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A Tale of Two Bailouts: AIG, Fannie and Freddie and Beyond

  

forbes.com | November 28, 2014 

By Richard Epstein

It has been some time since my last Forbes column on Fannie and Freddie. After eight weeks in Court, it appears as though the AIG trial, in which former AIG CEO Maurice (“Hank”) Greenberg is mounting a challenge to recover some $40 billion for shareholders from the United States, by attacking all the steps in the multi-billion U.S. bailout, initiated in September 2008, which started at $85 billion, but may have run to as much as $180 billion by May 2009. While separate arguments, there are some instructive elements to contrast the developments in the ongoing AIG dispute with those in connection with the multiple lawsuits brought by the private shareholders (both junior preferreds and common) of Fannie Mae and Freddie Mac against both the Federal Housing Finance Authority (FHFA) and the United States Treasury.

That comparison in turn sets the stage for discussion of two other issues: the recent motion by the Rafter litigation plaintiffs (including Pershing Square Capital Management), as friends of the court and holders of Fannie and Freddie common stock, in opposition of the government’s motion to stay discovery in Fairholme’s takings claim before Judge Margaret Sweeney in the Court of Federal Claims (CFC) and a recent statement by Sen. Tim Johnson (D-SD), the outgoing chairman of the Senate Banking Committee that:

“Everyone agrees that conservatorship cannot continue forever, so I hope my colleagues will keep working towards a more certain future for the housing market. However, if Congress cannot agree on a smooth, more certain path forward, I urge you, Director Watt, to engage the Treasury Department in talks to end the conservatorship.”

All these points are interrelated. As ever, I write about these issues as an advisor to several institutional investors with an interest in Fannie and Freddie. I have no similar involvement with AIG.

AIG v. Fannie and Freddie Any analysis of the relationship between the AIG and the Fannie/Freddie bailouts has to start by noting that AIG was a private company that did lead the double life of a Government-Sponsored-Enterprise. Thus before the onset of the government’s AIG’s September 16, 2008, bailout done just days after the Fannie and Freddie deal, there was no troubled history of past entanglements between AIG and the government remotely parallel to those for Fannie and Freddie whose extensive activities under the Housing and Community Development Act was only imperfectly offset by the implicit government guarantee of the high-risk loans that it made pursuant to that process.

The relatively clean relationship between AIG and the United States meant that the two parties negotiated the complex 2008 bailout terms at arm’s length between the two sides. Unlike the situation with Fannie and Freddie, the government had not forced out the private directors of AIG, who were therefore in a position to make the best deal they could for their shareholders. That deal in fact imposed tough terms on AIG, which included an initial interest rate at 14.5 percent, coupled with the right to acquire 79.9 percent ownership interest in AIG in exchange for an $85 billion bailout loan that it made for the company.

The deal in question was not executed all at once, but in complex stages, which were exhaustively reviewed in the excellent decision of Judge Paul A. Engelmayer in Starr International v. Federal Reserve Bank of New York in his November 2012 decision in the Southern District of New York. I shall not go through all the intermediate steps. But it is critical to note that each of these steps were in accordance with the original plan, and at no point during the course of the AIG bailout did the government attempt to introduce anything analogous to the Third Amendment, that is, to order a full dividend sweep of all of AIG’s assets. Clearly it could not have gotten the AIG board to sign off on that transaction, which was thus never attempted. In addition, many of the key issues in the takings claims were similar to those raised before Judge Engelmayer whose careful opinion will be difficult to distinguish.

One point on which this will be especially true is the question of whether the AIG somehow breached its fiduciary duties to AIG by coercing it into this transaction. Given that the United States acted as a lender dealing with a corporation represented by its own Board of Directors (who have refused to join in the Starr International suit against the United States), it seems hard to think that the United States will be found to have taken property from AIG during the course of these arm’s length negotiations. Similarly, it will be difficult to prove that the United States exceeded its authority under the Federal Reserve Act which allows it to make in in “unusual and exigent circumstances,” to offer discounted lending terms to a distressed “individual, partnership, or corporation,” which seem applicable here. In addition, it looks as though Judge Engelmayer is correct when he concludes that the “incidental powers” conferred on the Federal Reserve allow it to structure the loan transaction to include an equity kicker.

The Rafter Motion in Fannie and Freddie It should be evident that in every way the Fannie Freddie claims are stronger than the AIG claims. Fannie and Freddie did not have their own board, and the Third Amendment wiped out all future dividend flows. Both substantively and procedurally, Fannie and Freddie are in a stronger position. Yet ironically, while AIG is granted two trials, one in New York on breach of fiduciary duty and one in the Court of Federal Claims on takings, to make its case, the government is now contending that the private shareholders of Fannie and Freddie should not be allowed even discovery, let alone a trial to establish their claims on either count.

The situation with Fannie and Freddie is entirely different. The latest skirmish in this ongoing litigation is Judge Margaret Sweeney’s decision to allow the Rafter plaintiffs, including Pershing, to file a motion in opposition to the government’s stay of the Fairholme Funds takings claim also in the CFC. Some of the points made in the Rafter motion highlight the vast difference between the two cases, which makes doubly ironic the indefensible decision of Judge Royce Lamberth to dismiss the claims of the junior preferred shareholders in Fannie and Freddie without either deposition or discovery. Here is how those differences play out.

First, the AIG and Fannie/Freddie bailouts both took place in the agitated times of 2008. But the AIG Board was in place to represent its shareholders. The Fannie and Freddie Boards (which were never quite private companies) had been displaced by FHFA, so that all of Fannie and Freddie’s decisions on the terms of the bailout were for them by then acting director of Fannie and Freddie, Edward DeMarco, who had previously served as a high ranking Treasury official. At this point, the want of procedural independence requires that a searchlight be shined on the transaction to see that it was entirely fair to the junior preferred and common shareholders of Fannie and Freddie. The Rafter plaintiffs hold common not preferred stock, so that their claims are independent of those of the Fairholme plaintiffs.

The gist of their argument is that they are entitled to get discovery on key elements of their claims, no matter what happens in the Fairholme suit, which seems clearly correct. That discovery really matters. The first of these is that the collusion between FHFA and Treasury meant that FHFA was “an agent and arm” of Treasury and thus subject to suit along with Treasury for the taking of private property in the CFC. The second two claims relate to the question of whether Treasury had evidence of the “future profitability” of the companies, and if they did, whether the plaintiffs had “a reasonable investment-backed expectation of their future profitability.”

I regard the third of these issues as one that is so plain that it does not need discovery. Why else does anyone invest in stock except in the expectation of gain a profit? The upside potential cannot be ignored even if there is a strong likelihood, at least as of 2008, that Fannie and Freddie could not be nursed back to health. But the second really matters because it will in all likelihood flatly contradict government claims that Fannie and Freddie were still insolvent nearly four years after the original September 2008 bailout. And the common shareholders, even if they retain only 20 percent of their initial equity, still are in a position to object to the “full dividend sweep” of the Third Amendment, which wipes out all prospects of all future gains forever. Indeed, the only reason the private shares did not go to zero is that everyone thought that the claims against the government could prove strong enough to beat back the Third Amendment

The Rafter claimants make a strong case is that it is unwise for Judge Sweeney to stop the train on discovery, given that they would necessarily be released from their current stand-still agreement with the Treasury that they would not conduct duplicative discovery on these issues so long as Fairholme could go forward. In this connection, it is again critical to stress that all the takings claim against the United States and FHFA are distinct from the equitable claim for breach of fiduciary duty, either under federal or state law, that was in issue in Fairholme’s case before Judge Lamberth. The takings claim based on the Third Amendment is fixed as of August 2012, when the Third Amendment was put into place. The just compensation involved equals to the loss in value attributable to the conscious decision of the government to strip out all dividend and liquidation rights from both the junior preferred and the common stocks, with interest thereon. The claim is therefore ripe as of that date, for it does not depend in any way on the subsequent fortunes of both companies that still remain under the management of FHFA.

At this point, the most dramatic difference between the AIG and the Fannie/Freddie claims is that the AIG bailout did not involve any radical about-face by the government to rejigger the terms of the original deal in ways that allowed it to take all of the potential profits from future operations. It could well have been that the government well understood that any such high-handed operation would be met with stout and effective resistance from AIG’s private management and board, proves once again the political risk from the hybrid status of any GSE.

The Johnson Statements The full nature of the complexity is only increased by the recent public advice that Chairman Johnson of the Senate Banking Committee made to FHFA director Mel Watt. The request that the conservatorship of Fannie and Freddie be brought to a close is rich in political confusion. As a matters now stand, if the Third Amendment is valid, then the Treasury has no immediate financial incentive to give a dime of those profits back to the shareholders. Given its supposedly strong contractual rights, it can just stick its guns on the conclusive power of the Third Amendment. But from a business perspective, that posture is a political disaster for any further reform efforts. The Johnson statement telegraphs the simple point that so long as the Third Amendment stands, there is no way to raise capital from the private markets for residential mortgage lending. The investors that were burned have long memories and they will not commit massive amounts of new capital that can be expropriated by a repeat performance, perhaps with some new bells and whistles, of the August 2012 Third Amendment.

Thinking strategically, it will not serve the government’s long-term interest to get out of conservancy simply by turning everything over to the government. The shareholders of Fannie and Freddie still have formal title (but nothing else to their paper) and the Johnson statement should be best read as an invitation of Mr. Watt to institute settlement talks with shareholder representatives to resolve this crisis fairly and now, lest the ability to raise new private capital be lost for a generation or more.

I think that the correct resolution of those issues could take one of two paths. The government can either treat all the “dividends” paid over in excess of the amounts needed to keep current with the 10 percent dividend on the senior preferred, as a return of capital, and go forward just as if nothing had happened. Or there could be an effort to determine the wipeout of both classes of stock by the Third Amendment in 2012. If both of these claims eventually lose, the leverage for the shareholders will be weak in getting full compensation. But if both when, then they get to decide which measure of damages yields the higher rate of return. If the government holds out an olive branch right now, it could spare the further litigation and uncertainty that bode ill for the capital markets. For in the fate of the current litigation lies not only the financial claims of the private shareholders, but the larger question of whether a private residential financing market will ever become viable again in the United States. Your move, Mr. Watt.

Richard A. Epstein is the Laurence A. Tisch professor of Law at NYU, senior fellow at the Hoover Institution, and senior lecturer at the University of Chicago Law School.

 

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