GSE Conservatorships: A Washington Post Article Gets A Reality Check

To this day, I remain mystified by the widespread belief that Henry Paulson always tells the truth. To me it’s pretty obvious that the tail wags the dog in his recitation of events concerning the government takeovers of Fannie Mae and Freddie Mac. Just about everybody accepts his story as the official record, which I believe skewed Steven Pearlstein’s recent article in The Washington Post, “We bailed you out, and now you want what!?!”

It’s not easy to unwrap the many layers of deceit embedded within the conventional narrative about the takeover of the government sponsored enterprises; it requires a lot of explaining, which bogs down the flow of the text.

Exhibit A: My effort to supplement passages of Mr. Pearlstein’s article, and place events in their appropriate context. My comments, indented, follow.

When Treasury Secretary Hank Paulson decided the government needed to take over Fannie Mae and Freddie Mac in August of 2008, he too had a choice: Under the law governing the federally chartered mortgage giants, he could either put them in receivership, under which they would be shut down and their assets used to pay off their creditors, or put them into conservatorship, under which the government would attempt to stabilize them and nurse them back to financial health.

Paulson had no authority whatsoever to initiate either a conservatorship or receivership. Congress gave him special temporary powers to invest in the GSEs, on terms acceptable to the GSEs. Period. He had the power to invest in them for the purpose of stabilizing the financial markets, assuring the continued availability of mortgage loans, and protecting the taxpayers. Protecting the taxpayers was defined to mean, among other things, preserving the GSEs as private shareholder companies. The person with the authority to change the GSEs status was James Lockhart, director of the Federal Housing Finance Agency. But Paulson decided that he should run the show and bend Lockhart to his will.

And, contrary to what Paulson would have us believe, there was no evidence that a government takeover was necessary any time soon. Time is money. Any banker knows the difference between liquidity and solvency. For a financial institution, liquidity is like oxygen; you can’t live long without it. And for Bear Stearns, Lehman, AIG, plus a litany of hedge funds and mortgage lenders, a liquidity crisis (absent bailout) foretold certain death within 24 hours. Whereas solvency for a regulated financial institution is a much fuzzier concept, driven largely by timing differences under GAAP, which are generally calculated once a quarter.

The GSEs never faced any kind of liquidity problems. Ever. They had no difficulty funding their operations with short-term and medium-term unsecured debt. For many years, right up until September 5, 2008, the GSEs maintained 90 days liquidity. If, for some unprecedented reason, the GSEs were unable to refinance their unsecured debt for a three-month period, they could repay the maturing debt with cash, and with the sale proceeds of highly liquid securities held on their balance sheets. Contrary to what FHFA and others claimed, the GSE mortgage securities held on the companies’ balance sheets were highly liquid and actively traded up through September 5, 2008.

This familiar meme, that the GSEs needed the government to stabilize them in September 2008, had no factual basis. Nor were the companies expected to announce their quarterly earnings any time soon. But, as Paulson acknowledges in his memoir, the urgency was driven by his deadline for a government takeover days before Lehman Brothers released its third quarter earnings, on September 10, 2008.

Despite what many insinuate or claim, GSEs’ inability to issue new equity is not the same thing as day-to-day liquidity.

[Paulson] chose conservatorship but urged Congress to take steps to ensure they never again emerged in a form giving shareholders all the profits and taxpayers all the risk.

This popular “shareholder-gains-and-taxpayer-losses” meme, as it applies to the GSEs, has no factual basis whatsoever. First, we know now that the $187 billion “bailout,” has been more than fully repaid, though the government insists that it can never be repaid, because it’s equity.

Going back to September 2008, it was anybody’s guess what kind of financial burden the GSEs would impose on the taxpayers. But the only thing that was certain in 2008 was also certain for decades and remains absolutely certain today. GSE loan performance is and has always been exponentially superior to that of any other segment of the mortgage market. To state otherwise is to lie. And many commentators refer to the Fannie-and-Freddie-caused-the-crisis meme as The Big Lie.

Yet a small army of politicians, authors, academics, and journalists endlessly repeat the canards that affordable housing goals compromised the GSEs’ credit standards, caused the housing bubble, caused the mortgage crisis, and also caused the GSEs demise. Each and every one of these individuals rejects the metrics of capitalism.

They sidestep the business model for mortgage lending, which is all about getting your loans repaid with interest. (Everything else is inconsequential.) By the only standard that really matters, the GSEs are without peer. No one else had ever come close to matching their success. Also, mortgage lending is all about risk diversification, which is why lenders are judged by overall portfolio performance, not by some anecdote about risky loan products to poor people.

All the “experts” who insist that Fannie and Freddie failed share the same defining marker. Without exception, they refuse to compare GSE loan performance with that of any other segment of the market. You think it’s just an accident that all these “experts” refuse to talk about the fact that, between 1971 and 2007, Fannie’s average annual credit losses were below four basis points? Or that its annual credit losses, during 2008–2014, were one-fourth those experienced by commercial banks? You can’t exactly miss this stuff. Which is why GSE critics of all stripes adhere to vast conspiracy of silence, which prohibits any discussion of this data. These faux experts fabricate their thesis by way of smoke and mirrors, class bigotry and, in the case of professors at Columbia and Stanford, heavy duty race baiting.

As for measuring the GSEs’ solvency, never forget the immutable rule known to any financial institutions analyst: If you don’t understand the impact of timing differences, you are clueless. Timing differences — guesstimates about future loan writedowns and deferred tax valuations — are always subject to dramatic change. And when home prices were falling with no bottom in sight, any loss provision would be subject to dramatic readjustment. These non-cash timing differences, posted on GSE books between 2008–2011, triggered big drawdowns of taxpayer funds. But they were reversed, beginning in 2012. With 20/20 hindsight, the GSE loan loss provisions were wildly over inflated and the GSEs appear to be over-provisioned today based on current loan metrics.

If the GSEs’ accountants were clairvoyant, and were able to predict the actual realized loan losses with perfect accuracy, the necessary bailout funds during 2008–2011 would have been closer to zero.

The GSE bailouts were unique among all of Paulson’s September 2008 bailouts in three respects:

1. They were never used to offset liquidity shortfalls or fund operations,

2. They came at a heavy price, which served to impair the GSEs’ ability to restore capital, and

3. They were intended to be used as a de facto nationalization.

As for putting taxpayers at risk, GSEs critics appear to have been sleepwalking through the last eight years, when the GSEs, FHA and no one else provided the liquidity to stabilize the mortgage markets prior to the housing price uptick that began in 2012. The GSE benefits to the broader economy indirectly translated into benefits to the taxpayer, especially atfer the illusory GSE “losses,” which were reversed.

Both Paulson and the man who succeeded him, Timothy Geithner, have testified that it never occurred to them during the crisis that Fannie and Freddie might one day be able to fully repay the government or that there would be anything left over for shareholders by the time the conservatorship ended. But things turned out differently than they expected.

And why is this relevant? Actually, it isn’t. Or rather, it shouldn’t have been. First of all, Congress gave them no authority to decide the future fate of the GSEs. That authority resided exclusively with FHFA. Nor should the bailout have been structured according to Paulson’s expectations, but according to the mandate set forth by statute. The conservator’s mission coincides with the regulator’s mission; the one and only job is to support the GSEs’ financial health. Period. The conservator has zero authority to compromise the enterprises’ soundness and solvency to pursue some political agenda articulated by Hank Paulson, Timothy Geithner and Edward DeMarco. These three individuals are intent on abolishing the GSEs and calling it “GSE reform.”

If Paulson and Geithner were incapable of imagining that Fannie and Freddie would recover, it may be because they live within the bubble enshrouded by the vast conspiracy of silence. They didn’t consider how the GSEs had been highly profitable for 35 years. And maybe they remain in denial about the complete and unmitigated failure of private label residential mortgage securitizations, which were riddled with fraud,

Because of the success of the government rescue, and the near-total retreat of private lenders and guarantors from mortgage finance, Fannie and Freddie returned to profitability and solvency by the end of 2012 — perhaps not coincidentally, at the very time the government swept all of their profits into the Treasury.

Pearlstein doesn’t go as far as others, who insist that, when anything bad happens, it’s the GSEs fault, and whenever anything good happens, it was because of the bailout.

The rescue would have been equally successful without any cash drawdown, just a government backstop, because, unlike the investment banks and AIG, the GSEs’ always generated strong positive cash flow

Pearlstein makes passing mention of the government sweep, as if it were no big deal. And it might not be a big deal to someone unfamiliar with basic concepts of corporate law, insolvency law, and the statutes governing the GSE conservatorships. In the real world you wouldn’t see an insolvent company, or a company in conservatorship, pay out cash dividends because it’s illegal. It’s a violation of the directors’ fiduciary duty and the conservator’s fiduciary duty to preserve the value of the corporation for the benefit of all shareholders and creditors.

So, yes, sweeping all the profits out of a company, making cash dividends — distributions out of earnings that were non-cash reversals of non-cash losses that were highly suspicious in the first place — is a violation of a director’s and conservator’s fiduciary duty to the corporation, and a fraudulent conveyance intended to impair the economic claims of other shareholders, to whom the directors and conservator also owe a fiduciary duty.

The conservator had zero justification for agreeing to the Third Amendment, which, to anyone with financial literacy, looks like a sham transaction, a huge transfer of economic value in exchange for zero consideration. It doesn’t matter what the government did previously (past consideration is no consideration) and it doesn’t matter if the government agreed to defer senior preferred dividends in the future, because dividend payments are not firm legal obligations to make cash payments on fixed dates, like debt.

What Paulson and Geithner also didn’t anticipate was that, despite a bipartisan consensus that the mortgage giants should be wound down, Congress would be unable to agree on a system to replace them.

Beware. Whenever you read an article about the GSEs and see the word “consensus,” it’s a red flag. This consensus is synonymous with the vast conspiracy of silence, which refuses to engage in any open debate about the merits of the GSEs. Why entertain the idea that the GSEs had not failed, when a consensus (an ideological echo chamber) says otherwise?

“There appears to be a broad consensus that Fannie Mae and Freddie Mac should be replaced by a private system,” write the four economists for the New York Fed. These economists say the GSEs were destined to fail because of the, “moral hazard incentives emanating from the implicit guarantee,” which, they claim, is explained in a book written by four professors at NYU. In Guaranteed to Fall, we learn that legislation mandating affordable housing goals, passed in 1992, changed everything. They write:

“The GSEs had crossed their own Rubicon in the mid 1990s after the passage of [the 1992 Act]. The moment that the GSEs lowered their underwriting standards, there was no turning back, and as soon as housing prices started falling, their fate was sealed.”

That’s right, affordable housing goals must, by definition, translate into lower credit standards. And once the GSEs started catering to those people, management was incapable of making any mid-course correction during the 15 years that followed.

“There is little doubt that the housing goals played an important role in shifting Fannie Mae and Freddie Mac’s profile to riskier mortgage loans,” write the NYU professors, who back up their claim with zero evidence. For 15 years, from 1993 through 2007, Fannie’s average annual credit losses averaged 2.7 basis points. Which may possibly be the best track record for retail lending in American history. But why talk about loan performance when there is ‘little doubt’ about the impact of housing goals?

“There is a consensus today that these enterprises [the GSEs] pose a systemic risk and they cannot continue in their current form,” said Paulson on September 7, 2008. From that point onward, Treasury and FHFA have continually invoked that “consensus” opinion as if it were a certifiable fact, as certain as the case against cigarettes or lead paint. You can find references to the same “consensus” are here, here, here, and here.

Nobody anywhere has the legal right to keep the GSEs in conservatorship, that is, in a holding pattern, until a Congress revokes their charters. The present government policy was some kind of imaginary “mandate” that Hank Paulson pulled out of his hat on September 7, 2008, and which Geithner and the Obama Administration treat as sacrosanct.

Again. Pearlstein seems unaware of the law. It doesn’t matter what Paulson or Geithner anticipated; what matters is what the law says. The law says the opinion of the Treasury Secretary is irrelevant, because the conservator, FHFA, is the decider. Paulson sought to circumvent the law by drafting a Senior Preferred Stock Purchase Agreement that gave Treasury veto power over all of FHFA’s major decisions.

Today, this “consensus,” is embraced by Republicans, who have been told for years that the GSEs are evil incarnate, and by a handful of Democrats, who recognize that GSE abolition is the starting point for passing any housing finance legislation.

Ever since Hank Paulson announced the takeover on September 7, 2008, he and his cohorts have referred to this imaginary “consensus,” which is comprised of right wing ideologues and those who whore for Wall Street. They all adhere to a vast conspiracy of silence, which refuses, under any and all circumstances, to compare GSE loan performance with that of any other segment of the market. Trust me, no one in the business world would tolerate such nonsense.

Democrats and their industry allies insist that some limited form of government guarantees are necessary to ensure the availability of affordable 30-year mortgages at fixed rates. Tea party Republicans are just as adamant they will not agree to any government guarantees that once again put taxpayers on the hook.

Once again, Pearlstein lets the tail wag the dog. The only mortgage products that have stood the test of time over the decades are 30-yr and 15-yr FRMs. Just about every other loan product has blown up after a few years. Check out any data comparing FRM loan performance with that of ARMs during a period when rates were really low. But since the GSEs must die, and the GSEs have a competitive advantage in financing 30-yr FRMs, the same anti-GSE “consensus,” wages war against the loan product.

“Given the catastrophic conditions of Fannie Mae and Freddie Mac, it is clear that the 30-year fixed-rate mortgage is outright dangerous,” writes Michael Lea of The Mercatus Center. And less you miss the point, Karen Petrou declares “the 30-year fixed mortgage is a social entitlement.” “Government Must Jettison the 30-Year Mortgage” declares Edward Pinto. (Pinto is at the center of the vast conspiracy of silence, as explained here.)

If all mortgages were FRMs 8 years ago, there never would have been a mortgage crisis. If the GSEs had not financed these products in large numbers the housing crash world have been far, far worse

The only players with the capacity to offer 30-yr and 15-yr FRMs in large numbers are the GSEs. This is for two reasons. First, the GSEs issue mortgage backed securities which transfer interest rate risk, but not credit risk, to the investor. Investors are willing to take interest rate risk when credit risk is a non-factor. And the GSE’s can absorb credit risk, because their loans are booked before during and after the peak in a housing cycle. Whereas market timing has an explosive impact on recovery for private label securitizations.

Second, there is zero reason to believe that the GSEs could not continue what they were doing successfully without government support if they had 5% capital, which would have kept them fully solvent during the crash, based on their phantom “losses” of 2008–2011, which were largely reversed. There’s this kind of casual insinuation that 30-yr FRMs cannot operate without putting taxpayers on the hook, so therefore should be considered dispensable.

While it is three hedge funds — Perry Capital, Fairholme Fund and Pershing Square Capital, led by William Ackman — that have sued the government, the outcome will likely affect all shareholders. These include a number of small banks that were encouraged by the Paulson Treasury to buy preferred shares in the months before Fannie and Freddie’s downfall, and tens of thousands of small, individual holders of common stock, including many former employees and retirees in the Washington area. Their claim is that Congress and the White House are using Fannie and Freddie to fund the federal budget.
But James Parrott, a fellow at the Urban Institute, says the idea that these companies will ever emerge from conservatorship and be able to earn profits for their shareholders is a fantasy. Parrott helped conceive of the profit sweep while working in the Obama White House. He says that even if Fannie and Freddie were allowed to use current profits to pay back the Treasury’s $187 billion investment, they would still have to raise hundreds of billions more to have the capital to operate independently.

Parrott assumes that the GSEs, because they are Systemically Important Financial Institutions., must hold 10% capital, whereas his Urban Institute colleague, Laurie Goodman, says 5% is plenty.

Other government officials say Fannie and Freddie’s profits are themselves a fiction, because they would not exist but for the government handspun standing behind all of their financial obligations. If the Treasury were to charge them anything close to a market rate for its guarantee, there would be no profits.

Yes, if you are subject to the vast conspiracy of silence, and refuse to examine timing differences under accrual accounting, then you can easily arrive that the conclusion that the GSEs cannot operate without a formal government guarantee, as they had for decades.

These government officials and their cohorts seem to be oblivious to the structures of GSE mortgage-backed securities, which have strong advantages totally separate from any implied government support. These are the only MBS that involve the transfer of interest-rate risk but not credit risk, since they are all subject to corporate guarantees. This is huge, because market timing risk is huge in real estate lending. Investors don’t have to worry if they have a security interest in a specific mortgage pool are comprised of a bunch of loans booked at the peak of the market before the downturn, or if the loans are outliers, a bunch of lemons.

Investors feel comfortable with these MBS because they are self liquidating, and because, unlike all other residential mortgage securitizations, they ameliorate market timing risk

But that’s always been the case for Fannie and Freddie. From the beginning they were set up to be a unique hybrid: government-backed enterprises with private shareholders and private capital. Until Congress comes up with another arrangement, say lawyers for the shareholders, the profits are real and the shareholders are entitled to use them to pay down the Treasury’s investment and begin recapitalizing the company and paying themselves a dividend. By some estimates, that could happen in the next several years if profits continue at current levels.
Government lawyers and officials dismiss such speculation.
Under the law setting up the conservatorship, they argue, Fannie and Freddie’s shareholders are entitled to nothing. They have no right to sue in court. They are not entitled to vote on any corporate decisions. They are not entitled to a penny of the companies’ profits or any proceeds from the sale of company assets. Not now, not ever. In effect, the government is claiming the right to operate Fannie and Freddie however ever it wants, for as long as it wants, until it’s ready to close them down for good.

Problem is, the law setting up the conservatorship says nothing of the sort. Shareholders have no right to sue the conservator, if he acts within his duties. But if he acts outside of those duties, all bets are off. Shareholders may not be able to vote on corporate decisions, but the conservator, acting in the shoes of the directors, officers and shareholders, has a fiduciary duty, first and foremost, to the corporation, which is held in trust. Saying the government has the right to operate them how it wants is complete BS.

I defy anyone to point to any case anywhere in which the shareholders rights were completely nullified without the formal approval of a judge. And if such were the case, then why did FHFA allow the common and preferred shares to continue trading, with ownership registered with the corporation

In an opinion last fall, Judge Royce Lambert of U.S. District Court in Washington ultimately ruled that that was what Congress intended when it wrote the laws governing Fannie and Freddie but acknowledged that such a sweeping assertion of government powers may “raise eyebrows or even engender a feeling of discomfort.”

Lamberth’s problem was that he doesn’t know how to read carefully, and/or he seems to be financially illiterate. He concludes that the government can do whatever it wants, and is exempt from judicial review, because FHFA can assume all the powers and privileges of the directors, the officers and the shareholders. And, as Lamberth quotes the statute, “no court may take any action to restrain or affect the exercise of powers or functions of [FHFA] as a conservator or a receiver.” 12 U.S.C. § 4617(f).

OK. But certain actions are outside the powers or functions of a conservator, such as repudiating the conservator’s obligation to restore the soundness and solvency of a GSE, or making a complete sham of corporate governance, or disregarding relevant corporate law.

Lamberth also argues that FHFA can act like a receiver even before it places the GSEs in receivership. He writes in a footnote:

“Even if FHFA has explicitly stated an intent to eventually wind down the GSEs, such an intent is not automatically inconsistent with acting as a conservator. There surely can be a fluid progression from conservatorship to receivership without violating HERA, and that progression could very well involve a conservator that acknowledges an ultimate goal of liquidation. FHFA can lawfully take steps to maintain operational soundness and solvency, conserving the assets of the GSEs, until it decides that the time is right for liquidation.”

“There surely can be a fluid progression, “ when words have no meaning. A conservatorship doesn’t morph into a receivership according to the whims of the conservator. The mission of a conservatorship is to restore the company’s soundness and solvency; a receivership is supposed to wind down the company’s affairs. A receivership may commence after it’s been determined that the conservatorship cannot succeed. But a conservator cannot illegally sabotage the soundness and solvency of a company so that it becomes a better candidate for receivership.

You can preserve value when you are winding down affairs, but you can’t irresponsibly drain a company of equity before or after you begin winding down affairs, because you don’t know for sure how much equity will be needed to cover debt obligations in the future.

It will now be up to Sweeney and the Court of Claims to decide whether what Congress intended amounts to an illegal and unconstitutional taking.
One thing is already known, however. In deciding whether shareholders or taxpayers will profit from government bailouts, judges Sweeney in the Fannie and Freddie case and Wheeler in the AIG case are unlikely to have the last word. With so many billions of dollars at stake, their decisions are almost certain to be appealed all the way to the Supreme Court.
For Dennis Kelleher, a former Senate staffer and corporate litigator who heads an advocacy group for financial sector reform, it’s all just another example of Wall Street’s “indefensible arrogance. . . .Wall Street lives in an alternative universe where at all times it’s heads I win, tails you lose.”

In this instance, Henry Paulson’s indefensible arrogance dictated a multi-step wind down of the GSEs, irrespective of the statutory language and Congressional intent. The Obama Administration continued that mission by executing the Third Amendment.

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