not that short. Recent speculation about bank nationalization, uncertainty regarding regulatory standards, and the loud drumbeat of speculation are eerily familiar. The dangers of regulatory action that is poorly understood and consequentially significant are fresh in the minds of investors and citizens alike. Just as our nation’s leaders can contribute to a downward spiral of confidence they can also contribute to an uplifting of confidence. And this is not just about words. Any actions that contribute to respect for private property and the rule of law will be immediately greeted by improved investor sentiment. Whether as a bondholder or stockholder, investors need to know that they have rights and that the rules of the game are going to be fair and predictable. Any rule changes or actions should not simply be decided and announced over a weekend. Improved oversight can be constructive. Allowing significant policy changes to work their way through the system over time, rather than implementing them overnight because of stock price declines, can break the cycle of panic and fear.

The reason I have elaborated on these events is to put into perspective the environment in which companies like ours are operating. While all companies are impacted by the frozen credit markets, retail companies are impacted by reductions in funding from banks for their seasonal needs to build additional inventory during the Christmas holiday. This has had a crippling effect on some, both large and small, who are no longer in business. The credit markets have also impacted customers in terms of the availability of credit card financing and other funding for their purchases. When funding sources become less predictable, a retailer, or any other business for that matter, needs to adjust so that it doesn’t find itself without the ability to operate successfully.


Bob Dylan: All Along The Watchtower


There must be some kind of way outta here
Said the joker to the thief
There’s too much confusion
I can’t get no relief

Business men, they drink my wine
Plowman dig my earth
None were level on the mind
Nobody up at his word
Hey, hey

No reason to get excited
The thief he kindly spoke
There are many here among us
Who feel that life is but a joke
But, uh, but you and I, we’ve been through that
And this is not our fate
So let us stop talkin’ falsely now
The hour’s getting late, hey

All along the watchtower
Princes kept the view
While all the women came and went
Barefoot servants, too
Outside in the cold distance
A wildcat did growl
Two riders were approaching
And the wind began to howl

Saxton v. FHFA – Have FHFA and the Treasury Exceeded Their Limited Authority under HERA?

Earlier this month, a new front was opened in the legal campaign by investors against the federal government’s (mis)management of mortgage giants Fannie Mae and Freddie Mac. In the latest salvo, Saxton v. Federal Housing Finance Authority (FHFA), individual investors from Iowa filed suit to stop the government from syphoning private property into the U.S. Treasury’s coffers. This most recent litigation effort seeks to reign in the federal government as it subverts the rule of law.

Like every major financial firm in the U.S., Fannie and Freddie found themselves in acute financial distress during the financial crisis of 2007-2008. A root cause of this crisis was the collapse of the real estate market, which caused record mortgage defaults. This, in turn, made investors unwilling to buy the securities that Fannie and Freddie sold. At the height of the crisis the federal government moved in and bailed out both, injecting over time approximately $117 billion into Fannie, and $70.5 billion into Freddie, receiving in return rights to own 79.9% of the companies’ common shares – with the remainder in private hands.

Freddie and Fannie returned to profitability during the second quarter of 2012. Soon thereafter in August 2012, the government changed the terms of the bailout to “sweep” all of Fannie and Freddie’s profits back to the Treasury in the form of dividends – effectively making the companies’ debt infinite and wiping out the private shareholders. Against the bailout of $187.5 billion, Washington recouped over $228 billion from Fannie and Freddie by early 2015.

Unsurprisingly, the remaining shareholders sued, arguing that the government was supposed to return the mortgage giants “to a sound financial condition,” not divest them of all assets. There have been setbacks. Notably, last fall, Fairholme and Perry were dismissed by Judge Lamberth of the U.S. District Court for the District of Columbia, thereby sustaining the 2012 full dividend “sweep.”

But this is far from the end of the legal battle. Perry Capital appealed the ruling while Fairholme Funds remains in discovery at the U.S. Federal Claims Court. And the new Saxton suit injects additional vigor into the challenge.

In a carefully articulated complaint, Iowa investors Thomas Saxton, Ida Saxton, and Bradley Paynter claim that the FHFA and Treasury a) systematically exceeded their limited authority under theHousing and Economic Recovery Act (HERA), b) acted arbitrarily and capriciously, beyond the normal standards of administrative law, and, c) breached good faith and contractual obligations to the private shareholders of Fannie and Freddie.

Unlike earlier suits, many of which focused on constitutional claims, the Saxton complaint astutely focuses on FHFA’s statutory breaches – in particular the unprincipled actions in excess of the authority conferred by HERA. Although Fannie and Freddie were never necessarily insolvent, HERA sought to stabilize the unprecedented turbulence in the housing market. Accordingly, FHFA used authority under HERA to send the two companies into conservatorship.

Via this route, the FHFA believed it would be able to avoid challenges from shareholders that it was confiscating private wealth. As conservator, the FHFA’s duty is to conserve the companies’ assets for the benefit of the common and preferred shareholders with the expectation that the companies will return to sound condition in the future. Specifically, under section 1145 of HERA, the FHFA may “take such action as may be — (i) necessary to put the regulated entity in a sound and solvent condition, and (ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.”

However, rather than work as conservator to benefit Fannie Mae and Freddie Mac’s shareholders, as is its obligation under traditional conservatorship law, the FHFA acted for the benefit of the U.S. government – and to the detriment of those private shareholders. In a surprise deal, the FHFA effectively wiped out the private shareholders and essentially turned the proceeds of Freddie and Fannie to the U.S. Treasury.

When asked about mortgage giants Fannie Mae and Freddie Mac, Melvin Watt, director of the FHFA, said “I don’t lay awake at night worrying about what’s fair to the shareholders.” Flaunting his legal responsibilities, Watt continued, “My responsibility is to think about how can I do what is responsible for the taxpayers.” This is fundamentally the wrong approach.

As conservator under HERA, it is precisely the FHFA’s responsibility to work for the benefit of the shareholders. Under standard corporate law principles, that conservator is bound, by a strong fiduciary duty to protect the corporate assets for the benefit of both common and preferred shareholders. By working for the benefit of third party taxpayers – and to the detriment of private shareholders – the FHFA is in breach of its duties under HERA.

The courts have another chance to get things right this time around. Saxton provides another forum in which to correct where the U.S. District Court for the District of Columbia likely went wrong last fall.

Although the political winds of the moment may make it seem popular to seize these assets and ignore the claims of Fannie and Freddie’s shareholders, we cannot lose sight of the longer term ramifications. The precedent set by the FHFA is contrary to prior practice, will make long-term private sector investing a riskier proposition and will make capital access for housing less accessible, not more.

Saxton provides another opportunity to block the federal government from stripping private citizens of their assets to achieve its own political objectives.

Political expediency should not flout the rule of law.

© Yale Law School

2006: Watt on Hastert’s lack of reporting Mark Foley “He didn’t take seriously”

Watt says don’t jump to conclusions about Hastert

Publication Salisbury Post by Scott Jenkins
Date October 04, 2006

Amid calls Tuesday for the resignation of U.S. House Speaker Dennis Hastert in the wake of revelations about former Rep. Mark Foley’s sexually explicit e-mails to congressional pages, U.S. Rep
By Scott Jenkins

Salisbury Post

Amid calls Tuesday for the resignation of U.S. House Speaker Dennis Hastert in the wake of revelations about former Rep. Mark Foley’s sexually explicit e-mails to congressional pages, U.S. Rep. Mel Watt said he would reserve judgment until the facts are known.

Dr. Ada Fisher, a Salisbury Republican challenging Watt in the 12th District, issued a statement saying “any (Republican or Democrat) member of staff who willingly participated in a cover-up of Mr. Foley’s actions or who knew of these misadventures should be removed from leadership positions and resign.”

Foley, a Republican from Florida who has served 12 years in Congress and was seeking re-election, resigned last week after it became public that he sent explicit e-mails and engaged in lurid online conversations with teenage boys serving as House pages.

Critics charge that Hastert, a Republican from Illinois, had evidence that the exchanges were going on for several years and failed to act on that knowledge. Many have called for him to resign, among them Democrats in congressional races. But Watt said he needs to learn “what he knew and when he knew it.”

“If it is true that he knew, especially, the depth of what was going on as early as some people are now saying, I think he had some responsibilities that he didn’t exercise, he didn’t take seriously, reporting to police officials, taking more aggressive steps to protect the pages,” Watt said. However, he added, “I never want to prematurely call for someone to step down. I think you get the facts first and let the action follow the facts, and there’s time to get the facts.”

Watt, the Democratic incumbent, called the scandal “unfortunate primarily for the young people he was interacting with” and for Foley, who “probably has a serious problem of some kind. He said it is “yet another negative reflection on an institution that really can’t afford those kinds of negative reflections.”

But he took issue with Fisher’s charge that the Foley scandal is “a prime example of how Congress doesn’t apply to itself the laws that it implements for others” and with her connecting it to his opposition of Megan’s Law, which notifies communities of convicted sex offenders living among them, and a national database to track and identify sex offenders.

“If we are unwilling to protect our children, we are writing off the future of this nation,” Fisher said.

“There is no cure or effective treatment for people so predisposed, and monitoring their behavior may prevent others from being hurt even if they served their time,” she said. “It is not a question of civil liberties, but one of child protection.”

Watt said he opposed Megan’s Law because “I thought forcing people to pre-register in anticipation that they might do something in the future was unconstitutional,” he said. After the Supreme Court ruled that sex offenders could be forced to register, Watt said, he voted to fund the registration mechanism.

Members of Congress are not exempt from the law, he said. Still, “You certainly wouldn’t have Congressman Foley register on a sexual predator list before he was ever convicted of anything. So Megan’s Law wouldn’t have prevented this from happening.”

“It’s just one of those situations where she’s mixing two issues and probably not understanding fully either one of them, which is not unusual for my opponent,” he said.

The scandal is a topic in other local races, as well.

Republican Rep. Robin Hayes, who received money from political committees run by former Foley, was under particular pressure, both from state Democrats and re-election challenger Larry Kissell, a high school teacher running a grass-roots campaign against the well-funded incumbent from Concord.

“It’s becoming clear that a lot of folks in Washington knew about Foley’s problems long before the public did,” Kissell spokesman Steve Hudson said in a statement. “Our question is who knew what and when?”

Hayes’ spokeswoman, Carolyn Hern, said the congressman from Concord had no knowledge of Foley’s communications with pages.

“The first time that Robin was aware of any problems with Foley and this e-mail issue was when he heard it on the news like everybody else,” Hern said. “I wouldn’t say that he and Rep. Foley hung out. They had a working relationship, but not a friendship outside of work.”

The Associated Press contributed to this story.

Contact Scott Jenkins at 704-797-4248 or sjenkins@salisburypost.com.