The following is a print feature that appeared in MReport's November 2014 issue.
It has never been more en vogue to be a critic of the GSEs. From politicians to private citizens to watchdogs within the federal government, if you want to score political points or push an agenda, calling for an end to Fannie Mae and Freddie Mac or just castigating the conservatorship itself as somehow unfair is a popular way to get there.
And it’s not just talk. There have been approximately 20 lawsuits filed in federal courts by investors to recover some of the millions in profits generated by the GSEs that have been funneled to the U.S. Treasury. As if that wasn't enough, members of Congress are lining up to determine how to reorganize the GSEs, while others conspire to eliminate them entirely. Even the FHFA Office of the Inspector General got into the game recently. But are the criticisms fair? And what (if anything) should be done about them?
The Threat From Private Investors
In a recent lawsuit filed by Perry Capital and Fairholme Funds, investors sued for breach of contract regarding promised dividends and what they termed to be an illegal "taking" under the U.S. Constitution. U.S. District Judge Royce Lamberth ruled against the plaintiffs. This outcome pleased those who believe that profits generated by the GSEs should to go to the U.S. Treasury.
In support of Judge Lamberth's decision, Wall Street Journal published an editorial, lauding the judge for "dismissing claims against the federal government brought by private investors." They congratulated the judge for "seeing through plaintiffs' argument that combined dubious legal reasoning with junk economics."
In the decision, Judge Lamberth maintained that he was just interpreting the details of the conservatorship, and that if investors have a gripe, it's with Congress for writing the law.
The editorial continued, quoting an official from the Federal Reserve Bank, who said that "the profits being used to pay dividends did not arise from the contributions of private shareholders, but entirely reflect risks borne by the Treasury and taxpayers."
The opinion of the WSJ editorial agrees with that of Edward Pinto, co-director and chief risk officer at the American Enterprise Institute. He said that without the support of the government in 2008, and the continuing support of the taxpayers, Fannie Mae and Freddie Mac would not exist as ongoing entities.
"Many saw this as an opportunity for speculation, but they may have chosen poorly," Pinto said. "They knew that Freddie and Fannie were subject to a charter established by Congress that could be revoked at any time." Pinto said that anyone who bought stock had to know that this was a political entity with a unique charter that could be amended at will by Congress.
The advice is confirmed by Jim Vogel, Executive Vice President at FTN Financial Capital Markets. "Private capital invested in a government-sponsored enterprise always runs the chance of disappearing with a change in government policy," Vogel said. The situation with the GSEs is a good example.
Judge Lamberth's decision, denying any compensation to shareholders, was met with vehement response by some. "No way," screamed numerous investors, including consumer advocate and multiple-time presidential candidate Ralph Nader. They contend that giving the money to the Treasury is a violation of their Fifth Amendment rights against the seizure of private property for public use without just compensation.
Nader has been a high-profile spokesman for Fannie Mae and Freddie Mac shareholders for several years. Nader owns about 100,000 shares cumulatively between Fannie and Freddie, which he has held since before the 2008 conservatorship, according to a report in The Washington Post in May.
"This issue's not going to go away with one district court decision by any means," Nader said during a recent conference call hosted by Fannie and Freddie shareholder advocacy group Investors Unite. "This was deception of the first order. If any corporate executives engaged in something like this, even the slumbering SEC would have moved to action."
The group that Nader spoke to, Investors Unite, is a coalition of approximately 1,000 private investors committed to the "preservation of shareholder rights" in the GSEs and to obtaining full restitution on investments.
The organizer and leader of this group is Tim Pagliara, a 32-year veteran of the investment business. He is also the chairman and CEO of CapWealth Advisors based in Franklin, Tennessee. He believes there was never any determination of insolvency about the GSEs. "Everyone needs to have the facts straight on this issue," he said.
He said that back in 2008, Fannie and Freddie still had the ability to raise additional capital and had other options that were taken away in September of that year when the GSEs were put into conservatorship. He maintains that there was a choice of whether to put the GSEs into a conservatorship, liquidate them, or put them into receivership. Conservatorship was not the only option.
But in August 2012, FHFA and the U.S. Treasury agreed to revise the terms of their agreement. Instead of a 10-percent dividend, the Treasury would receive all net income earned by Fannie Mae and Freddie Mac paid in a quarterly "sweep." Now 100 percent of the profits from Fannie and Freddie go into the U.S. Treasury. "What this means is that the government has nationalized the housing industry and is using it as a tool for budget reduction," he explained.
According to a New York University Law School professor, the ruling handed down by Judge Royce Lamberth is flawed. Richard A. Epstein, the Laurence A. Tisch professor of Law at NYU, says that the mistakes in the judgment are so serious and one-sided that the judge should withdraw his decision and reconsider the facts.
"First, the judge's opinion seriously misstates the rights and duties of the Federal Housing Finance Agency (FHFA) as a conservator," Epstein explained. "Second, it seriously misstates the authority of Treasury under HERA." Epstein pointed out that the amendment to the conservatorship was not negotiated by an independent board of directors.
According to Epstein, the amendment was not intended to return Fannie and Freddie to the private market, but was designed to ensure they would never be able to return to the market, no matter how profitable their operations had become.
"What this means is that no private company is ever safe," he explained. "No private party will ever rely on government assurances or guarantees if the amendment is allowed to stand. The rule of law, which is critical to the proper functioning of free markets, has no meaning if it can be suspended whenever deemed convenient."
But despite their protestations and with full knowledge of the uphill battle in the courts that lays ahead, investors are still buying into the GSEs. For example, in recent weeks reports have surfaced that Bill Ackman, leader of Pershing Square Capital Management, a New York-based hedge fund that is itself involved in a lawsuit against the federal government related to GSE profits, has added to the fund's GSE stock portfolio.
Billions Lost and Lessons Learned
Hindsight is a wonderful thing. It helps us learn; it also can be used to point fingers.
A report recently released by the FHFA Office of Inspector General (OIG) revealed that Freddie Mac and Ginnie Mae ignored "red flags" regarding a mortgage fraud scheme perpetrated by lenders Taylor, Bean & Whitaker and Colonial Bank, resulting in billions of dollars in losses for the GSEs.
But Ginnie Mae president Ted Tozer did not take the report lying down, taking issue with the OIG. In fact, he maintained that the OIG was misinterpreting the situation. He offered that if the OIG had contacted him prior to releasing the report, "We could have explained a lot of this stuff away because everything they pointed out were positives."
The ordeal began in 2002, when Lee B. Farkas was running a relatively small mortgage company in Ocala, Florida, and was caught selling eight fraudulent mortgages to Fannie Mae. Odd thing was that his name as borrower was on all of the mortgages, each of which defaulted without a single payment being made.
According to the report, when Fannie Mae discovered the fraud, they stopped doing business with Farkas' firm, the Taylor, Bean & Whitaker Mortgage Corporation. However, Fannie Mae neglected to share the information with Freddie Mac and Ginnie Mae.
Farkas just went down the street and sold bundles of securities to Freddie Mac and Ginnie Mae, as well as other such financial institutions as Deutche Bank and GNP Paribas in Europe. In fact, his company, Taylor Bean, sold $1.75 billion of worthless asset-backed commercial paper in short-term notes to various entities until this charade ended in 2009. Farkas is currently serving a 30-year sentence for his "creative" techniques in selling the same mortgages two or three times.
As a result of this debacle, the FHFA now requires increased monitoring of counterparties that exhibit abnormal or unusual characteristics. They also require the GSEs and Ginnie Mae to share negative performance and compliance data and evidence of illegal activities of counterparties in order to prevent similar losses in the future. As another precaution, Ginnie Mae President Tozer says he thinks that Ginnie Mae auditors should audit the books of counterparties instead of contractors.
Congress Weighs In
Not content to sit on the sidelines, members of Congress are trying to change the structure or charter for the GSEs. Presently, the Senate is leading the charge to fundamentally reform housing finance. These efforts are in limbo during this lame duck session preceding the swearing in of the new congress in January 2015.
The Housing Finance Reform and Taxpayer Protection Act was first introduced by Senators Bob Corker (R-TN) and Mark Warner (D-VA). The plan was crafted with the goal of winding down and eliminating Fannie Mae and Freddie Mac over a five-year period, and establishing the Federal Mortgage Insurance Corporation (FMIC) to provide a government backstop for mortgage-backed securities (MBS) and regulate the new market. Later, Senate Banking Committee Chairman Tim Johnson (D-SD) and Ranking Member Mike Crapo (R-ID) would add on to the plan and make it their own.
Like the earlier plan, this one also includes eliminating the GSEs over a five-year period and establishing the FMIC with a few additional changes. In its definition of an eligible singlefamily loan, Johnson-Crapo requires a down payment of 3.5 percent for first-time homebuyers and 5 percent for all other homebuyers (to be phased in over time). Corker-Warner requires all loans to have a 5-percent down payment. Johnson-Crapo would also establish an Office of Multifamily Housing in the FMIC that was not recommended in Corker-Warner.
"This agreement moves us closer to ending the five-year status quo and beginning the wind down of Fannie and Freddie while protecting taxpayers with strong private capital, building the components for a stable secondary market and avoiding repeating the mistakes of the past," Mike Crapo said at the time that it passed the Senate Banking Committee. "Government control of Fannie Mae and Freddie Mac with no private capital to protect taxpayers against losses is unacceptable."
Pagliara believes that the Johnson-Crapo bill will recreate the conditions that existed in the 1930s when people got into trouble because they could not refinance their homes. "Today, we realize that long-term fixedrate mortgages are an asset," he said. "However, this might not be available with Corker-Warner, which advocates raising interest rates and making the availability of long-term financing less attractive and less available."
Still, the political gridlock in Washington D.C. has never been stronger, and as we enter into the last two years of an administration that has become increasingly unpopular, the likelihood of meaningful housing finance reform diminishes with each passing day. Forecasted Republican gains in the congress will only make the gridlock more palpable.
So what is the point? Is the conservatorship really on the brink of an existential crisis, or is it all speculative greed and political posturing? Whatever the future holds, it remains unlikely that there will be a resolution anytime soon.