GSE Lawsuit Settlement Against Accounting Firm Is Now Settled
Nov. 1, 2016 8:48 AM ET| Glen Bradford
..... Summary .....
-- The accounting fraud lawsuit against PricewaterhouseCoopers has been settled and ruled dismissed after FHFA pulled their emergency objection.
-- Prior GSE executives seem to have a growing voice: one has filed a lawsuit, one writes about their capital buffer in the news and one runs a GSE blog.
-- The government has decided to appeal Judge Sweeney and will not be producing documents in time for the Perry Capital Appeal.
One down, one to go. Judge Fredrico A. Moreno ruled that the Edwards V. PricewaterhouseCoopers be dismissed. This was one of two accounting fraud lawsuits. The larger of the two is Edwards V. Deloitte and that one is ongoing. These are two lawsuits of dozens surrounding the conservatorship and actions taken against Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) since 2008. Most of the actions are against the net worth sweep which took place in 2012. Judge Lamberth ruled in 2014 that the net worth sweep was legal and Pratt, Robinson, and Pagliara all ruled in line with Lamberth. Lamberth has been appealed and has been fully briefed for 3 months now implying a ruling is imminent from the DC District Court Of Appeals. The way the government has structured Fannie Mae and Freddie Mac since 2008, they take their net worth and wind their net worth down to $0 over a few years. This effectively decapitates the junior equity which consists of publicly trading common shares and preferred shares. As such, the government has made them worthless.
Investment Thesis: Shareholders have filed lawsuits alleging they have rights. The government is arguing that all their rights were transferred to the government in 2008. The government used to argue that the net worth sweep was to save the companies but has subsequently dropped that argument for two reasons. The first is that Judge Lamberth simplified their argument to effectively say that the facts don't matter and that the government operated within the law when it started sweeping the net worth of a private enterprise to itself. The second is that documents have been produced by the government that have been seen by the public that suggest that the government entered into the net worth sweep for its own benefit when it realized it would be forced to reverse earlier accounting losses. Owning publicly traded securities in Fannie Mae and Freddie Mac is a bet that the government simply cannot get away with billions of dollars of their money without violating shareholder rights and courts protecting those rights. From an investment standpoint, the commons have more potential upside and more risk than the publicly traded preferreds but I own the preferreds. In general the preferreds share appreciation upside is capped around their par value.
Smaller Accounting Fraud Lawsuit Settled
Judge Federico A. Moreno entered a final order of dismissal:
Normally this would be relatively insignificant but FHFA tried to stop the settlement and then at the last second removed its opposition. On the 30th, a joint voluntary dismissal by plaintiffs, defendants and FHFA was filed. Prior CFO of Fannie Mae Timothy J Howard shared this blurb on his blog:
No. I don't have any information about it, and opinions without information aren't worth much.
But to be candid, I likely will try to get some information about it soon- to confirm (or refute) my suspicion that settlement of the PWC case allows more time, money and energy to be put into the more potentially important and consequential Deloitte case- but I will do so under a promise of confidentiality, and so will not be able to share what I learn.
Not even he knows exactly what happened but it is interesting that he seems to think that it is possible that the Deloitte case isn't likely to follow the same course given that the two cases are practically identical.
Never Before: Commonplace In GSE Litigation
The Federal Circuit recently entered into an order accepting the Amicus Brief from the Cato Institute. Inside Mortgage Finance picked this up and similar issues exist in the shareholder rights cases:
He argued that the agency terminated him without cause. ?Never before has regulatory authority ordered the taking of private contract rights without cause and without compensation,? said the think tank, which believes the government overreached its power in the case. For more details, see the new edition of Inside The GSEs, now available online.
Plaintiffs in the GSE shareholder lawsuits make similar contract rights claims in some of their lawsuits. The government maintains that it has done nothing outside of its statutory authority in all cases and so far has built a pretty good track record of wins that all rest on an initial Lamberth ruling.
Tom Forrester's $3B Capital Solution
Tom Forrester suggested that $3B in capital would make a world of difference especially if the draws were annually and not quarterly:
The irony here is that his views effectively echo the main thesis behind the accounting fraud lawsuits to begin with. If $3B in capital would make a world of difference, it draws increasing scrutiny to the hundreds of billions of dollars of accounting losses the GSEs were forced to report in the early years of conservatorship that were subsequently reversed. Fannie and Freddie have historically held much more capital than this and were placed into conservatorship even though they had their highest levels of capital in history.
The Government Doesn't Hand Over Anything Before Perry Capital Appeal
The government filed with Judge Sweeney. They aren't handing over any of the documents and have filed an appeal to Sweeney's order and also a Writ. Richard Epstein seems to think that the government is simply stalling:
John Carney disagrees. I'm not a lawyer but I don't think I need to be in order to discern what actually happened. Fannie and Freddie were making a ton of cash during the earlier conservatorship years and it seems self-evident that the reported losses were designed and implemented around the thesis that the best nationalization is a zero cost nationalization. While this is true for the government, it is not true for public shareholders. The government has produced thousands of documents and it has decided to withhold thousands of responsive documents surrounding these events. A handful of the produced documents have been made public.
Judge Sweeney reviewed all of the government privilege assertions and gave them the benefit of the doubt regarding whether or not privilege had even been asserted properly. The problem is that privilege assertions are not supposed to be used to permit the government from seizing assets and covering their tracks. The government disagrees and therefore it is unlikely that the handful of documents that Judge Sweeney was able to review will be seen by the Perry Capital Appeal's panel of three judges before they issue their order.
Summary & Conclusion
If you think that the government can do whatever it wants an investment in Fannie Mae and Freddie Mac might not be for you. My view is that they've done whatever they've wanted to do for 8 years now but eventually the laws that constrain its citizens will eventually equally be applied to the government's own actions. Although my view is that the entire conservatorship was a slow rolling nationalization by design and that at every point in time if it was reversed including today the world would be better off, I own preferreds because I build my investment portfolio based on what can be argued.
Right now I'm arguing that it seems reasonable to expect the third amendment net worth sweep to be reversed since it is ultra vires. Whether or not that happens at the hands of the judges of the panel or the lower court assuming a remand is up to the panel. My view is that it's an open and closed case. Having an administrative record doesn't matter because any action that is designed around wiping out the conservatee is simply not a conservator action. That being said, I can see how the three judge panel would rule that it would matter and remand it back to get the complete administrative record. People are human beings and this is the largest potential theft of our lifetime with assets ranging around $5T.
I have 4050 shares of FMCCH, 9340 shares of FMCCP, 9714 shares of FMCCT, 2600 shares of FMCKI, 1025 shares of FMCKO, 6585 shares of FMCKP, 27225 shares of FNMFN and 5 shares of FNMFO. These shares freely trade. The government takes the net worth of Fannie and Freddie and yet doesn't consolidate them onto its balance sheet because of people like me who own these freely trading shares. The way things are structured is in everyone's view unsustainable but the two companies continue to build their own guillotine. The common securitization platform and the risk sharing deals seem to be the government's preferred exit strategy where shareholders are wiped out and the mortgage market gets a federal guarantee and the big banks get the lions share of the mortgage market and its profits.
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