Fannie Mae-No Politics (FNMA)

[navycmdr]

The Punitive Treatment Of GSE Investors:
The Big Short, Goldman Sachs, Treasury And The FHFA

Aug. 25, 2016 8:19 AM ET| About: Fannie Mae (FNMA), FMCC


Wayne Olson, CFA

..... Summary .....

-- The market prospects of the GSE equity securities remain heavily dependent on future developments in the courts.

-- It may be useful to review some of the history of the subprime crisis, the financial crisis, and subsequent recovery of the U.S. economy and U.S. equity markets.

-- The GSEs have been treated differently from any of the other firms that were “bailed out” during the financial crisis period.

-- Investors in Fannie Mae and Freddie Mac securities should do their own due diligence.

Q1. What is the purpose of this article ?

A1. In this article, I will revisit some of the history of the subprime crisis, the financial crisis, and the conservatorship of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which are together known as the government sponsored enterprises or GSEs. I will focus primarily on trying to understand why the GSEs and their investors have been treated differently from other firms that were "bailed out."

This is an important question for GSE common and preferred investors as it affects the future prospects of the GSE common and preferred stocks. While I would tend to argue that the prospects for GSE equity investors justify the risk of investing in these securities, there is political risk, which affects both the timing and the probability of significant "upside" from holding GSE equity securities.

While the future prospects of the GSE common and preferred stocks are largely dependent on actions by the courts, we are largely in a holding pattern until the U.S. Court of Appeals, D.C. Circuit decides whether to affirm, overrule, or remand Judge Lamberth's decision back to the District Court. It is hard to predict when the Circuit Court will rule. There are continuing developments in the various other court cases as well.

Generally, the ongoing litigation in the courts has to do with the 3rd Amendment to the Senior Preferred Stock Purchase Agreements (SPSPAs). The SPSPAs are separate agreements between the U.S. Treasury (Treasury) and Fannie Mae and between Treasury and Freddie Mac. The SPSPAs were agreed to by the Federal Housing Finance Agency (FHFA) on behalf of Fannie Mae and Freddie Mac on September 7, 2012, one day after they were put intoconservatorship.

Q2. Are you familiar with the so-called "Princeton oligarchy study" ?

A2. Yes, I am. In this study, Princeton professors Martin Gilens and Benjamin Page examine whether economic elites with high income and wealth and interest groups that cater to big business have disproportionate influence relative to "average citizens." They find that there is empirical evidence that supports the theory that economic elites and the interest groups that serve big business "have substantial independent impacts on U.S. government policy, while average citizens and mass-based interest groups have little or no independent influence."

Q3. Why is this relevant to the situation facing GSE equity investors ?

A3. My working hypothesis is that economic elites and some interest groups serving big business are opposed to the continued existence of Fannie Mae and Freddie Mac as investor-owned companies. These economic elites and interest groups would prefer that the current situation continue, i.e., de facto nationalization of the GSEs and direct expropriation of the economic interests of GSE common and preferred investors.

Grand corruption is the manipulation of policies, institutions, and rules of procedure in the allocation of resources and financing by political decision makers, who abuse their position to sustain their power, status, and wealth.State capture is where private firms are able to influence public policy to their own benefit. Crony capitalism is where political networks dominate important private assets, such as the GSEs.

Note that while there is fierce opposition against the GSEs and their equity investors, there are also proponents of fair treatment of GSE equity investors. These proponents are litigating the appeal of Judge Lamberth's decision, the cases before the federal Court of Claims, and the other U.S. District Court cases.

Investors Unite is a coalition of GSE equity investors that "works to educate Fannie Mae and Freddie Mac shareholders and lawmakers of the importance of reforming the GSEs in a way that will reimburse shareholders what they are contractually and legally owed, but have not been paid."

Q4. Why is the book, The Big Short, relevant to this discussion about the GSEs ?

A5. Many GSE investors have read Michael Lewis' book, The Big Short(2010), which profiles investors, such as Michael Burry, who figured out early on that there was a bubble in the subprime and sought ways to profit from that insight.

Rather than focusing primarily on the villains of the subprime and financial crises, Mr. Lewis had the brilliant idea of focusing on who got it right--the people that saw what was happening in U.S. mortgage markets and figured out how to make investments that resulted in the realization of capital gains based on their insights. Rather than focus on the "big players" like John Paulson and Goldman Sachs, Mr. Lewis focused on smaller players such as Steve Eisman, Dr. Michael Burry, Charlie Ledley, Jamie Mai, Vincent Daniel, Danny Moses, Porter Collins, and Ben Hockett. It took time, but they turned out to be right.

Q5. Did the GSEs cause the subprime crisis ?

A5. No. While the GSEs are sometimes blamed for the financial crisis, they did not cause the crisis. According to the Financial Crisis Inquiry Commissionor FCIC, the GSEs "followed rather than led Wall Street and other lenders in purchasing subprime and other risky mortgages." One hypothesis I've thought about is that the demonizing of the GSEs and their investors is a way to change the subject, i.e., to shift the focus onto the GSEs and away from the mortgage originators and private-label securitizers that are largely to blame for the subprime crisis and the financial crisis. There is also the ideological issue--some people may dislike having a "New Deal" entity such as Fannie Mae around.

Note that Peter Wallison of the American Enterprise Institute (AEI)dissented from the FCIC report, arguing that "U.S. government housing policy" was to blame. However, I'm not aware of any government agency forcing mortgage originators to make what I will call "bad" mortgages or forcing private-label securitizers to include "bad" mortgages in private-label MBS.

Q5. If the GSEs didn't cause the subprime crisis, who did ?

A5. While that is a difficult question to answer, it is my understanding that the big banks have paid roughly $110 billion in mortgage-related fines, penalties, and/or settlements related to the mortgage crisis.

FHFA, on the other hand, has achieved settlements of about $18. 2 billion in litigation with the 18 big banks having to do with securities law violations (including fraud) in the sale of private-label securities (PLS) to the GSEs. [The financial benefits of the FHFA settlements have flowed to Treasury via the net worth sweep.]

Note the direction of these payments. The GSEs experienced losses during the 2005-2007 period, followed by payments to FHFA, many years later, to settle disputes between the FHFA (on behalf of the GSEs) and the big banks. Thus, it appears that the mortgage originators and the private-label securitizers were the ones that engaged in illegal behavior (including outright fraud).

There were numerous participants in the subprime saga and it is difficult to assign blame. Yet, the $110 billion or so that the big banks have paid out as penalties for their behavior during the 2005-2007 period is a useful indicator.

Note that FHFA or its predecessor regulatory have not been found to have acted in an illegal manner. Nor have the GSEs that the FHFA regulates.

I think the evidence points toward the correctness of the hypothesis that blaming the GSEs is a distraction, a way to change the subject away from the real culprits.

Q6. Did Goldman Sachs sell mortgage-backed securities (MBS) to the GSEs during the 2005-2007 period based on inadequate disclosure ?

A6. Yes. On August 22, 2014, Goldman Sach's inadequate disclosure to the GSEs led to a $1.2 billion settlement with the FHFA with respect to violations of federal and state laws resulting from private-label MBS purchased by the GSEs between 2005 and 2007.

Separately, on April 11, 2016. Goldman Sachs agreed to a $5.06 billion settlement with the U.S. Department of Justice, which includes a $2.385 billion civil monetary penalty pursuant to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), certain consumer relief, and other agreed upon terms.

In return, Goldman Sachs is released from "any civil claim the United States has against the Released Entities for the Covered Conduct." Thus, Goldman Sachs is released from claims arising from:

FIRREA, 12 U.S.C. § 1833a; the False Claims Act, 31 U.S.C. §§ 3729, et seq.; the Program Fraud Civil Remedies Act, 31 U.S.C. §§ 3801, et seq.; the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §§ 1961, et seq.; the Injunctions Against Fraud Act, 18 U.S.C. § 1345; common law theories of negligence, gross negligence, payment by mistake, unjust enrichment, money had and received, breach of fiduciary duty, breach of contract, misrepresentation, deceit, fraud, and aiding and abetting any of the foregoing; or that the Civil Division of the Department of Justice has actual and present authority to assert and compromise pursuant to 28 C.F.R. § 0.45.

Goldman Sachs has even admitted its guilt by agreeing to a "list of facts" as part of the $5.06 billion settlement with the U.S. Department of Justice. The quotes in the following paragraphs are from that agreed-upon statement of facts. Some of these facts include:

1. Goldman's Mortgage Capital Committee rubber-stamped MBS transactions. "Goldman's Mortgage Capital Committee typically received memoranda detailing each proposed securitization, including summaries of Goldman's due diligence results for certain of the loan pools backing the securitization. Despite the high numbers of loans that Goldman had dropped from the loan pools, the Mortgage Capital Committee approved every RMBS that was presented to it between December 2005 and 2007."

2. Goldman made untrue representations to investors about the characteristics of the underlying loans. "[I]n the due diligence process, Goldman received information indicating that, for certain loan pools, significant percentages of the loans reviewed did not conform to the representations made to investors about the pools of loans to be securitized."

3. Goldman made untrue representations to investors about Goldman's due diligence process for scrutinizing mortgage originators. Goldman made detailed representations to investors about its due diligence with respect to vetting loan originators and informed investors and one rating agency that Goldman would engage in ongoing monitoring of loan sellers. Goldman acknowledges in the statement of facts that it "received certain negative information regarding the originators' business practices" and that this information was not disclosed to investors.

Part of the problem with Goldman's attempts to compete in the private-label MBS markets has to do with the labor and time intensive aspects of the mortgage securitization process. Unlike the GSEs, Goldman Sach's business model may not be well suited for the detailed and thorough due diligence that mortgage securitization requires. Thus, the Statement of Facts details examples where Goldman didn't do what it said it would regarding due diligence of the underlying mortgages in its MBS as well as its failure to adequately disclose its due diligence results to investors.

Goldman Sachs also had difficulties overseeing its originators. [The GSEs also had difficulties related to its dealing with originators during the 2005-2007 period.] For example, in its dealings with Countrywide Home Loans as described in the Statement of Facts, "Goldman did not disclose to investors that it had identified certain issues with Countrywide's origination process."

As another example, Goldman's prospectus supplements for its late-2006 and early-2007 MBS deals with Fremont Investment & Loan backed by Fremont loan transactions, Goldman did not disclose to investors that it believed that "certain of Fremont's 'soft' underwriting guidelines were 'off market' or 'aggressive.' Instead, Goldman 'ndertook a significant marketing effort' to tell investors about what Goldman called Fremont's 'commitment to loan quality over volume' and 'significant enhancements to Fremont underwriting guidelines.'" It is my understanding that Fremont was shut down by federal regulators within several months of these statements. [In The Big Short, a footnote (p. 158) describes a meeting that Steve Eisman had with Fremont's CEO in January 2007, where he asserted that expected losses would run at a five percent rate. Nine months later, Fremont acknowledged that 30 percent of its subprime loans were in default.]

Goldman Sachs, famously, realized that the MBS markets were going to"implode" before the other major financial institutions did, making profits instead of losses out of the subprime crisis. The source of this insight may have been a December 10, 2006 report from the CEO of Senderra, a subprime mortgage lender partly owned by Goldman. The Statement of Facts mentions that:

Goldman also received information about risks in the mortgage market from Senderra, a tiny regional originator in which Goldman had previously acquired a 12.5 percent stake. On December 10, 2006, the Chief Executive Officer of Senderra sent an email to, among others, a Goldman mortgage department manager, with observations regarding the 'dramatic shifts and disruption in the industry.' Senderra's CEO noted that credit quality had become a 'major crisis' across the subprime market, and that 'nvestors ha[d] taken a strong stand' in response to 'unprecedented defaults and fraud in the market' and were 'pushing loans back to originators/lenders in record numbers.' The Senderra executive noted that some originators had announced publicly that they were shutting down due to increasing EPD claims. The Senderra executive also reported seeing increasing numbers of loans in the market with 'inflated appraisals, inflated income and occupancy fraud.'

Goldman figured out the problems in subprime markets early on, perhaps helped by its affiliate Senderra. Not to mention that, according to The Big Short, Michael Burry was buying credit default swaps on particular mortgage-backed securities via transactions with Goldman Sachs and Deutsche Bank, which may have clued Goldman in. Note that Goldman was acting as an intermediary--Goldman wasn't the ultimate seller.

There is also Matt Taibibi's famous "vampire squid" article on Goldman Sachs. Mr. Taibibi writes that:

The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who's Who of Goldman Sachs graduates.

I don't want to imply that Goldman Sachs singlehandedly "caused" the financial crisis. For example, FHFA has pursued lawsuits against 18 big banks, not just Goldman Sachs.

Q7. When was the "net worth sweep" first considered ?

A7. It's hard to say. However, the August 28, 2008 draft "keepwell agreement," which was an early version of the SPSPAs, includes a reference to an "excess capital sweep." While no details are provided, this may be an early reference to what became the net worth sweep, which was announced on August 17, 2012. The net worth sweep amounts to the direct expropriation of GSE equity investors, with the GSEs' transferred to the U.S. Treasury rather than to the GSEs investors.

Q8. Have the GSEs engaged in "lobbying" since the conservatorship was announced on September 6, 2008 ?

A8. No. Before the imposition of conservatorship, the GSEs engaged in substantial lobbying efforts, allegedly totaling $200 million during a 10 year period. Since the conservatorship, the GSEs have not engaged in lobbying.

On September 7, 2008, the Director of the FHFA, James Lockhart, stated that"Eighth, all political activities-including all lobbying-will be halted immediately. We will review the charitable activities."

This prohibition of all political activities, including lobbying, by the regulator is highly unusual, if not unprecedented in the regulation of investor-owned firms in the U.S. One usually thinks of Argentina, Cuba, and Russia as the kinds of places where something like this can happen.

Q9. Who said "never let a crisis go to waste" ?

A9. While he is not necessarily the first to say this, Rahm Emanuel made this point at a Wall Street Journal CEO Conference in Washington, D.C. on November 18, 2008. To be precise, Mr. Emanuel said that:

You 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. I think America as a whole in 1973 and 1974, and not just my view but obviously the administration's, missed the opportunity to deal with the energy crisis that was before us. For a long time our entire energy policy came down to cheap oil. This is an opportunity, what used to be long-term problems, be they in the health care area, energy area, education area, fiscal area, tax area, regulatory reform area, things that we have postponed for too long, that were long-term, are now immediate and must be dealt with. This crisis provides the opportunity, for us, as I would say, the opportunity to do things that you could not do before. The good news, I suppose, if you want to see a silver lining, is the problems are big enough that they lend themselves to ideas from both parties for the solution.

While it would be difficult to trace causality between what Rahm Emanuel said and what Hank Paulson did, it's become more-and-more clear that both the GSE conservatorship and the 3rd Amendment were orchestrated efforts to nationalize the GSEs and expropriate GSE equity investors without the protections provided by "due process." Therein lies both the opportunity and the risks associated with investments in GSE common and preferred stocks. It really is up to the courts to decide.

Q10. Has a document dated December 20, 2010 come to light that indicates the Administration's commitment to what is now known as a net worth sweep ?

A10. Yes. An Action Memorandum for Secretary Geithner December 20, 2010 states that:


Legal journalist Alison Frankel discusses this document here.

Q11. Has FHFA discussed the role that GSE common and equity investors play in the oversight of the GSEs. ?

A11. No. GSE common and preferred equity investors continue to exist on the GSEs' balance sheets. Nevertheless, the FHFA focuses exclusively on the GSEs' Senior Preferred Stock and ignores the GSEs' common and preferred equity investors.

In the FHFA's 2012 Strategic Plan, the FHFA states that:

One problem I see is that the GSEs' common and preferred investors have never been explicitly expropriated. It's been done in a circuitous manner via the SPSPAs and the Senior Preferred Stock certificates. Circuit Court Judge Ginsburg and Judge Brown should be capable of recognizing that the 3rd Amendment had the economic effect of a direct expropriation of GSE investors.

With respect to the Administrative Procedures Act of 1935, none of the normal "due process" procedural constraints, i.e., notice, reasons and evidence for their actions, hearing, arguments and evidence have been followed. I have discussed this issue here, here, and here.

Q12. What conclusions would you draw ?

A12. It's difficult to resist the temptation to conclude that the GSEs and their equity investors have been treated differently--and punitively--relative to the other firms that were "bailed out" during the 2008-2009 period. Thus, we are left with waiting for the courts. It remains hard for me to believe that what Treasury/FHFA did is 100 percent legal, but political risk remains my chief concern.

In an earlier article, I identified some possible "catalysts" for a shorter holding period. I quote from that article here:

Favorable ruling by the U.S. Court of Appeals on the 3rd Amendment litigation. Briefing is scheduled to end in November 2015. Oral argument is not yet scheduled. A decision would be expected by June/July 2016-it is my understanding that the usual guess is that an appeals decision will issue 6-12 months after oral argument. Outcomes could include granting of the requested relief, i.e., remand to the lower court with instructions to reverse the 3rd Amendment, among others. Of course, far less favorable outcomes are also possible, including an appellate decision upholding Judge Lamberth's decision.

As it turned out, oral arguments were held on April 15, 2016. My estimate of a 6-12 month lag in that article implies a decision sometime after October 15, 2016. While I've argued in the past that a decision in August 2016 is plausible (clerks typically leave at the end of August and this case will require a lot of effort on the clerk's part), it is impossible to predict exactly when the Circuit Court will review.

There are other court cases as well, including cases at the federal Court of Claims.

Disclosure: I am/we are long FMCKJ, FNMAS, AND OTHER GSE PREFERRED STOCKS.

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.