Was the Fannie/Freddie 'Death Spiral' All a Mirage?

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On April 13th, Judge Margaret Sweeney of the United States Court of Federal Claims delivered a decisive blow to the government's attempts to keep the truth about the Third Amendment under wraps. She unsealed seven documents produced during ongoing litigation challenging the lawfulness of the Treasury's 2012 decision to sweep all of Fannie Mae and Freddie Mac's profits. The documents - excerpts of three depositions and four emails - undermine the government's position that the notorious profit sweep was essential to avoid a "death spiral" in the national housing market. However, the documents strongly suggest that no such threat existed at the time. What is more, the documents reveal that at the time of the Third Amendment, government officials had every reason to know that the GSEs' outlook was improving.

When Treasury imposed the net profit sweep on the GSEs, government officials argued that it was a necessary measure. Allowing the Treasury to take 100% of the firms' profits was the only way to avoid a "circular draw" whereby the GSEs would, in essence, be forced to pay the Treasury for their outstanding commitments with money borrowed from the Treasury. In effect, the government argued that desperate times called for desperate measures.

However, notwithstanding all this talk of a GSE death spiral, Fannie and Freddie returned to record-setting profitability months after the profit sweep went into effect. (Fannie alone posted $59 billion in profits in the first quarter of 2013.) This left many commentators wondering how Treasury's projections managed to fall so far short of the mark.

The depositions unsealed by Judge Sweeney last week reveal a story that contradicts the government's narrative. In one deposition the former CEO of Fannie Mae, Susan McFarland, explained that a week before the Third Amendment was announced she reported to Treasury officials that the company was "now in a sustainable profitability, that we would be able to deliver sustainable profits over time." Her optimism was guarded, but emphatic. "We were not there yet," McFarland added, "but. . . you could see positive things occurring. . . So when the amendment went into place, part of my reaction was that they did that in response to my communication of our forecasts and the implication of those forecasts, that it was probably a desire not to allow capital to build up within the enterprises and not to allow the enterprises to recapitalize themselves."

Another deposition suggests, at the very least, that government officials cannot keep their story straight. Mario Ugoletti, formerly a special advisor to the Director of the FHFA, contradicted a prior affidavit in which he stated that at the time of the Third Amendment, the FHFA and Treasury believed that the GSEs' deferred tax assets would not be released, further impairing the companies' ability to return to profitability. However, when pressed on the issue during his deposition, Ugoletti stated simply, "I don't know what anybody else thought about it."

The unsealed documents also yield a second major revelation: the markets are a lot more resilient than the Treasury Department thinks they are, and the judiciary is a lot more independent than Treasury officials might expect it to be. The government has fought tooth and nail to avoid discovery and public disclosure in the lawsuits challenging the Third Amendment. Initially, the courts gave the government the benefit of the doubt with respect to the potentially destabilizing implications of public disclosure.

In a 2014 declaration filed with Judge Sweeney, then Director of the FHFA Mel Watt warned that public disclosure of information about the Third Amendment would unleash a chain reaction of nearly nuclear proportions on the American housing market. It would "have a destabilizing effect on the Nation's housing market and economy," he warned, and "easily could set off a chain of volatile and unpredictable reactions in the financial markets that could not be contained." At that time, Judge Sweeney authorized discovery in the case to proceed, but she imposed a strict protective order to prevent public disclosure of information produced out of deference for the government's concerns.

But with the government's claims growing more outrageous by the day, the court has changed course. When government lawyers recently redoubled their efforts to keep discovered information out of the public eye by resubmitting Watt's 2014 declaration to Judge Sweeney, she did not take the bait. In a blistering reproach of Treasury and FHFA officials, Judge Sweeney rejected the government's efforts to stonewall the public, writing:

While the court recognizes that protection of the Nation's financial markets and fledgling financial institutions were legitimate goals when the court first entered its order, with the passage of time, the potential for harm to the Nation's markets and then-fledgling financial institutions no longer exists. Instead of harm to the Nation resulting from disclosure, the only "harm" presented is the potential for criticism of an agency, institution, and the decision-makers of those entities. The court will not condone the misuse of a protective order as a shield to insulate public officials from criticism in the way they execute their public duties.

Judge Sweeney's decision to remove the "Protected Information" designations from the documents was a restrained and measured move that will have far-reaching implications for the GSEs and for the rule of law generally. And if the first round of public disclosures is any indication of what is to come, public officials will have a lot to answer for in the way they have executed their public duties through the GSEs.

Tara Helfman is associate professor of law at Syracuse University College of Law.  

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