Congress Can’t Wash Away the Executive Branch’s Sins

Richard Epstein

The stakes could not be any larger in the multi-billion dollar financial dispute pitting a large group of institutional investors in Fannie Mae and Freddie Mac against the United States government. Thus far, the debate has largely taken place in the courts, and I have commented extensively on the fundamental weakness of the government’s effort to sign away the rights of these investors through a deal entered into by the Federal Housing Finance Authority and the Treasury Department. 

That debate has how spilled over in to the political arena. Right now, the main mission of the Senate Banking Committee’s Johnson-Crapo housing finance bill is to develop a new framework for future residential home mortgages. Unfortunately, the bill also tries to ditch the many lawsuits brought by private shareholders of Fannie and Freddie Mac against the government for existing claims. While the authors of the bill continue to claim that the proposed legislation leaves the issues relating to investors’ rights to the courts, Section 604 of the bill declares that the August 17, 2012, Third Amendment to the original Senior Preferred Stock Purchase Agreement (SPSPA) “shall not be amended, restated, or otherwise changed to reduce the rate or amount of dividends” and thus perpetuates the government’s right to take all the profits from the two companies.

Let’s set this audacious move into context. In September 2008, the original SPSPA authorized the $188 billion government bailout of Fannie and Freddie. Its terms required each company to pay a 10 percent dividend in cash on outstanding balances, rising to 12 percent if Fannie and Freddie deferred repayment. Just as the housing market turned up in 2012 (when Fannie and Freddie became profitable), the Third Amendment, signed by Timothy Geithner for Treasury and Ed DeMarco for the Federal Housing Finance Authority, dumped the 2008 agreement, agreeing to a full sweep of all Fannie and Freddie dividends to Treasury. From that time forward, the private shareholders of Fannie and Freddie could not get back one dime, no matter how profitable their operations became (Full disclosure: As I’ve noted elsewhere, I have consulted with several institutional investors on this issue). This was a big deal. Of equal importance is the fact that the taxpayers have now received back over $200 billion on their $188 billion advanced to the GSE behemoths, and now the US Treasury is poised to realize billions more.

It was a rotten deal from start to finish. DeMarco was conservator, with fiduciary duties to Fannie and Freddie’s private shareholders. Neither company was in or near default at the time, so the Treasury could not unilaterally wipe out the shareholder interests (which is why the new transaction is described as the Third Amendment to the original deal). DeMarco faced no compulsion to join with his former bosses at Treasury to wipe out their shareholder interests — but he did owe fiduciary duties to both the common and junior preferred shareholders.

In court, the shareholders attacked the Third Amendment on three grounds. The first is that DeMarco and Geithner engaged in massive self-dealing to loot Fannie and Freddie. The second is that the Third Amendment was, in reality, a new deal, which could not be made because the then-operative statute did not allow for any new deals as of January 2010. The third is that this wildly imbalanced sweep took Fannie and Freddie assets without just compensation.

The government has defended its asset grab in part by insisting that the shareholders don’t even have standing to protest the government action. The dicey nature of the government’s arguments has led the executive branch to seek legislative reinforcement. Congress wants Johnson-Crapo’s Section 604 to end the breach of fiduciary duty, administrative law, and constitutional claims. It may have luck on the administrative law claims, on the ground that the government is entitled after the fact to authorize previous maneuvers that its officials have undertaken. The contract and constitutional issues, however, remain. Waving a legislative wand won’t make them go away.

The shareholders fiduciary duty claims arise out of FHFA’s contract rights under the SPSPA. The 1996 Supreme Court decision in United States v. Winstar Corp. held that government is bound to its contracts with banks just like any private party. That principle applies to the SPSPA. The government cannot pass an ad hoc law that tells the courts to ignore its breach of contract.

The takings claim is still alive as well. Constitutional rights are immune from legislative annihilation. The government could not pass legislation that authorized it to take land for public use without just compensation. Clearly, then, no legislation could invalidate a claim for compensation against the government for actions that were completed before the legislation was passed. Shareholders have rights to both control and cash flows. The Third Amendment and Section 604 purport to annihilate both. Yet, as Winstar shows, government lacks the power to back out of its own obligations.

The real tragedy of Johnson-Crapo is that a strong bipartisan populism now privileges the public purse over public duties. But the government’s effort to use the Fannie and Freddie money to ease the pain of deficits gets matters backwards. Taxation is the proper way to raise public funds. Honoring past deals under the rule of law is critical if the government is to remain a credible financial player.

Right now, Congress is desperately trying to persuade Wall Street firms and other investors to pony up hundreds of billions in capital for a new residential mortgage system. But what firm would lend money knowing that the recipient, with the help of the federal government, could wipe out its debts and contractual obligations with the stroke of a pen? First Chrysler, now Fannie and Freddie. ­The inevitable question: who’s next?