DC Jury Decides GSE Shareholder Contracts Breached
Aug. 17, 2023 5:44 PM ET - Glen Bradford
Summary
Fannie Mae and Freddie Mac shareholders win legal victory as jury finds FHFA acted arbitrarily in entering into Net Worth Sweep.
Pending equity restructuring includes warrants, common shares, junior preferred shares, and senior preferred shares.
There are significant, follow on implications for other cases now that a jury has decided that the government breached the implied covenant of good faith.
As of August 14, 2023, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) shareholders have a new legal victory to celebrate. After a decade of uphill legal battles, shareholders have finally notched a win, but the potential impact to outcome is much more significant than the monetary damages awarded by the jury which decided:
FHFA, in its role as the Conservator of Fannie Mae and Freddie Mac, acted arbitrarily or unreasonably in entering into the Net Worth Sweep, thereby violating the reasonable expectations of holders of Fannie Mae junior preferred stock, Freddie Mac junior preferred stock, and/or Freddie Mac common stock
Question #1 Verdict
Question #1 Verdict (glenbradford.com)
Fannie and Freddie have been retaining earnings since 2019. Fannie and Freddie have more net worth than ever before in history since their guarantee fees have roughly doubled during conservatorship. There are four components to their pending equity restructuring:
Warrants (Government Owned).
Common Shares.
Junior Preferred Shares.
Senior Preferred Shares (Government Owned).
I only recommend owning junior preferred shares because they have dilution protection in an administrative reform outcome and the strongest legal claims in a court-led outcome.
Investment Thesis
This either gets resolved via administrative action or court action. This marks the first major FHFA loss in court where a jury unanimously decided that FHFA breached the implied covenant of good faith built into the contract rights of shareholders.
Outside of administrative reform, courts will resolve this. This jury awarded damages of $611M to shareholders. Judge Lamberth did not let plaintiffs present the expectancy reliance damage model which would have opened the door to damages closer to the outstanding par value of junior preferred, $34B+. Nearly every available damage model is designed to pay out face value to preferred shareholders, expectancy, restitution, reliance, etc. The damage model that went to trial is extremely controversial. FHFA has 60 days from the verdict to file notice of appeal. If I was Arnold and Porter I would be recommending to their client that if they wanted to proactively end the conservatorship now would be a good time to do so. Should they pursue appeal and go the court route, they risk facing a damage model that actually fits the breach of contract that a jury has decided they committed.
This court ruling in my view only helps the case for administrative reform. In an administrative solution, since the companies are retaining earnings --- receivership is off the table and junior preferred would be made whole in the process. The companies would likely turn on junior preferred dividends to settle the pending litigation while they move forward with recapitalization and release. Junior preferred would trade up to face value.
Fannie Mae Q2 2023
Fannie Mae made $5B in Q2 2023. The SPS liquidation preference was $185B and the net worth was $69B. Fannie Mae CEO Priscilla Almodovar declared Fannie Mae has been transformed on the quarterly call:
You know, this fall marks 15 years since Fannie Mae was placed in conservatorship. A lot has changed since that time. Today, Fannie Mae has been transformed. Fannie Mae is safer and stronger, thanks to years of work to improve the resiliency of our business and our steadfast focus on strong risk management. Because of this, we continue to be a stabilizing force in the market and to deliver on our mission, like we did through the COVID-19 pandemic, and how we're doing now through this challenging economic cycle. We are committed to being a reliable source of liquidity and stability to the housing finance system in the United States.
Fannie Mae has more money than they ever have had in history and the government still has them in conservatorship.
Freddie Mac Q2 2023
Freddie Mac made $2.9B in Q2 2023. The SPS liquidation preference was $111B and the net worth was $42B.
Freddie Mac has more money than they ever have had in history and the government still has them in conservatorship.
Shareholder Attorney Provides Context On Size of $611M Legal Win
The lead attorney for the shareholders compares the $611M legal victory to the $32B that shareholders invested as reported by National Mortgage Professional:
The government deserved and would have received, without the net worth sweep, a huge profit on its investment. But it was not entitled to 100% of all profits forever. That was not the deal made in September 2008. Private preferred shareholders invested over $32 billion, of which $20 billion was at the behest of government regulators during the housing crisis years of 2007 and 2008.
If FHFA allows this verdict to be appealed, it risks losing an upsized reliance damage model of $32B when it is in a position to resolve this now for much less. This puts FHFA is in a unique position to cap their litigation losses before they potentially balloon. They have about 60 days to appeal or pursue other options.
2023 Stress Tests
August 10th, FHFA released the 2023 Dodd-Frank Act Stress Test Results. The stress test results result in Fannie and Freddie making a combined $9.9B even if equity prices fall by 45% and home prices decline 38%. Under these conditions, FHFA does forecast that if they are able to use their discretionary accounting authority to write down Fannie and Freddie's assets like they did in 2008, the companies would lose $8.4B. Even with the loss the companies on a combined basis since they have been able to retain earnings since 2019 would have a net worth of $88.9B in this worst case scenario.
My perspective is that guarantee fees doubled during conservatorship and it is much harder to drain a bathtub when you pour in water as fast as it drains out, which is basically what happens to achieve these stress test results whereas in the past earnings were half what they were today and you could accumulate a few years of losses --- now even if the economy falls apart Fannie and Freddie stay afloat on earnings alone.
Meanwhile, FHFA currently has a Capital Framework which says they are undercapitalized and holds them hostage in conservatorship, but it looks like they are trying to do something about it.
FHFA put out an RFI and the intellectually honest submissions (I was able to find one exception by the guy who signed the net worth sweep that a jury ruled to be a breach of contract) all seem to call for a reworking of the ERCF which makes sense in the context of these stress test results. I walk through a handful of these submissions below and the growing chorus for admin reform now supported by this legal ruling.
FHFA's RFI On GSE Single Family Mortgage Pricing Framework
In May 2023, FHFA put out a request for input for Fannie Mae and Freddie Mac Single-Family Mortgage Pricing Framework. The basic purpose of this RFI is to solicit industry feedback on how it should match pricing up with the capital requirements imposed by the Enterprise Regulatory Capital Framework - ERCF. The industry has responded with comments and feedback. The overwhelming response to the FHFA RFI has been to streamline the capital rule and step aside.
Urban Institute
The most notable shift in my opinion coming from this RFI is the more administrative reform positioning coming from Urban Institute. Urban Institute has really evolved their perspective to be more supportive of a utility model and raising new third-party capital which is a positive shift in support of administrative reform. Urban Institute forecasts a need for Fannie and Freddie to raise private capital:
In either case, they will need to raise private capital, which will require a return attractive enough for whichever of the two models is chosen.
Urban Institute says that the ECRF needs to be revised lower:
The GSEs' approach to pricing strikes us as reasonable, but it suffers from a capital framework unnecessarily tethered to the Basel framework. The risk-invariant components and complexity of that framework are arguably appropriate for large banks, given the number and complexity of the risks they manage, but they make little sense for Fannie Mac and Freddie Mac. Applied to the GSEs, they exert unnecessary upward pressure on pricing, pressure that has been borne by the GSEs thus far but, at some point, will be passed along to the consumer. Before that happens, the FHFA should revise the requirements, removing a headwind to homeownership and better aligning the GSEs' pricing with their risk.
Lower capital requirements and raise new third-party capital is the path forward according to Urban Institute.
Community Home Lenders of America
The CHLA argues in its letter that the objective of the capital rule is for Fannie and Freddie to exit from conservatorship:
Second, while CHLA supports a key underlying objective of that capital rule - the exit of Fannie Mae and Freddie Mac from conservatorship - given the current political realities, such exit appears to be a remote, if not non-existent, possibility. In an ideal world, we would either roll back excessive fee hikes to raise capital or move forward to exit from conservatorship. Instead, arguably, we have the worst of both worlds.
The CHLA seems to think that the Biden administration is unwilling to let Fannie and Freddie recap and release and exit from conservatorship. Note that they may have submitted this letter before the legal ruling came out.
After the legal ruling came out, Rob Zimmer said that this legal ruling cements the future of Fannie and Freddie being recapped and released despite not knowing the exact timing of when:
Rob says this legal ruling cements R&R
Rob says this legal ruling cements R&R (Twitter)
Rob Zimmer seems to have reviewed the bulk of the responses to RFI etc. Rob's comments align with CHLA's Scott Olson's from last year too:
My personal opinion is that the best approach is for Fannie and Freddie to exit conservatorship under a true utility model using the housing mission tools of HERA, a vigilant FHFA that makes sure the GSEs do not take on dangerous levels of risk to maximize shareholder profit, and an explicit federal backstop to establish MBS investor confidence.
CHLA is very supportive of administrative recap and release and believes it is an eventuality --- just a matter of when.
Mortgage Bankers Association
The Mortgage Bankers Association is telling FHFA that the ERCF shouldn't be based on Basel III. Fannie and Freddie are not banks! They should have a simple capital requirement that is based on actual risk. This reads like a nudge to lower the capital requirements. Seems like there is consensus from most interested parties on this topic:
MBA RFI Feedback Ending
MBA RFI Feedback Ending (FHFA)
Prior CEO of MBA David H Stevens declares this court ruling a landmark win for GSE Shareholder interests and had this to say on HousingWire:
The victory in Berkley vs. FHFA is sweet for shareholders, notably in that it's their first one since the beginning of conservatorship, said David Stevens, a former Federal Housing Administration commissioner and Mortgage Bankers Association president.
"Whether this sets the tone for a new direction for the conservatorship is yet to be seen," Stevens said. "But without question, a political leadership that oversees these two companies in Washington will be likely focusing on options ahead. While the jury awarded less than what was asked for by the plaintiffs, it is without question victory for the shareholder interest. What happens next will be interesting."
David H Stevens has come full circle this year as he is advocating for administrative reform to end the conservatorships of Fannie and Freddie as a means of solving their political problem brought on by making the FHFA director a political appointee thanks to the SCOTUS ruling in Collins vs. Yellen.
Center for Responsible Lending
The CRL has replied, arguing that the ERCF needs to be considered and recalibrated to take into consideration the actual financial risks of Fannie and Freddie:
The case for reconsidering the Enterprise Regulatory Capital Framework ("ERCF") is clear and compelling.
Developments over the past two and a half years have made it even clearer that the ERCF is seriously flawed.
The ERCF stands as an obstacle to progress on these fronts. Given the stress test results, the developments since the adoption of the ERCF that have reduced the GSEs risks, and the multiple fallacies of the ERCF itself, FHFA should reconsider the amount of capital required by the ERCF and the ERCF's definition of what constitutes capital.
And, so long as the GSEs are expected to achieve a "reasonable rate of return" on an unreasonably large capital base-currently over $300 billion- it will be difficult, if not impossible, for the GSEs to pursue such initiatives at the scale needed to fulfill their mission.
Independent Community Bankers of America
The ICBA has replied calling for FHFA to work with the U.S. Treasury to restructure its ownership stake in Fannie and Freddie in order to attract:
ICBA therefore strongly urges the FHFA to establish a revised single-family pricing framework alongside a roadmap for the Enterprises to raise outside equity, eventually exit conservatorship, and to do so with a clear vision of their ongoing role in the secondary housing market.
Absent any changes to the preferred stock purchasing agreements (PSPAs), this means that they will then be required to resume sweeping any excess earnings to the Treasury, effectively making it impossible to exit conservatorship. ICBA has long argued that a perpetual conservatorship is unacceptable and unsustainable.
Without acknowledging that the GSEs need to prepare to exit conservatorship, there is little incentive to materially change to ROE to a rate that would make them competitive for investor funding as semi-private companies. This concern is exacerbated by the fact that the GSEs remain undercapitalized according to the existing ECRF and that the government's ownership of the Enterprises remains unresolved. As mandated by the Housing and Economic Recovery Act (HERA), FHFA must therefore collaborate with the U.S. Treasury to begin the process of resolving the government's ownership of Fannie Mae and Freddie Mac.
After nearly fifteen years of conservatorship, ICBA is greatly concerned that the lack of progress in resolving this issue by FHFA and the Treasury endangers the safety and soundness of both Enterprises and could pose a threat to the stability of the mortgage market.
The ICBA call for Treasury to work with FHFA to resolve its equity interests in Fannie and Freddie aligns with charting their path out of conservatorship.
NAFCU
NAFCU provided a comment letter which speaks for itself:
Until the FHFA can articulate its expectations for returns while supporting high capitalization and low rates, the FHFA should not control guarantee fees for the GSEs. NAFCU supports allowing the GSEs to ultimately be removed from their conservatorships and recognizes that goal would be delayed by substandard returns.
The GSEs need to make returns that support their capital requirements according to NAFCU in order to ultimately exit conservatorship.
National Association of Realtors
NAR targets ROE based on utilities:
Furthermore, the FHFA should formally adopt a return on equity (ROE) appropriate for market utilities, implement a cap and floor on ROE, explore an explicit government guarantee, and must establish a robust and durable process for establishing appropriate returns at the Enterprises during conservatorship and after.
NAR also focuses on life after conservatorship:
The FHFA should continue its important work to develop a process that sets a band of returns for the Enterprises' cost of capital to use in establishing their g-fees and pricing outside of conservatorship.
NAR also says that the capital required by the ECRF is excessive:
These implied ROEs are appropriate to the Enterprises but were achieved for the wrong reason; the level of capital in ECRF is excessive.
If the FHFA adjusts the ECRF so that the companies can hold less capital than their current ECRF, then NAR will be happy.
Housing Policy Council
This letter is signed by Ed Demarco, the guy who signed the net worth sweep that the jury just ruled to be a breach of contract and was submitted the same day the jury ruled that his actions breached the shareholder contracts.
Ed Demarco argues that the Basel III Proposal Conflicts with the FHFA ERCF. Further, he notably recommends increasing guarantee fees to support the ERCF. I couldn't find any other comment letter where someone else is arguing for increased fees like Ed Demarco of the Housing Policy Council appears to be:
The FHFA commentary on the recent pricing changes focus in part on the need to generate sufficient returns to satisfy the capital standards set forth in the Enterprise Regulatory Capital Framework (ERCF). HPC is on record supporting the ERCF, recognizing that small adjustments may be necessary. The current framework reflects the substantial research and analysis performed by FHFA and the Enterprises as well as extensive commentary from stakeholders. The existing ERCF was promulgated following a full comment period, which provided the opportunity for meaningful input from all sectors of the mortgage industry. No standard will ever fully satisfy every housing stakeholder, but this ERCF represents a well-developed compromise. We recommend that FHFA retain the ERCF and require pricing levels that will allow the Enterprises to earn FHFA's targeted rate of return in accordance with the ERCF, over a reasonable period of time.
Leave it to Ed Demarco to argue for additional increases to guarantee fees that completely ignore the recent stress test results and the doubling of guarantee fees during conservatorship. His perspective seems to have fallen out of step with Urban Institute.
Breach of Contract Damage Models
If you have not been closely following the developments, it is worth noting that Judge Lamberth rejected all four damage models presented by the plaintiffs - namely, expectancy, restitution, reliance, and the lost share alternative - prior to the trial. The plaintiffs are now seeking to appeal these decisions with the aim of obtaining a damage model that aligns more closely with their actual financial loss due to the net worth sweep.
During the trial, Judge Lamberth allowed one specific damage model to proceed, resulting in a relatively modest damages amount of $611 million. However, this outcome has stirred controversy due to the nature of breach of contract damages models, which are designed to restore the injured party to their pre-breach state. In the context of junior preferred shares, this would involve receiving a payout close to the face value. While the plaintiffs achieved a favorable outcome in the trial, the damages awarded were notably smaller than what one would anticipate in a breach of contract case, where the typical outcome is closer to a payout that would be closer to the original value of the contract, or "par." I've heard estimates anywhere between 8-18 months for the duration of such an appeal.
Expectancy
The concept of "Expectancy" entails restoring the non-breaching party to the state they would have been in had the breach not occurred. This involves considering the repayment of the liquidation preference that would have been received and factoring in the principal amount along with pre-judgment interest at a rate of 6%, approximately equaling 150% of the principal.
Restitution
"Restitution," on the other hand, centers around ensuring that the breaching party returns any net benefits acquired through the contract. This involves deducting any gains obtained by the non-breaching party as a result of the contract.
Reliance
The principle of "Reliance" seeks to reinstate the plaintiff parties to the position they were in prior to entering into the contract.
The reliance damages model were in my view incorrectly not addressed by this Jury because Lamberth prevented them from going to trial twice due to timing issues, not because they were not a valid damages model.
CapWealth's Pagliara on American Banker
In response to this ruling, some have speculated that FHFA will appeal, but FHFA said they will review and determine post-trial options according to American Banker:
"FHFA, Fannie Mae and Freddie Mac are disappointed in the verdict," an agency spokesman wrote in an email to American Banker. "FHFA will review the verdict and determine post-trial options."
In fact, GSE Shareholder Tim Pagliara says not so fast:
But a move to challenge the verdict would not be a risk-free proposition for the FHFA, Tim Pagliara, chief investment officer of the financial advisory firm CapWealth, said.
"If the government appeals the verdict, it could backfire and the $612 million verdict could balloon to over $30 billion because the government could be forced to pay 100% of the preferred stock that they breached the contract on," Pagliara, whose clients are GSE shareholders, said. "There is controversy surrounding the damage model that the jury was allowed to consider in the trial that was just completed."
I believe Tim Pagliara is referring to the reliance damages model that Lamberth prevented from going to trial twice which effectively equals par less cumulative dividends.
Tyler vs. Hennepin
GSE Shareholder Plaintiff Bryndon Fisher points to Tyler vs. Hennepin as a means to try and get his case heard in the federal circuit arguing that his case was wrongly decided and this new Supreme Court ruling changes everything.
I applaud Bryndon Fisher's legal efforts. Below is the overall most recent litigation calendar from the end of last month:
July Litigation Calendar
July Litigation Calendar (Twitter)
You will note that Oral arguments in Collins vs. Yellen are early next month.
Risks
Fannie and Freddie shareholders could continue to lose all the lawsuits and the government could keep them in conservatorship despite eventually retaining enough earnings to be adequately capitalized. The world could fall apart and become unrecognizable with more devastating economic consequences than outlined in the 2023 Stress Test and the companies could be placed into receivership where existing shareholders are zeroed out. Common shares could be diluted out of any material upside in any equity restructuring.
I think the biggest risk is really one of time. I've been in this trade since 2014. I thought that this would get resolved by the original Lamberth ruling that went completely opposite to my interpretation of the law. What is ironic is that the day before the 8 Jury members unanimously decided FHFA breached the contracts, they requested to have the law provided to them so they could read it for themselves. It is nice to see a panel of 8 Americans read the law and interpret it the same way I have in a world where no court seems to agree with prior FHFA director Mark Calabria's interpretation of the law.
Summary and Conclusion
The current Biden administration has been silent on the issue for restructuring its equity position in Fannie and Freddie but I suspect that will not be the case during the rest of the Biden admin and I believe that this jury verdict opens up a path for moving forward with an administrative initiative to release Fannie and Freddie from conservatorship. The overwhelming response to FHFA's RFI has been to set the ECRF to be more in line with current guarantee fees in a post-conservatorship environment and to solicit input from US Treasury. I found a family office note that summarizes the impact of this legal ruling nicely:
Family Office CIO Note
Family Office CIO Note (Twitter)
I recommend junior preferred shares because in any equity restructuring that happens outside of receivership they are made whole in addition to having strong enough legal claims now that they have won breach of contract to have a path forward of seeing par under a reliance damages model.
