Fannie Mae (FNMA)

[camacho]

Yale Law Prof opinion paper on stealing FnF:

STEALING FANNIE AND FREDDIE

Jonathan Macey1 and Logan Beirne2

1 Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law
School.

2 ISP Fellow, Yale Law School.

3 According to Forbes Global 500, available at
http://money.cnn.com/magazines/fortune/global500/2013/full_list/?iid=G500_sp_full.

Politicians are running rough-shod over the rule of law as they seek to rob private citizens of their
assets to achieve their own amorphous political objectives. If we were speaking of some banana
republic, this would be par for the course – but this is unfolding in the United States today.



“The housing market accounts for nearly 20 percent of the American economy, so it is critical that
we have a strong and stable housing finance system that is built to last,” declares the Senate
Banking Committee Leaders’ Bipartisan Housing Finance Reform Draft. The proposed
legislation’s first step towards this laudable goal, however, is to liquidate the government-
sponsored enterprises Fannie Mae and Freddie Mac – in defiance of the rule of law. This paper
analyzes the current House and Senate housing finance reform proposals and faults their modes of
liquidation for departing from legal norms, thereby harming investors and creditors, taxpayers, and
the broader economy.

Under proposals before Congress, virtually everyone loses. First, the GSEs’ shareholders’ property
rights are violated. Second, taxpayers face the potential burden of the GSEs’ trillions in liabilities
without dispensing via the orderly and known processes of a traditional bankruptcy proceeding or
keeping the debts segregated as the now-profitable GSEs seek to pay them down. Finally, the rule
of law is subverted, thereby making lending and business in general a riskier proposition when the
country and global economy are left to the political whims of the federal government.



I. Background


The Federal National Mortgage Association (commonly known as “Fannie Mae”) and the Federal
Home Loan Mortgage Corporation (“Freddie Mac”) are privately owned, for-profit mortgage
finance companies whose shares trade on the New York Stock Exchange and remain two of the
largest companies in the world, as measured by both asset value and revenue.3 They are known as
“government sponsored entities” (“GSEs”) due to their federal charters, which charge each with
providing stability and assistance to the secondary mortgage market and promoting access to
mortgage credit.

Fannie Mae was created as federal government agency by Congress in 1938 amid the en masse
mortgage defaults of the Great Depression. It was charged with creating a liquid market for
residential mortgage-backed securities, with the aim of encouraging homeownership. Fannie Mae
succeeded in its mission of creating a liquid market, but in the process accumulated substantial
debt. In fact, it grew so large that by 1968 President Lyndon Johnson, faced with mounting public
debt during the Vietnam War, moved Fannie Mae’s debt portfolio off of the federal government’s


balance sheet by converting it into a publicly traded company owned by investors.4 Mirroring
Fannie Mae, Freddie Mac was then created in 1970 to prevent its predecessor from acting as a
monopoly. It eventually went public in 1989. Both were consistently highly profitable over the
decades and are now responsible for backing 90% of mortgages.

4 For a succinct overview of the GSEs’ history, see Kate Pickert, “A Brief History of Fannie Mae
and Freddie Mac”, Time Magazine (July 14, 2008), available at
http://content.time.com/time/business/article/0,8599,1822766,00.html.

5 12 U.S.C. § 1455(h) (2006) (regarding Freddie Mac’s obligations and mortgage-backed
securities); id. § 1719(b) (regarding certain Fannie Mae obligations); id. § 1719 (d), (e)
(regarding Fannie Mae’s mortgage-backed securities and subordinated or convertible
obligations). David Reiss, The Federal Government's Implied Guarantee of Fannie Mae and
Freddie Mac's Obligations: Uncle Sam Will Pick up the Tab, 42 GA. L. REV. 1019, 1023.

6 David Reiss, The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's
Obligations: Uncle Sam Will Pick up the Tab, 42 GA. L. REV. 1019, 1025.

7 White House Office of the Press Secretary, Obama Administration Auto Restructuring
Initiative (Apr 30, 2009) (www.whitehouse.gov/the_press_office/Obama-Administration-Auto-
Restructuring-Initiative).

8 See, e.g. A. Joseph Warburton, Law And The Financial Crisis: Economic Regulation During
Turbulent Times, 60 Syracuse L. Rev. 531.

Historically, the federal government has explicitly refused to guarantee the companies’ liabilities.
By statute, securities issued by Fannie Mae and Freddie Mac must contain an explicit disclaimer
that they are “not guaranteed by the United States and do not constitute a debt or obligation of the
United States.”5 As a longtime practical matter, however, the two companies “are so deeply
enmeshed in the regulatory regimes of other American financial institutions that the federal
government has effectively signaled that it would support Fannie Mae and Freddie Mac if they
were unable to make payments on their obligations.”6 This largely came to pass during the
financial crisis of 2008.



II. Flawed Model: Chrysler and General Motors


During the severe economic downturn of 2008, many institutions suffered. The federal
government’s reaction was as chaotic as it was mixed – e.g. orchestrating the sale of Bear Stearns,
allowing Lehman Brothers to fail, propping up Citigroup on favorable terms, bailing out AIG
multiple times. For automotive giants, Chrysler and General Motors, the government resorted to a
“political bailout.”

Instead of the traditional bankruptcy reorganization process, the Obama Administration opted for
a “quick and surgical” reorganization that would “make it easier for Chrysler and General Motors
to clear away old liabilities.”7 The bankruptcy process is meant to follow standard rules in which
the proceeds of unencumbered assets are distributed to creditors according to a strict priority
schedule, governed by the nature of each creditor’s claim. Secured creditors, such as bondholders,
come before the unsecured creditors, which in the case of Chrysler and General Motors included
union health and retirement funds.8


However, the unsecured – but politically powerful – United Auto Workers union (“UAW”) was
offered special treatment. The Obama Administration tied the large sums owed to the UAW to the
companies’ assets rather than discharging these liabilities along with the other unsecured
creditors.9 In this way, the Government elevated the unsecured claims of organized labor above
the secured claims of investors, overturning well-established creditor priorities in bankruptcy. This
comes in spite of the Bankruptcy Clause’s uniformity requirement, which has long held to prohibit
Congress from enacting bankruptcy laws that specifically apply to just one named debtor.10
Following a comparable, politically-motivated course of action with Fannie Mae and Freddie Mac
would be detrimental to taxpayers, lenders, and the economy at large.

9 Id.

10 Railway Labor Executives’ Assn. v. Gibbons, 455 U.S. 457.

11 Particularly, the Office of Federal Housing Enterprise Oversight.

12 Fannie Mae and Freddie Mac had reported losses and faced sinking share prices but were
nevertheless able to meet all obligations to all creditors up to and including when placed into
conservatorship.

13 3 See, e.g., FDIC, RESOLUTIONS HANDBOOK 70–71 (2003), available at
http://www.fdic.gov/bank/historical/reshandbook/index.html

(last visited Feb. 19, 2014)

14 12 U.S.C. § 4617(b).

15 In May 2009, this amount was extended to $200 billion.



III. Federal Takeover


As the mortgage crisis gain momentum in 2007, Fannie Mae and Freddie Mac bowed to pressure
from its federal overseers and began to purchase subprime and other risky securities in order to
support the economy.11 Partially as result of this increase in subprime holdings, the companies
were hit hard by the financial crisis of 2008.12

Although the GSEs never reached the point of insolvency, they experienced heavy losses and
Congress enacted the Housing and Economic Recovery Act of 2008 (“HERA”), pursuant to which
the federal government placed the companies into conservatorship. 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.13 Under
section 1145 of HERA, the Federal Housing Finance Authority (“FHFA”, the independent federal
agency that regulates the Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks) 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.”14

Acting via the Secretary of the United States Treasury (“Treasury”) and FHFA, the government
entered into senior preferred stock arrangements (the “Stock Agreements”) with Fannie Mae and
Freddie Mac, whereby Treasury would advance $100 billion15 in exchange for $1 billion in shares
of senior preferred stock with a cumulative 10% dividend and would be increased dollar-for-dollar
by any amounts Treasury invested. Pursuant to the Stock Agreements, each company also issued


Treasury 20-year warrants to purchase 79.9% of the common stock for a mere $0.00001 per
share.16 The FHFA Office of Inspector General acknowledged that these actions exacted a heavy
toll on the existing shareholders' holdings.17 And despite the popular narrative that such investors
were all leviathan hedge funds, many community banks invested heavily in preferred shares.18

16 Complaint, Washington Federal v. U.S. 13-385 C, page 3.
https://docs.google.com/a/matterhorndata.com/file/d/0B6ofth-
ELqJpcmRrZ3FpSWl6ZGs/edit?pli=1.

17 Id.

18 Nick Timiraos, Fannie-Freddie Bill Leaves Little for Shareholders, The Wall Street Journal
(Jun 5, 2013), available at http://blogs.wsj.com/moneybeat/2013/06/05/fannie-freddie-bill-
leaves-little-for-shareholders/.

19 Complaint, 9.

20 Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and
Freddie Mac (Aug 17, 2012), available at http://www.treasury.gov/press-center/press-
releases/Pages/tg1684.aspx (capitalization of the heading is altered).

21 12 U.S.C. § 4617(b).

22 Richard Epstein, Grand Theft Treasury, DEFINING IDEAS (Jul 16, 2013) available at
http://www.hoover.org/publications/defining-ideas/article/151966.

23 Id.

Rather than working as conservator to benefit Fannie Mae and Freddie Mac’s common and
preferred 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.
Subsequent to the Stock Agreements, the government also forced the companies to delist their
shares, suspend shareholder meetings, assume additional subprime assets, and accept tens of
billions of dollars from the Treasury that were not necessarily needed to maintain solvency.19 In
fact, as the company returned to profitability in 2012, the government used an administrative
procedure to pass the Third Amendment to the Stock Purchase Agreement, thereby requiring “a
full income sweep of all future Fannie Mae and Freddie Mac earnings to benefit taxpayers for their
investment.”20 Fannie Mae and Freddie Mac are generating cash – enough to more than repay the
$187.5 billion in emergency funding received from the government during the downturn – but
have been forbidden from using that income to “put the regulated entity in a sound and solvent
condition.”21

“The purpose of a conservatorship is to preserve the assets for the benefit of the individuals whom
it represents,” as Richard Epstein notes, “which in this instance covers both classes of shareholders.
Accordingly, the conservator represents the shareholders in their relationship with the government.
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.”22 In the
case of Fannie Mae and Freddie Mac, however, “the designation of the FHFA as the conservator
created an impossible conflict of interest. The Boards of Directors of Fannie Mae and Freddie Mac
were shut out of the deliberations that took place exclusively between branches of the federal
government.”23 In pursuing their mandate to protect the third party taxpayers, the government is
neglecting its duties to the shareholders – something that under traditional corporate law runs
counter to a conservator’s role.




IV. Proposed Reform


The proposed housing finance reform legislation in the House and Senate seeks to continue down
this path of eschewing legal norms. The H.R.2767 Protecting American Taxpayers and
Homeowners Act of 2013 (“PATH Act”), S.1217 Housing Finance Reform and Tax Payer
Protection Act of 2013 (“Corker-Warner Bill”), and Amendment to S. 1217 Housing Finance
Reform and Tax Payer Protection Act of 2014 (“Johnson-Crapo Bill”) all seek to wind down the
once again profitable companies without adequately protecting shareholder interests.24

24 Rep. Maxine Water’s “Housing Opportunities Move the Economy Forward Act of 2014” does
not seek to codify Treasury's takings.

25 See e.g. Andrea J. Boyack, Laudable Goals and Unintended Consequences: The Role and
Control of Fannie Mae and Freddie Mac, 60 Am. U.L. Rev. 1489 (June 2011).

26 Section 101 of H.R.2767; Section 501 of S.1217; Section 602 of Amendment to S. 1217.

27 See, e.g., claims filed in Fairholme Funds v. FHFA and Perry Capital v. Lew. Epstein, supra
note 12.

28 Section 604 of Amendment to S. 1217

29 364 U.S. 40 (1960), as quoted in Epstein, supra 18.

Despite the debate over whether to preserve these now-profitable GSEs or perhaps sell them to
private parties,25 the proposals repeal the GSEs’ charters and provide for the government to
liquidate each.26

Each of the proposed bills compounds the government’s dereliction of its duties under the
Administrative Procedure Act (APA).27 HERA was designed to return the GSEs to a sound and
solvent state, but the government’s self dealing (between the FHFA and Treasury) is violating the
statute’s safeguards and is instead absorbing and dissolving the interests of those private
shareholders HERA was designed to conserve. For example, Sec. 604 of the Johnson-Crapo Bill
states, “The wind down of each enterprise must be managed by FHFA to obtain resolution that
maximizes the return for taxpayers,” thereby ignoring obligations to shareholders.28

The reforms’ proposed liquidations in effect finalize the government’s taking of the GSEs’
shareholders’ property. In the words of Armstrong v. United States, the just compensation
requirement of any taking was intended to prevent the government from forcing “some people
alone to bear public burdens which, in all fairness and justice, should be borne by the public as a
whole.”29 But with the proposed liquidations, the government appears to be doing precisely that.
As it continues to force the companies to invest in and hold toxic securities, the government is
siphoning away the profits that the companies might use to regain their footing; and Congress
plans to drive them into the ground without exploring other approaches that may help shareholders’
recoup losses.

In fact, the Obama Administration in November 2013 rejected a corporate bid for the GSEs’
insurance businesses. Rather than allow private businesses to invest $52 billion in an effort to
restructure Fannie Mae and Freddie Mac into profitable private companies that follow industry


best practices,30 the Administration has promoted the proposed legislation – and, along with it, the
politically-motivated liquidation it entails.

30 Tom Risen, White House Opposes Privatizing Fannie Mae and Freddie Mac, New York Times
(Nov 23, 2013), available at http://www.usnews.com/news/articles/2013/11/21/white-house-
opposes-privatizing-fannie-mae-and-freddie-mac.

31 Federal Housing Finance Agency, Enterprise Share Of Residential Mortgage Debt
Outstanding: 1990–2009 [hereinafter “FHFA Chart”], available at
http://www.fhfa.gov/webfiles/15556/Enterprise%20share%20of%20Resident%20Mortgage%20Debt%20Outstanding%201990_%202009.xls.

32 The GSE liabilities will only need to be covered by taxpayers if there is another downturn in
the housing market.

33 Tom Raum, US rescue of Fannie, Freddie poses taxpayer risks, USA Today (Sep 8, 2008),
available at http://usatoday30.usatoday.com/news/washington/2008-09-08-127573146_x.htm.

34 p. 3 and p. vii of the 2010 CBO report.

35 As discussed supra, the Obama Administration rejected a corporate bid for the insurance
business of Fannie and Freddie.

36 Others have written of the inadequacies of the Bankruptcy Code as a mechanism for resolving
systemically important institutions and discussed possible reforms to the Code. See, e.g. Edward
Morrison, “Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of
Systemically Important Institutions?” 82 Temple Law Review 449 (2009); David Reiss, “An
Overview of the Fannie and Freddie Conservatorship Litigation”, Draft Journal of Law &
Business (forthcoming 2014). It is not the purpose of this paper to make broad claims about the
best route for all institutions, but instead to evaluate the proposed liquidation specific to Fannie
Mae and Freddie Mac. While the Code may present challenges with regard to speed and
flexibility during crises, not only were these companies never insolvent, they have stabilized and
are even profitable once again. Further, their proposed liquidation comes after specific
government obligations to existing shareholders.

Further, the Senate proposals potentially burden taxpayers with Fannie Mae and Freddie Mac’s
enormous liabilities. According to economist James Hamilton, the mortgage giants’ liabilities
amount to $5.2 trillion,31 representing a 29.6% increase to the record $17.54 trillion national debt
should the full sum be pulled onto the federal balance sheet.32

The proposals effectively reverse LBJ’s 1968 removal of Fannie Mae’s debt portfolio from the
U.S.’s books. As the Associated Press reported in 2008, “with the government takeover of Fannie
Mae and Freddie Mac, U.S. taxpayers now essentially own the bulk of the nation's mortgage
market.”33 In other words, when Fannie Mae and Freddie Mac went into conservatorship in
September 2008, the two GSEs became, in the words of the Congressional Budget Office,
“governmental,” and this “effectively made the government’s backing of their debt securities and
[mortgage-backed security] guarantees explicit.”34 Rather than maintaining these profitable
companies, selling them to private parties,35 or discharging the debt via a traditional bankruptcy
process,36 the Senate proposals seek to codify this massive burden by pledging the full faith and


credit of the United States for both GSE legacy debt and legacy mortgage-backed securities,37
thereby further imperiling the nation’s credit rating, curtailing economic growth, spurring
inflation, threatening social programs, and diminishing the nation’s social, economic and political
power.

37 Section 501 of the Corker-Warner Bill, Section 604 of the Johnson-Crapo Bill. But see, Rep.
Maxine Water’s “Housing Opportunities Move the Economy Forward Act of 2014”, which does
not seek to codify Treasury's takings.

38 Chapter 7 would likely not be a good vehicle for something so large, but, in theory, a Trustee
would be appointed, and she or he would distribute assets according to priority.

39 11 U.S.C. §1129(b)(2)(B)(ii).

40 While we cannot know the identities all of the GSEs’ investors they are almost certainly not a
monolithic group of hedge funds but also likely include individuals’ 401ks and pensions as well
as smaller investors including community banks.

In a traditional bankruptcy proceeding under Chapter 11 of the Bankruptcy Code,38 the plans for
liquidation of Fannie Mae and Freddie Mac must comply with the absolute priority rule. 39 After
payment of the inevitable administrative expenses – attorneys and accountants for the Debtor, the
committee of creditors, and the likely committee of equity holders – secured creditors must be
made whole before any other claimant may receive any recovery. Next, priority claims, such as
tax claims, must be paid before unsecured claims (effectively all debts for which no security
interest has been pledged) are then paid. Finally, the equity holders would recover, with preferred
shareholders receiving higher priority than common shareholders. This is the orderly process by
which debts are equitable discharged that has long marked the liquidation of private companies
and has been internalized by the market.

Under the proposed liquidations, however, virtually everyone loses. Not only are the GSEs’
shareholders’ property rights are violated, the U.S. taxpayers face the burden of the GSE’s trillions
in liabilities without dispensing via the orderly and known processes of a traditional bankruptcy
proceeding or keeping the debts segregated as the now-profitable GSEs seek to pay them down.
Finally, the rule of law is subverted, thereby making lending and business in general a riskier
proposition when the country and global economy are left to the political whims of the federal
government.

The United States was founded on a firm commitment to Americans’ property rights. In fact, of
the Declaration of Independence’s charges against King George III, a majority of the ten are
offences against private property. The political winds of the moment make it popular to extract
short term taxpayer advantage on the backs of what is popularly perceived as the moneyed hedge
fund shareholders of the GSEs;40 however, we cannot permit such political pressure to allow crony
capitalism to take hold as the government picks the economy’s winners and losers by changing the
rules of the game. In the longer run, the governments’ handling of Fannie Mae and Freddie Mac
could subvert certainty and order – a key competitive advantage for the U.S. economy in attracting
investment. With Chrysler, General Motors, and now Fannie Mae and Freddie Mac, a growing
number of precedents erode the rule of law that has enabled the United States to thrive.