Will The Starr Suit Impact Fannie And Freddie?
- December 4, 2014
Guest Post By David Sims
- Fannie and Freddie agreement changed in 2012.
- Fannie and Freddie losses were mandated by the government.
- AIG losses were due to profit-seeking motives.
- AIG had liquidity issues and the GSEs did not.
- Bailout terms were meant to punish shareholders.
Now that Hank Greenberg’s Starr International Co. lawsuit over the AIG bailout has finished in the court room, there are unverified rumors floating about that we could expect a verdict from Judge Wheeler on the suit as early as December 15th. Whatever the time frame, for Fannie Mae (FNMA) and Freddie Mac (FMCC) investors, it pays to know how this might affect your stock values. Clearly, the facts in each situation are different. Here are some of the similarities and dissimilarities.
What caused their pain and suffering?
Both companies suffered as a result of widespread bad behavior in the financial sector, some of which they engaged in themselves.
With respect to Fannie and Freddie, there is some evidence to suggest that the government is actually responsible for some of their behavior. For instance, the Financial Crisis Inquiry Commission found that HUD mandates were partially responsible for increased lending by the GSEs at the heart of the housing bubble period. If government mandates are partially responsible for losses, should shareholders pay for those losses?
The increased appetite to loans created for less credit-worthy borrowers, however, did not explain the rampant fraud at companies like Countrywide and WAMU, which fueled the subprime bubble. This fraud is evident in the failure of the companies, the high default rate on subprime mortgages, and the billions of dollars in PLS settlements with the banks.
Additional evidence of government involvement included the $180 billion in subprime that the GSEs were asked to buy. A video recently began circulating among shareholders that shows Larry Summers speaking about the terrible default rates expected on private label securities and a stealth program enacted through the GSEs to buy these terrible investments. These mandated purchases eventually led to significant losses. If the government mandated these purchases as part of a “stealth” program to support the market, should private shareholders pay for it?
Some of the worst allegations in the AIG case involve the fact that AIG counter-parties were made whole by the regulators and that assets were sold to the New York Federal Reserve at a deeply discounted value. AIG willingly made the credit default swaps that got them into trouble, but one could argue that the assets sales should be considered as part of an arms-length transaction, not an opportunity to punish the companies.
Seizure by Regulators
In July 2008, Congress passed the Housing and Economic Reform Act (HERA), which gave Treasury the power to inject capital directly into the GSEs. It also established the framework for the administration of their businesses under the direction of the Federal Housing Finance Administration (FHFA). At the time, prominent figures like Federal Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson, and FHFA Director James Lockhart were engaging in a public relations campaign to help inject private capital into the GSEs and assure investors that they would not need to nationalize the companies. In fact, Ben Bernanke and Hank Paulson called the GSEs “adequately capitalized” in July 2008.
So, it came as quite a shock to shareholders when Hank Paulson used his bazooka to decapitate shareholders just two months later. In his book, On the Brink, Paulson brazenly describes how he wielded his power, almost as though he relished the ultimate power and paid no heed to the ramifications.
Thursday, September 4, 2008
Do they know it’s coming, Hank?” President Bush asked me. “Mr. President,” I said, “we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
I’m a straightforward person. I like to be direct with people. But I knew that we had to ambush Fannie and Freddie. We could give them no room to maneuver. We couldn’t very well go to Daniel Mudd at Fannie Mae or Richard Syron at Freddie Mac and say:
“Here’s our idea for how to save you. Why don’t we just take you over and throw you out of your jobs, and do it in a way that protects the taxpayer to the disadvantage of your shareholders?”
The news would leak, and they’d fight.
Several years later, Paul Volcker, a man that held Paulson’s position as Secretary of the Treasury called Paulson’s actions “boneheaded.”
There was literally no reason for the average retail shareholder to believe there were big problems at Fannie and Freddie (even though Paulson told some of his buddies at Eton Park otherwise). Fannie and Freddie still had access to the capital markets and continued to do business as usual.
In contrast, AIG began having liquidity issues in July 2008 and approached the Federal Reserve Bank of New York to see if they would open up their “discount window” to the company. Opening the discount window would have provided AIG with liquidity and kept them afloat. For a limited time, AIG also had an opportunity to pursue private sources of funding on their own.
For AIG, everything changed when Lehman declared bankruptcy. After that Paulson and Geithner began talks with investment banks, including Goldman Sachs, JP Morgan, and Morgan Stanley on how to seize AIG. Greenberg asked to attend these meetings, as the largest shareholder of the firms and his access was denied. A big portion of the Starr International case on AIG is about shareholder’s rights to attend meetings and vote on things like reverse stock splits, and the NY Federal Reserve’s authority to purchase equity.
As Dr. Richard Epstein points out in a recent Forbes article, the AIG board of directors remained in place during bailout negotiations. Compare that to the takeover of Fannie and Freddie, where the board of directors and management were removed at the exact same time that the companies were seized. There were no negotiations with Fannie and Freddie’s management or board of directors, and no representation by anyone outside the government. In fact, the key figure negotiating terms for the GSEs was Ed Demarco, a former Treasury official.
Market Support Mechanisms
During the financial crisis, AIG, Fannie Mae, and Freddie Mac were all used to backstop the financial markets in different ways. AIG had sold risky collateralized debt obligations (CDOs) to insure some types of investments from loss. Fannie and Freddie, as government sponsored entities (GSEs) were directed by Congress to purchase $180 billion in subprime securities. The GSEs also modified millions of mortgages under the HAMP and HARP programs, under supervision of Treasury and HUD. All of the companies continued to operate, with no significant break in their operations.
Terms of the “Rescue” Packages
common theme among AIG, Fannie, and Freddie was that the government takeovers of these institutions was meant to be punitive. This is something that Geithner and Paulson have written in their memoirs and testified in court.
For AIG, the senior preferred stock carried a 14% annualized cost and the government seized 79.9% of the common equity.
“The terms were bizarre: there was no relationship between the stock and the loan, as the government would keep the stock even after AIG repaid the loan in full. It was as if your bank lent you money to buy a home, and even if you repaid the loan, they took ownership of your home as well. The government had “rescued” a number of institutions during the financial crisis and not one was subject to such arbitrary and punishing terms.” – GW Law
For Fannie and Freddie, the senior preferred stock carried a 10% rate and the government seized 79.9% of the common equity as well. (It should be noted that the warrants are still unexecuted.) This agreement later changed to include a 100% sweep of all net worth.
Other companies received much more favorable bailout terms, including the banks, which were able to borrow $9 trillion from the Fed’s discount window at rates as low as 0%. Of the major investment banks that helped decide AIG’s fate, JP Morgan was the only bank that was not a major beneficiary of the Fed’s deeply discounted credit terms. But JP Morgan’s borrowing rate under TARP was still significantly better than the punitive terms extended to AIG.
While the terms of the bailouts were harsh, Dr. Epstein also notes that the original bailout agreement with AIG was followed to the letter of the contract. This included several steps that took place over a period of time. The 3rd Amendment to the Senior Preferred Stock Purchase Agreement, in contrast, was a significant deviation from the original agreement. This is an extraordinary case that should be reviewed completely separate from the AIG outcome.
Dr. Epstein adds,
“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 common element among the multiple lawsuits challenging the conservatorship and AIG bailout is that regulators exceeded their statutory authority. Selecting bailout terms that were punitive to shareholders, in fact, is the opposite of their missions. Their primary mission should be safety and soundness, not imposing punitive terms.
Even if Judge Wheeler rules against Greenberg, the ruling itself might provide some commentary on the punitive nature of the bailouts and actions taken by regulators that appear to be favorable to the banks over these companies.
And it should be made very clear that the AIG ruling has no bearing on the lawsuits challenging the 3rd Amendment to the Senior Preferred Stock Purchase Agreement.
Greenberg’s AIG case has some parallels to the lawsuits brought by preferred and common stockholders of Fannie and Freddie. Therefore, a ruling that is a loss for Greenberg could negatively impact the equity prices of Fannie and Freddie in the short run. Be prepared for short term volatility, but remember that the cases are very dissimilar from a legal perspective. Any drop could be an opportunity to acquire more shares.