Oral Arguments in Perry Capital v. Lew Devolved Into Nonsense

"To see what is in front of one’s nose needs a constant struggle," wrote George Orwell, who aptly described the litigation surrounding the Third Amendment to the Senior Preferred Stock Purchase Agreement, under which the Department of Treasury purchased $187 billion in equity to "bail  out" Fannie Mae and Freddie Mac.

What’s in front of everyone’s nose is that a conservator drained a quarter trillion dollars in equity out of two undercapitalized corporations. To anyone who ever completed a course in accounting or corporate law, what is in front of everyone’s nose should be easy to figure out. The cash dividends, which drained $250 billion out of Fannie and Freddie, were patently illegal.

•    Dividends paid in cash reduce corporate equity.  Whereas dividends paid in kind preserve corporate equity.

•    A corporation has no legal obligation to pay cash dividends within any specified timeframe, ever. If there were such an obligation, the investment would not be equity; it would be debt. Debt is extinguished upon repayment of principal. If an equity investor wants to recover his initial principal outlay, his only option is to sell the stock.

•   A company may pay cash dividends only to the extent that it can afford to. Otherwise, under a variety of laws, it is prohibited from doing so.

•    By definition, a company in conservatorship cannot afford to pay cash dividends. When preferred stock dividends come due, the company must pay those preferred dividends in kind, because conservatorship is a legal obligation to conserve cash and preserve equity. The foundation of all insolvency law is that equity gets paid last. Shareholders must wait until the company returns to self-sufficiency before they receive a cash payout.

Some otherwise intelligent people seem to have forgotten these basic concepts. Which is why they got sidetracked during oral arguments in Perry Capital v. Lew, heard before a three-judge panel in the D.C. Circuit Court.  At times the back-and-forth seemed less like a legal colloquy and more like theatre of the absurd. Plaintiffs sought to overturn a lower court ruling that summarily dismissed their lawsuit challenging the legality of the Third Amendment sweep. 

The plaintiffs in Perry do not challenge the legality of cash dividends paid before implementation of the Third Amendment.  This must have led the judges to presume that those pre-2013 dividends were legal.  In fact, none of the cash dividends were legal, if you apply the four basic concepts noted above. Of course, I offer these criticisms with all due respect to the jurists and to the D.C. Circuit Court.

Don't pay cash dividends if you can't afford them.

Early on in the proceeding, plaintiffs' counsel Ted Olson reminded everyone of a basic concept. "The dividends could have been paid in kind," he said.  Such payment, "would have preserved the capital of the institution[s]." This provoked a spirited response from Judge Patricia Millett:

JUDGE MILLETT:  Well, surely that decision whether to require dividends in cash or in kind is exactly the type of judgment that's going to be conferred on the [GSE's] conservator that we could superintend, would you agree with that.MR. OLSON:  Well, but what we're talking about here is the --JUDGE MILLETT:  But would you agree that we certainly couldn't say, we couldn't say the conservator erred and enjoined them, or a declaratory judgment, they should have done a liquidation rather than preference rather than cash.

And later, Judge Douglas Ginsberg commented...

JUDGE GINSBURG:  They were inferring that from the pattern of continued losses, and I think twice maybe more times in which the GSEs borrowed the money simply to pay it back as a dividend, rightMR. OLSON:  Well, the payment of the 10 percent dividend did not have to be done, not a cash dividend.JUDGE GINSBURG:  I understand that, but --MR. OLSON:  Could have been done --JUDGE GINSBURG:  -- Judge Millett just covered that with you, that's true, but that's a discretionary decision that's hardly our role --Sorry Judges Millett and Ginsberg, cash dividends, while discretionary, are subject to certain legal conditions. If words have meaning, a conservator of an undercapitalized GSE does not have the discretion to drain it of cash and equity. Also--and this is important Judge Ginsberg--the GSEs never "borrowed" money to pay back cash dividends. The government simply increased its equity investment in the GSEs. And if the GSEs had paid out dividends in kind, it would have been unnecessary to draw down further on a federal commitment to "fund" any dividends that exceeded current earnings. To keep the law tethered to reality, you need to follow the money, which in this case means following the flow of funds. This is why federal courts, when reviewing cases in transfer pricing or money laundering, look beyond the form of a transaction to examine its economic substance, its underlying fundamentals. 

The discussion proceeded...  

JUDGE GINSBURG:  So, I want to put ourselves in the position of the FHFA prior to, just prior to the Third Amendment, and at that point as I understand it the GSEs have been pretty consistently losing money, the prospect of realizing anything on the tax credits because there will be profitable quarters in the projected future, is looking like 2013, 2014, somewhere in that range, there's a handwritten note on a document suggesting, a Treasury document suggesting that, right?

And then there was an extended discussion about what people knew and when they knew it. Olsen respectfully proceeded down that factual rabbit hole. Judge Ginsberg, who cares if FHFA believed or didn't believe the GSEs were going to realize tax credits? That line of inquiry is marginally relevant to the issue at hand, which is whether FHFA defied its legal duties.  The agency has two jobs, which basically overlap.

FHFA must promote the GSEs' health; it can do nothing else.

As regulator, FHFA's job is to promote the safety and soundness of the GSEs. As conservator, FHFA's job is to "restore the soundness and solvency" of the GSEs. Unless and until FHFA puts the GSEs in receivership, which would never happen because it would cause the mortgage and housing markets to crash, FHFA has no power to do anything else. It has no power to "reform" housing finance or the mortgage markets.  It has no authority to do anything other than support the financial health of the GSEs.  FHFA has no authority to take action that is antithetical to its job. 

Note that FHFA has redefined its job description, and invoked all sorts of imaginary powers pertaining to "GSE reform" in order to justify its efforts to stymie recapitalization of the GSEs.

Judge Millett seemed to buy into FHFA's notion of imaginary powers, based on the political goals of various unrelated parties:

JUDGE MILLETT:  See, I think as I read the record it's more complicated and nuanced than that, and that is that an awful lot of folks both on Capitol Hill and within the Executive Branch think that we cannot go back to the pre-2008 situation here, but we, FHFA are not, we're not the ones to make that call, or is Treasury by itself, and so what we will do, we do not want to liquidate these two entities, that would be extraordinarily damaging to the economy -. MR. OLSON:  So, we want to --JUDGE MILLETT:  -- we're going to hold them, we're going to hold them, and we're going to keep things in a stable condition until the policy makers make a decision.MR. OLSON:  This is not --JUDGE MILLETT:  What's wrong with that?MR. OLSON:  That's not sound and solvent.  The statute requires keeping institutions sound and solvent. JUDGE MILLETT:  It's sounding solvent [!?!?], you told me they're making all this money, that sounds like the definition of sound and solvent.MR. OLSON:  Not if the conservator which is supposed to be acting as a trustee, a fiduciary to the entities decides I will take all of the profits and give it to the Treasury Department.JUDGE MILLETT:  Well, a fiduciary to whom, because this statute is different, it doesn't say a fiduciary to stockholders, it's a fiduciary serving the best interests of the entity or the agency.MR. OLSON:  No, I submit that that reference, which is under incidental powers in the statute itself, doesn't provide a conservator to act in its own best interests, or in the interests of --JUDGE MILLETT:  Well, what does it mean?  What does it mean if it doesn't say they can't take something in the interests of the agency?MR. OLSON:  Well, it can, and are incidental --JUDGE MILLETT:  I think the FDIC has the same language.

Focus Judge Millett. The conservator has a fiduciary responsibility, first and foremost, to the companies in conservatorship. Period. I don't know where you got this idea that dividends in conservatorship might, "serve the best interests of the agency," which in this case I presume you mean FHFA. If by serving the "best interests of the agency" you mean keeping the GSEs on ice until Congress comes up with an alternative, then I must disabuse you of these imaginary powers presumed by FHFA.

A regulator can only do what it is authorized by statute. Though statutes can be construed different ways, there is no statute anywhere, and no legislative history, to suggest that FHFA can do anything other than promote the financial health of the GSEs prior to any formal receivership. So FHFA and Treasury and The White House don't like the GSEs or their business model, too bad. FHFA has a firm legal obligation to promote the financial health of the GSEs, and to take action  in clear defiance of that legal obligation is worse than a dereliction of duty..

Receivership is more than a formality.

And yet, in the D.C. Circuit courtroom, the nonsense proceeded...

JUDGE GINSBURG: [T]hey're still, in their capacity as conservator they haven't yet pulled the trigger as a liquidator, right?MR. OLSON:  Well, they're pulling the trigger --JUDGE GINSBURG:  As a receiver...MR. OLSON:  -- but they're not admitting it, and they're still supposed to be acting as a conservator, and then they decide no, we're going to take --JUDGE GINSBURG:  Just go back, I have your point, just go back a moment to what Judge Millett was saying about the somewhat conflicting views of the long-term outlook, I think there was consensus that there would be a lot of fluctuation, volatility over any period of time for the GSEs, but the, what's the date of the Third Amendment, the 17th?

Focus Judge Ginsberg. Predictions are hard, especially about the future. Which is why neither the corporate directors nor the conservator would drain a company of cash or equity when a company is undercapitalized and the future is uncertain. To do so is illegal, because it defies of the directors' fiduciary duties and the conservator's statutory duties to the corporation.

There was more.... 

MR. OLSON:  No, our first, our preference is that this Court recognize that what was done in August of 2012 was directly contrary to the responsibilities of the Agency acting at the direction of the Treasury which was against the statute.JUDGE GINSBURG:  I don't see how that's consistent with saying the record's inadequate.MR. OLSON:  Well, we have learned enough to know that, where the record was nonetheless inaccurate we, we're learning more things --JUDGE GINSBURG:  I think what's happened is that with what we've learned is that there was another view out there... And the 10-Qs say we do not expect to generate net  income or comprehensive income in excess of our annual dividend obligation to the Treasury over the long term.

Another view of what, Judge Ginsberg? Treasury never had any right to cash dividends prior to the companies' emergence out of conservatorship or through liquidation. 

But the confusion over what is debt and what is equity continued... 

JUDGE MILLETT:  So, what action did they do here that -- let me give you a hypothetical.  If there had been no deferred tax asset issue, and so as it turned out Fannie Mae and Freddie Mac never made at any time between 2008 and the present, or 2012 when the Third Amendment came in, in the present never made a profit --MR. OLSON:  Well, when you --JUDGE MILLETT:  -- if they adopted the Third Amendment and there were no profits, so all they did was protect Fannie Mae and Freddie Mac from more and more debt, would that be consistent with being a conservator?MR. OLSON:  No, it would not be consistent with being a conservator because --JUDGE MILLETT:  Why would it not?MR. OLSON:  -- it wasn't an act towards rehabilitating the entities, they -- JUDGE MILLETT:  It was stopping the hemorrhaging, if they were just going to keep, imagine they just keep losing money, or if they get profits that are less than the $19 billion they owe --MR. OLSON:  They made it impossible, they made it impossible, Your Honor, for these entities to operate.  If you can imagine in the private sector taking a corporation that for, or a bank for which you have responsibility to rehabilitate, to keep it sound and solvent, then issue a decree saying I'm going to take all of your profits and give them to my uncle, or to give them to my friend, and so you can't operate in that normal way, we're going to, we're going to --JUDGE MILLETT:  Yes, but we have a different  statute here that let's --JUDGE JANICE BROWN:  But --JUDGE MILLETT:  I'm sorry.JUDGE BROWN:  I'm sorry.  I was just going to say Judge Millett is asking a hypothetical.MR. OLSON:  Yes, I know.JUDGE BROWN:  And the hypothetical is let's assume that when Treasury gave up its right to dividends the entities were not profitable. So, in fact, they would have been getting nothing because there were no net profits.

Sorry Judges Millett and Brown, nothing in the original PSPA ever suggested that the GSEs would ever finance dividends with debt. Quite the opposite. Up until the Third Amendment, when FHFA authorized cash dividends in excess of reported earnings, the shortfall was always financed by equity,  with an additional purchase of senior preferred shares by Treasury.  If FHFA were concerned about protecting the companies and the taxpayer, it could have avoided an additional "bailout" draw by paying the dividends in kind. What you describe as "stopping the hemorrhaging" is more akin to slashing the wrists of a hemophiliac.

As for concern about the future, you seem to have it all backwards. Housing and mortgage lending are cyclical. You need to build up an equity cushion during the good years as insurance against possible problems and losses in the bad years. This isn't something I made up. This concept of building up equity, or capital, is embedded in all financial regulation, in the fiduciary duties owed by officers and directors to a corporation, and in basic corporate law.

One more time, Treasury never had any right to receive cash dividends.

Moving on...

MR. OLSON:  Well, the record I think suggests that the downward spiral, the death spiral, whatever they've called it, is not justified by the record.  We haven't explored all of that, but basically, the Treasury said itself at the time of August of 2012 we're going to make sure that the tax payers get everything, and the stockholders get nothing.  That was their intention.  Their intention was -- for --JUDGE GINSBURG:  And they said in compensationMR. OLSON:  -- to wind it down --JUDGE GINSBURG:  -- in compensation for the risk  we've taken.MR. OLSON:  But that was not being acting as a conservator.  If they could have decided, if they had to move to a position of liquidating, you know, to a receivership, which is also permitted by these statutes, by this same statute that we're talking about, you could move to a receivership which is essentially what they did, but they would then have to pay attention to the rights of stockholders and creditors. JUDGE GINSBURG:  This press release you're talking about, that's from the Treasury, right? MR. OLSON:  Yes.JUDGE GINSBURG:  They're a creditor.  What's the difference what the creditor says about what the conservator is doing?

OK Judge Ginsberg, you need to focus here because this is very important. Treasury is not a creditor. It never had the rights of a creditor. Creditors invest in debt, which is a whole different kettle of fish. When creditors are paid back, the debt is extinguished. Stockholders get paid back by selling their shares to somebody else. There's no other way for a stockholder to recover his initial outlay right away

Treasury was compensated for the risk it assumed at the time it obtained more senior preferred shares. That was the deal that was originally negotiated. It never had a right to receive cash dividends prior to emergence out of conservatorship, which is why it extended no consideration as part of the Third Amendment.

But Judge Millett seemed stuck on this idea that draining the GSEs of equity would insulate them from a non-existent future obligation to pay cash dividends, which was the premise of her "stop the hemorrhaging" hypothetical. And she stuck with this nonsensical idea.

JUDGE MILLETT:  And if they thought, again, this is hypothetical, I'm not fighting with your record materials, if they thought there were not going to be any profits were have to stop the hemorrhaging, we have to stop the hemorrhaging, there's never going to be enough profits we think in the foreseeable future to pay the dividends, and so they do the Third Amendment on that basis, would that not count...and would that constitute, as sound and solvent as this thing can be by stopping the hemorrhaging and carrying on the business and conserving the assets by stopping the hemorrhaging.MR. OLSON:  No, they weren't stopping the hemorrhage --JUDGE MILLETT:  If they were in my hypothetical, my hypothetical, not --MR. OLSON:  But your hypothetical makes up facts that are directly contrary to the record.  The hemorrhaging --JUDGE MILLETT:  That's what hypotheticals do.MR. OLSON:  The hemorrhaging was --JUDGE MILLETT:  That's what hypotheticals do. Come on.  I want to know when you talk about what it means to keep something in a sound and solvent condition, and conserving the assets, if they don't think there's going to be a pattern of profits, and there's going to be more hemorrhaging than profits could they take a step like this? I know you say that isn't this case and that's the problem here, and the record, you have your record arguments about that, but could it ever be consistent with a conservator's duties under the statute to stop the hemorrhaging by saying just give us whatever you can pay each year, we won't demand more than whatever you can pay?

One more time, Judge Millett, you have it all backwards. Treasury never had a right to any cash dividends so long as the companies were undercapitalized. It violated the statutes, and the concept that all equity is subordinate to any debt. If Treasury wanted to get its cash back sooner than later, it could have negotiated a deal with subordinated debentures convertible into senior preferred stock. 

Nobody liquidates a company by draining out all the equity first.

Judge Ginsberg then explored the idea that draining the companies of equity was necessary, because FHFA could not easily liquidate the companies.

JUDGE GINSBURG: So, throughout this period and when the Third Amendment was entered into as I recall the combined portfolios of the two GSEs was roughly $5 trillion, is that right?  Yes.  So, suppose that a supplemented record would reveal that the Treasury and the FHFA were of the view that there's no way to liquidate a $5 trillion portfolio, all of the possible purchasers of pieces of this portfolio could not muster $5 trillion, so we're going to have to wind it down till we get to a stage where it's practical to liquidate, and that will happen assuming they don't make profits that no one expects them to make, that will happen with this sweep, at least that way it'll happen within a few years and then we'll be able to liquidate.MR. OLSON:  What I think you're asking me then what should they have done under our theory?JUDGE GINSBURG:  And indeed, what they did do wouldn't have a benign explanation?

No, Judge Ginsberg,  the opposite is true. A liquidation is a death spiral. Each month, the pool of mortgages generating cash or fee income necessary to offset credit losses shrinks, and as it shrinks, you remain unaware of the final measure of credit losses until all the loans are liquidated andtaken off the books. Which is why it is important to conserve corporate cash and equity until the very end.

 And continuing...

JUDGE GINSBURG:  And so, if we fully explore that, if you get an opportunity fully to explore that I'm saying. isn't it possible that one of the things one could turn up is an entirely lawful explanation?  Because --MR. OLSON:  I don't believe it's going to happen.JUDGE GINSBURG:  -- liquidation at that scale was not practical, and that only by winding it down to a practical scale could they ever appoint themselves receiver.Liquidation is only practical when the government has a replacement for the GSEs, which is really what this is all about.

FHFA's Real Agenda

Here we come to the chicken/egg situation that explains what this is really all about. The business model of the GSEs, and all balance sheet lenders, is that all of the performing mortgages in the portfolio are used to offset losses from all of the non-performing mortgages in the portfolio.

All mortgage debt is self liquidating, and GSE loan portfolios have historically liquidated rather quickly. But the only reason why mortgage loans are prepaid well before the 30-year final maturity date is because the homeowner can sell his house to somebody who can get a mortgage, or because the homeowner can refinance at a lower rate. And the only reason new mortgages are in existence is because the GSEs are in business. 

 But then again, Judge Ginsberg needs to ask himself: Why would a safety and soundness regulator feel it is incumbent upon him to wind down two companies after he drained out $250 billion in equity?

The past 10 years have proved that Wall Street's private label residential mortgage backed securitizations were an unmitigated failure. Though a relatively tiny number of issuances have occurred since 2007, the prospects for that market to make a significant recovery are dim at best.

 But Wall Street wants a significant, lucrative piece of the action, and it resents the GSEs' competitive advantages in selling 30-year and 15-year fixed rate mortgages. Which is why "GSE reform" is doublespeak for GSE abolition. The movement for "reform" has always been predicated on The Big Lie, which is that the GSE model is fatally flawed and must not continue. This mythology has been promoted by a host of notables--Hank Paulson, Timothy Geithner, Ben Bernanke, to name a few--and a host of shills for Wall Street.

FHFA's "new capital paradigm" says the GSEs don't need equity.

But the coup de grace in the proceeding was the argument offered up by  Howard Cayne, counsel for FHFA. He said the conservator and regulator invoked "a new capital paradigm," a term of doublespeak that debases the meaning of Federal statutes beyond all recognition.

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