The Favoritism Underlying Fannie & Freddie's Conservatorship

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Recently, the D.C. Circuit heard oral arguments on the challenges to the government's continued stripping of value from Fannie Mae and Freddie Mac. The arguments may be couched in legalese, but they raise fundamental questions about fair administration of the law affecting the companies, mortgage markets, investors, and the public.

Since 2012, Treasury has seized more than $245 billion from the companies - including virtually all of their buffers against future losses - which is more than $55 billion that the entities borrowed. This quarterly confiscation continues today - leaving the public to bear any future losses from these mortgage giants. New documents demonstrate that Treasury decided to start stripping all value from the companies "coincidentally" when Fannie Mae and Freddie Mac began to earn operating profits. While this directly affects investors who assumed the government would comply with governing law and financial contracts, these seizures also directly increase risk to the public and undercut any future expectations that the government will treat all parties fairly. In short, can the government simply ignore the law governing its actions as well as the contracts governing our markets?

Since the U.S. Treasury placed Freddie Mac and Fannie Mae into Federal Housing Finance Agency conservatorships in 2008 under the Housing and Economic Recovery Act ("HERA"), Treasury's posture on the protections of the private investors has changed dramatically. Initially, in 2008, Treasury confirmed that the "[c]onservatorship preserves the status and claims of the preferred and common shareholders". However, in 2012, Treasury acted to eliminate any interest by the private investors through a "net worth sweep" that strips Freddie Mac and Fannie Mae of any retained earnings - and never reduces their debt to the government. Despite having repaid tens of billions more than was borrowed from Treasury - with interest - the net worth sweep continues. Most perniciously, it leaves you and me - as taxpayers - completely exposed to any future losses in Freddie Mac and Fannie Mae by stripping any remaining capital cushion to zero. That is not only perverse, but dangerous because it ensures a future bail-out when the housing market turns.

Why does this matter? Because government's role in regulating the market and providing a well-designed bankruptcy system is fundamental to the economic and political freedoms we enjoy. In fact, unbiased governance of regulation and insolvency is a key distinguishing feature between successful and failed market economies.

The "net worth sweep" and stripping of value in the perpetual Freddie Mac and Fannie Mae conservatorships ignore the necessary role of government. I do not make this statement lightly. After more than twenty years at the FDIC, and frequent participation in domestic and international efforts to improve insolvency laws, I provided technical advice to Congress on HERA. My primary model - and an internationally recognized standard - was the Federal Deposit Insurance Act (FDIA), which has served this country well for more than 80 years by closing insolvent banks, protecting insured depositors, and recycling the failed bank's loans back to sound banks. In fact, HERA parallels the FDIA in virtually all of its provisions.

HERA was never meant to authorize a seven-year conservatorship. Under HERA, FHFA and Treasury have the clear statutory authority to begin reform by ending the conservatorships of Fannie and Freddie. Director Watt has acknowledged this authority. Many, including Senate Banking Committee Chairman Tim Johnson, have called on Watt to do so.

FHFA's statutory authority to end the conservatorship isn't a question of interpretation or policy debate. It is simply a question of what HERA actually says - supported by long-standing interpretations of its model, the FDIA.

First, HERA - just like the FDIA - provides for conservatorships and receiverships to give the FHFA some flexibility to decide how best to resolve a failing Freddie or Fannie. However, the discretion is not unlimited. In fact, HERA requires termination of the conservatorships and appointment of FHFA as receiver if Freddie and Fannie remain insolvent. The FHFA Director is required to make periodic findings on this point precisely to provide discipline to the process.

Second, not only does HERA provide this discipline, it also imposes duties on FHFA as conservator. In this role, FHFA is instructed to return Freddie and Fannie to "a sound and solvent condition" and to "preserve and conserve the assets and property" of the companies. The FDIA includes the same instructions. The FDIC has always treated conservatorships as short-term solutions leading to the recapitalization and return of the failing bank to full private control or to a receivership and payment of creditors and stockholders.

Finally, the continued diversion of Freddie and Fannie's profits to Treasury misuses HERA as well as ignores the international standards underpinning all insolvency frameworks. This is important because one foundation of corporate finance, and our system of commercial laws, is that insolvency law assures creditors that the remaining value of the company will be paid out under defined priorities. If this standard is ignored, as it has been through the Treasury sweeps from the Freddie and Fannie conservatorships, it will undoubtedly affect future investment in housing finance and the financing costs for businesses.

By keeping Freddie and Fannie in perpetual conservatorships, the FHFA is ignoring the basic duty of a trustee - to protect the interest of all creditors. By keeping the companies in conservatorships and diverting their cash to Treasury, the FHFA is preferring one creditor over all others. While Treasury provided critical up-front funding, the original agreements already well-compensated it. It cannot simply strip the companies of cash in perpetuity. Every sound insolvency process - including HERA and the FDIA - repays the funding provided, but then pays all creditors the remaining value. In bank resolutions, once the FDIC's cash outlay is repaid, it gets no more. The continuation of the sweeps through the conservatorships is a violation of every principle established in bankruptcy and in the more than 80 years of FDIC bank resolutions. And, it has no support in HERA.

Michael Krimminger is a partner at Cleary Gottlieb, and former general counsel at the Federal Deposit Insurance Corporation (FDIC).  

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