By Glen Bradford June 29, 2105
- The consent clause was used to place Fannie Mae and Freddie Mac into conservatorship.
- According to FHFA Director Lockhart, a very strong case was made to the boards of directors so that they did not have a choice.
- If the third amendment is struck down, Fannie and Freddie are worth upwards of $20, if the entire conservatorship is voided Fannie and Freddie commons are worth upwards of $100.
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two government sponsored enterprises operating in conservatorship since September 6, 2008 when FHFA used its authorities to place them into conservatorship, which is not receivership.
The Housing and Economic Recovery Act of 2008, commonly referred to asHERA, enacted in July 30, 2008 was designed primarily to address the subprime mortgage crisis. 12 U.S. Code § 4617 (A)(3) entitled “Grounds for discretionary appointment of conservator or receiver” is the focal point of this article.
The Consent Clause Was Used To Place Fannie And Freddie Into Conservatorship
Fannie Mae and Freddie Mac were placed into conservatorship using the ninth option (pictured below) which has nothing to do with the financial conditions of Fannie Mae and Freddie Mac:
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Henry M. Paulson Jr. wrote a book about how it all happened entitled ‘On the Brink’ where Paulson provides a once-in-a-lifetime first person account of how he as Treasury Secretary worked to save the world from impending financial Armageddon. I find this to be an invaluable resource in the context of the framing up the recent accounting restatements that have been proposed. If you’re looking for a deeper analysis on a point by point basis regarding the section entitled “Grounds for discretionary appointment of conservator or receiver” start here.
The first excerpt from Paulson’s book that I’ll reference sets the stage for consent:
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Key HERA Provision Used To Enact The Consent Clause
12 U.S. Code § (6) provided safety for the board of directors to consent without being liable and this clause is not present in any other regulatory statute:
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This clause is important because as long as the board of directors consent in good faith using the consent clause, they are not liable. This view was corroborated by Paulson in front of the board of directors:
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Paulson Planned Consent Carefully In Advance
On Thursday, September 4, 2008 Paulson told President Bush, “Mr. President we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
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Paulson didn’t tell Fannie Mae and Freddie Mac executives that their plans came with punitive terms structured to crush shareholders even though they asked:
The Fannie executives asked how much equity capital we planned to put in. How would we structure it? We wouldn’t say.
One thing that is remarkable is that so far the members on these consenting boards of directors have not said anything publicly about the conservatorships since they’ve began. Again, Paulson’s book comes in handy:
As we had with Fannie Mae, we swore everyone in the room to silence.
Part of this particular consenting process involved being sworn to silence. The boards were sworn to silence before they were expected to voluntarily agree to a consent agreement. This sort of process might look somewhat familiar to members of secret societies where at the end of pledgeship you become an active in similar surprise fashion. CEO of Fannie Mae Daniel H. Mudd doesn’t appear to be the biggest fan of operating in secrecy as Paulson confirms from his first person perspective narrative:
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According to the Financial Crisis Inquiry Commission Report, Mudd told the FCIC: “I did not think in any way it was fair for the government to have been in a position of being in the chorus for the company to add capital, and then to inject itself into the capital structure.”
Mudd’s dialog with Paulson seems to suggest that Fannie and Freddie were doing really well and were zooming along while doing everything Treasury asked and being as cooperative as possible. Mudd could sense that something was up, but he couldn’t tell that there were plans of a conservatorship that were made in silence to slam the brakes on Fannie and Freddie as going concerns. It simply was not possible for Mudd to know this when he was purposely not told Treasury had made plans in advance to set up a structure with FHFA that was disadvantageous to shareholders.
(click to enlarge ascari chicane in Italy)
After Fannie Mae and Freddie Mac were placed into conservatorship, FHFA’s Director James Lockhart recalls a similar story:
Sears Holdings (NASDAQ:SHLD) had some interesting thoughts on the GSEs in their February 2009 chairman’s letter:
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.
How Hide and Seek Accounting Gets Found
The financial statements Fannie and Freddie have produced in conservatorship mimic a game of hide and seek with a toddler if you know enough about accounting to know where to look. Poor financial conditions at Fannie and Freddie were not the reason why they were placed into conservatorship so hide comes first. Once in conservatorship, FHFA was in charge of accounting and FHFA signed a deal with Treasury where FHFA could subsequently trigger non-cash write downs that would provide future dividends to Treasury and at the same time cover up the fact that Fannie and Freddie didn’t need money since they were cash money profitable.
For years, FHFA made lots of write downs and made it look like the decision to place Fannie and Freddie into conservatorship was because Fannie and Freddie were deteriorating business models hemorrhaging lots of money, but they were gradually inching closer to making sure that Fannie and Freddie could never come back. FHFA signed several amendments to the original PSPA. The most recent amendment they signed gives all the money Fannie and Freddie produce the privilege of going anywhere except to recapitalize Fannie and Freddie. Once the money goes to Treasury it becomes part of the general revenue fund which offsets government spending.
This is the point in time when things started happening that started making people who were paying attention really start seeking answers. The first thing that happens is that FHFA allows Fannie and Freddie to slowly write back up their write downs as slowly as possible. At this same time, FHFA is winning legal settlements with the true culprits of the private label mortgage backed security crisis. This temporarily inflates accounting profits and accounting profits after the third amendment trigger flows of capital that go off to Treasury where they aren’t specifically accounted for.
This is seems like it might be a very smart way for Treasury to take over Fannie Mae and Freddie Mac. There is, however, a series of problems:
- The first problem is that Fannie and Freddie were not in any financial troubles at all and could have weathered the crisis just fine without any bailout.
- The second problem is that Treasury had to override Fannie Mae’s board of directors.
- The third problem was that Treasury had to override Freddie Mac’s board of directors because Fannie Mae’s board could only be overridden if Freddie Mac’s board was overridden.
- The fourth problem was that the board of directors had to be silenced so that they couldn’t talk about it or know about it before it was going to happen or after it happened.
- The fifth problem is FHFA had to override their auditors as conservator to force write downs causing Technical draws from Treasury.
- The sixth problem is that FHFA had to forget that they forced write downs causing technical draws when they were making forward looking projections.
- The seventh problem is that they had waited too long and the companies had already written down everything before they were making these projections.
- The eighth problem is that FHFA had to drop forecasts by 50% month to month in the process of making the projections to justify that the companies were not ever going to be profitable again in excess of Treasury’s dividend take.
- The ninth problem is that FHFA and Treasury were government agencies and FHFA was supposed to be independent even though Mario Ugoletti worked on the PSPA when he drafted it at Treasury and when he amended it at FHFA.
- The tenth problem is that in order to justify the full income sweep is that FHFA had to overlook the PIK option.
- The eleventh problem is that they didn’t put Fannie and Freddie into receivership because they couldn’t and the stock is still outstanding.
- The twelfth problem is that Fannie and Freddie have been making money all along and when Treasury worked with FHFA to reverse the flow of funds putting the cover on top of the big accounting hole that FHFA had made Fannie and Freddie dig for themselves it filled up with money so fast that it exploded profits out of the top of it and made Fannie and Freddie pay back more than they had borrowed by over $40B so far.
- The thirteenth problem is that Treasury and FHFA did not swear the auditors to silence.
- The fourteenth problem is that an agreement that violates the law is still subject to the law even if the agency that makes it is not restrained by the law if they operate within the law.
- The fifteenth problem is that a security that participates in the residual income of a business is common equity, not preferred.
- The sixteenth problem is that Treasury and FHFA cannot prevent private investors from accessing their email records simply by marking it as privileged in a court of law as the plaintiffs have a right to know if what gets said to have happened actually happened that way or not.
- The seventeenth problem is that Treasury and FHFA officials cannot prevent officials from being deposed when plaintiffs would like to ask them questions about things that they find peculiar.
- The eighteenth problem is that Treasury and FHFA cannot sustainably win legal battles with demonstrably incomplete administrative records.
- The nineteenth problem is that FHFA provided detailed review of quarterly and annual SEC filings and the companies reviewed their deferred tax assets every quarter according to Treasury’s administrative record.
- The twentieth problem is that crushing a company’s stock price is not the same as crushing the underlying business.
The list of problems Treasury and FHFA have faced is incomplete and some have yet to happen. The biggest problem here is that poor financial conditions were not the reason Fannie and Freddie were put into conservatorship.
Treasury preferred Fannie and Freddie in conservatorship rather than out of conservatorship as a means of control since the financial conditions of Fannie and Freddie were so good that even during the crisis when everyone else seemed to be running out of money Fannie and Freddie did not actually need the money FHFA forced them to take from Treasury.
In the name of tax payers, the money has even been paid back, according to acting Treasury Secretary Jack Lew. Jack Lew says Fannie and Freddie haven’t removed the risk from the explicit federal backstop, which is interesting, because according to the White House, they don’t have one.
A forensic accounting analysis took a look and found that Fannie Mae and Freddie Mac were extremely cash profitable during the same periods of time they were manufacturing financial statements showing losses of net income on a quarterly basis. After these financial statements were produced, the very same losses they took were reversed in a later period. If you didn’t have the context of conservatorship, you might wonder how FHFA was forcing Fannie Mae and Freddie Mac to manufacture financial statements inconsistent with their cash operations.
Without conservatorship, FHFA would not have been able to run the accounting department and overrule Deloitte and PricewaterhouseCoopers and make it look like Fannie Mae and Freddie Mac were losing money when they were actually making billions of dollars of cash money per quarter. One way to remove the risk from Fannie Mae and Freddie Mac’s balance sheets would be to remove them from conservatorship because outside of conservatorship FHFA will be less able to invoke improper write downs and make it look like the businesses are falling apart when they actually aren’t.
The choice of conservatorship by Treasury has produced over $40B of net proceeds so far and is set to increase. Perhaps this is a case of Treasury seeing Fannie and Freddie as too profitable for their own good during the time of crisis and thinking that perhaps it would be better if they served the public good more than their respective charters permitted. The familiar adage goes: “Never let a good crisis go to waste.” Treasury’s and FHFA’s quest to serve tax payers has not only been closed to the public, but will continue to be closed to the public:
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The Purpose Of The Third Amendment
The year following the third amendment resulted in Fannie Mae reporting financials that made it the world’s most profitable company in history that nobody talked about because Fannie was proactively prevented from recapitalizing itself. According to prior Fannie Mae CFO Timothy Howard:
The third amendment to the senior preferred stock agreement was adopted to prevent Fannie Mae from benefiting from the reversal of extremely conservative accounting decisions made earlier
Peter J. Wallison, author of ‘Hidden in Plain Sight’ and co-director of the American Enterprise Institute’s program on financial policy studies corroborates the answer:
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Fannie Mae and Freddie Mac are in conservatorship and not receivership as Wallison was quoted as saying. Fannie and Freddie were in such good financial condition that Treasury and FHFA needed consent to put them into conservatorship and are proving to be in such good condition that prior Secretary of the Treasury Tim Geithner was afraid of Fannie and Freddie looking like a successful, profitable corporation.
The fear was not that Fannie and Freddie were a successful, profitable corporation as they have proven to be throughout the crisis. The problem was one of appearance and that Geithner thought it was dangerous if Fannie and Freddie looked as profitable as they actually are before the crisis, during the crisis, and still are today.
If nothing wrong has happened, no one should be afraid of Fannie and Freddie looking like a profitable, successful corporation. In Treasury’s case, control was and still appears to be based on Fannie and Freddie appearing to be broke so that people believe their business models are failures. The notion that appearances may be deceiving has not been lost on Treasury. It might seem that the GSEs were forced into conservatorship so that they could be forced to look like they needed to be in conservatorship so that they could be forced to stay in conservatorship so that justifications could eventually be made that transitioned the GSEs into receivership and wound them down.
There isn’t anything wrong with private companies making money and being successful. It remains to be seen whether or not there is something wrong with the aforementioned systematic way of separating profitable, successful businesses from their shareholders when every step along the way requires soliciting consent in conditions of secrecy and silence. United States District Judge Royce C. Lamberth expresses this feeling in his memorandum opinion:
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What looks like a multi-year game of hide and seek that is finally coming into focus as discovery has been fruitful in document production and depositions of key officials are currently underway and under wraps is really a game of pass the buck. Below is a picture of profits for Fannie Mae going back to 1989:
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Note that the profits are not unlike the path you’d expect to take if you came across a chicane (pictured above and below).
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A chicane is an artificial feature creating extra turns in a pathway than otherwise would be necessary. When graphed, Fannie Mae and Freddie Mac’s financial statements since they have been in government conservatorship look like a chicane. The government chicanery that is seen in the roller-coasteresque profits of the GSEs has been causing a slowing effect on the housing recovery. Fewer people today have access to mortgages through the GSEs than used to and as time passes personal credit histories that were destroyed by the crisis are being repaired which means that over time we can expect that some people who lost their homes in the crisis will come back as boomerang buyers.
June 29, 2015
Investors Unite released an analysis of the joint letter by the Community Mortgage Lenders of America and the Community Home Lenders Association to FHFA Director Mel Watt “to express concern over the Administration’s seemingly shifting narrative on the purpose of the recent Common Securitization Platform.” Investors Unite argues that placing the fate of the entire market in the hands of a select group of systemically important financial institutions will not provide for continued access to mortgage credit while insuring as much stability as possible.
In addition, the government has filed a motion for an enlargement of time to respond to plaintiffs’ motion to remove the “protected information” designation from the depositions of Edward Demarco and Mario Ugoletti. The government needs more time so that they can consult with agency counsel to obtain internal review in order to coordinate a meaningful response to Fairholme’s motion and they want fourteen days when Fairholme only was willing to approve up to seven:
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First, I would be interested to know if there was a deposition scheduled between seven and fourteen days from now. Second, asking for more time to do something on the date that something is due as opposed to in advance is a technique that I’ve seen implemented in academia amongst those who were able to put falling behind to their advantage.
Either way, it sounds like the government is going to do its best to prevent these depositions from being made public and that is important because according to the plaintiffs these depositions not being made public allows the government to provide different sets of facts to different courts. While this motioning is in Sweeney’s Court of Claims, there are claims of relevancy in the D.C. District Court of Appeals. Regardless, Sweeney granted this motion to the government less than two hours after it was filed:
Accordingly, its motion is GRANTED. Defendant shall file its response by no later than Monday, July 13, 2015.
Perry Capital LLC filed its initial opening brief for institutional plaintiffs. Perry cites Treasury’s very own administrative record as evidence that Treasury was the driving force to the companies’ supposed financial problems:
Although Fannie and Freddie haven’t had any non-conservatorship related financial problems on a cash basis, the CMLA and the CHLA think that other companies may have financial problems if the CSP is built by Fannie and Freddie and it is taken from them for use by a small group of systemically important financial institutions. As the joint letter by the CMLA and the CHLA puts it in their letter:
While on its face, a statement that the CSP could be adaptable for use by other secondary market participants sounds laudatory, in practice any such access will likely not accrue to small lenders, which do not have the ability to invest large fixed sums in staffing and systems to take advantage of issuing and hedging securities. Instead, the largest banks would be the main beneficiaries, as they can invest the sums of money to enter this marketplace and use their existing federal subsidies to help underwrite this new endeavor.
Small lenders would suffer if Fannie and Freddie are no longer able to run their business. Perry also makes it clear that FHFA had considered the Companies’ multi-billion-dollar deferred tax assets as they provided “detailed review of quarterly and annual SEC filings”:
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The benefit of the doubt appears to travel far and wide when you’re the government. The most interesting part of the filing to me is FHFA and Treasury appear to have won in Lamberth’s D.C. District Court with demonstrably incomplete records:
Summary and Valuation
Right now all but one of the shareholder lawsuits contests the Third Amendment. The Washington Federal lawsuit contests the entire conservatorship. Section 6.7 of Fannie and Freddie‘s Senior Preferred Stock Agreements sets an interesting stage:
If the entire conservatorship is unwound per section 6.7, the long term valuation for the common shares of Fannie Mae and Freddie Mac is upwards of $100.
If the third amendment is reversed and the warrants are cancelled, the long term valuation is upwards of $20.
If the following three criteria are met, Fannie and Freddie commons are worth $0:
- Third Amendment stands; and
- The accounting is not restated; and
- The conservatorship stands
Conservatorships are designed to be temporary in nature. If the above three are true, we should expect that at some point in time Fannie and Freddie would be put into receivership by the acting director of the FHFA, who presently is Melvin L. Watt. This would likely happen sometime around 2018, when Fannie and Freddie’s capital is zero, and might involve the FHFA writing down DTAs for a second time to ensure that the capital hole leaves nothing for common shareholders.