Perry v. Mnuchin: A case study in disingenuity

Clever people can rationalize anything. They might take one or two factoids out of context, misrepresent the broader written record, and ignore the contravening evidence, so that they can arrive at an otherwise unsupportable conclusion. Exhibit A: The absurd outcome the D.C. Circuit case, Perry v. Mnuchin, which validates the government's net income sweep designed to drain all earnings and equity out of Fannie Mae and Freddie Mac. Judges Douglas Ginsberg and Patricia Millett (they don't specify who wrote the 2-1 majority decision) turn a blind eye to:

1.  the broader regulatory framework,
2.  tenets of accounting and finance,
3. government documents in the public domain, and
   
4. common sense.

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Let's walk through what the judges chose to ignore.

The regulatory framework

 The judges base much of their analysis on the keen distinction between the words, "may" and "shall." "May” is permissive but not obligatory, whereas "'shall" is mandatory. "May" refers to rights and powers; "shall" refers to duties and obligations. The judges focus on how Congress used "may" and "shall" in different places in the text of the Housing Economic Recovery Act of 2008.  One statute, 12 U.S.C. § 4617, "Authority over critically undercapitalized regulated entities," includes a subsection 12 U.S.C. § 4617(b),  "Powers and duties of the Agency as conservator or receiver." More specifically, 12 U.S.C. § 4617(b)(2)(D), titled "Powers as conservator," says:

The Agency may, as conservator, take such action as may be—(i) necessary to put the regulated entity in a sound and solvent condition; and(ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity. 

So we know what the conservator may do pursuant its statutory powers.  What else--aside from restoring the government sponsored enterprises' soundness and solvency, and preserving and conserving their assets--may a conservator do? What other powers are enumerated? The judges point to U.S.C. § 4617(b)(2)(J),  "Incidental powers,"

The Agency may , as conservator or receiver—(i) exercise all powers and authorities specifically granted to conservators or receivers, respectively, under this section, and such incidental powers as shall be necessary to carry out such powers; and(ii) take any action authorized by this section, which the Agency determines is in the best interests of the regulated entity or the Agency.

 The judges write:

In short the most natural reading of the [Housing Economic Recovery Act of 2008] is that it permits FHFA, but does not compel it in any judicially enforceable sense, to preserve and conserve Fannie’s and Freddie’s assets and to return the Companies to private operation. ... Entirely absent from the Recovery Act’s text is any mandate, command, or directive to build up capital for the financial benefit of the Companies’ stockholders. That is noteworthy because, when Congress wanted to compel FHFA to take specific measures as conservator or receiver, it switched to language of command, employing “shall” rather than “may.”

It's hard to overstate the disingenuity of this analysis, which mimics that of the lower court decision by District Court Judge Royce Lamberth. Look again, the words,"the regulated entity," should be a big tipoff.  Contrary to what the judges insinuate, HERA does not exist in a vacuum. The bill merely supplements the broader regulatory framework originally set forth in the Federal Housing Enterprises FinancialSafety and Soundness Act of 1992.  GSE regulation did not stop on September 6, 2008, when Fannie and Freddie were formally placed in conservatorship. The conservator has no power whatsoever to exceed the strictures set forth in other statutes. (Surely, if Congress ever contemplated otherwise, it would have said, so.)

Consider, for instance 12 U.S. Code § 4513, "Duties and authorities of Director [of FHFA]":

a) Duties(1) Principal duties.  The principal duties of the Director shall be—(A) to oversee the prudential operations of each regulated entity; and(B) to ensure that—(i) each regulated entity operates in a safe and sound manner including maintenance of adequate capital and internal controls;(ii) the operations and activities of each regulated entity foster liquid, efficient, competitive, and resilient national housing finance markets (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities);...

So the director of FHFA, who is also the conservator of Fannie and Freddie, shall, as in must, oversee the companies to ensure that they operate in a safe and sound manner. In this context, safety and soundness is not some vague platitude subject to varying interpretations. It is a highly developed concept linked to the Uniform Financial Institutions Rating System (UFIRS), used by all federal regulators of financial institutions. This system  is more commonly known by the acronym CAMELS, which stands for:

C:        the quality and adequacy of capital;

A:         the quality of assets:

M:        the capability of the board of directors and management;

E:         the quantity, sustainability, and trend of the bank’s earnings;

L:         the adequacy of the bank’s liquidity position; and

S:         its sensitivity to market risk.

So nothing in HERA obviates FHFA's principal duty to ensure the adequacy of Fannie or Freddie's capital. Moreover, maintenance of capital adequacy is a core function of FHFA, as detailed 12 U.S. Code Subchapter II - REQUIRED CAPITAL LEVELS FOR REGULATED ENTITIES, SPECIAL ENFORCEMENT POWERS, AND REVIEWS OF ASSETS AND LIABILITIES. These include

12 U.S. Code § 4611 - Risk-based capital levels for regulated entities12 U.S. Code § 4612 - Minimum capital levels12 U.S. Code § 4613 - Critical capital levels12 U.S. Code § 4614 - Capital classifications12 U.S. Code § 4615 - Supervisory actions applicable to undercapitalized regulated entities12 U.S. Code § 4616 - Supervisory actions applicable to significantly undercapitalized regulated entities12 U.S. Code § 4617 - Authority over critically undercapitalized regulated entities

Again, the concepts of conservatorship and receivership are set forth within 12 U.S. Code § 4617 -"Authority over critically undercapitalized regulated entities."

Circling back to the distinction between "may" and "shall," the conservator's actions are limited to what the regulator shall allow under its statutory mandate. The regulator has a specific duty to ensure that the GSEs maintain adequate capital. Authorizing cash dividends, any cash dividends, while undercapitalized is antithetical to that legal duty, something that Judges Ginsberg and Millett choose to ignore.

An additional wrinkle. On October 9, 2008 FHFA announced: "The Director has determined that it is prudent and in the best interests of the market to suspend capital classifications of Fannie Mae and Freddie Mac during the conservatorship...FHFA will continue to closely monitor capital levels, but the existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship."

FHFA had no legal authority and no rational basis for suspending capital classifications. Moreover, on October 9, 2008 the GSEs were adequately capitalized.  Not many people paid attention at the time; they were distracted by the broader financial meltdown. In later years, FHFA would cite this spurious suspension of its duties as a justification to ignore its duty to rebuild GSE capital. 

Tenets of accounting and finance

When faced with a challenge to the Third Amendment sweep in court, the government offered up a story that fails the laugh test. As litigation proceeded, the government's story was debunked. In response, the government pivoted, and claimed that its motivations were irrelevant, given that Congress had extended the conservator virtually unlimited discretion, which was exempt from judicial review.

Yet Judges Ginsberg and Millett accept the government's story and in so doing come across as financial illiterates. They write:

Fannie’s and Freddie’s frequent inability to make those dividend payments, however, meant that they often borrowed more cash from Treasury just to pay the dividends, which in turn increased the dividends that Fannie and Freddie were obligated to pay in future quarters....In simple terms, the Third Amendment requires Fannie and Freddie to pay quarterly to Treasury a dividend equal to their net worth—however much or little that might be. Through that new dividend formula, Fannie and Freddie would never again incur more debt just to make their quarterly dividend payments, thereby precluding any dividend-driven downward debt spiral.

False. This "dividend-driven downward debt spiral," is divorced from reality, a conceit in which the judges conflate the definitions of equity, debt and cash. Prior to 2012, the GSEs had insufficient equity or earnings to pay senior preferred cash dividends. So, to finance $36 billion in cash dividends, FHFA drew down "bailout" funds wherein Treasury purchased additional senior preferred equity.  That way, the GSEs could then turn around and then send funds back to Treasury. The net result would be that the GSEs’ total cash and equity position would be unchanged and Treasury’s cash position would be unchanged. Contrary to the judges' claims, the companies never incurred more debt to pay out cash dividends.

It is true that some companies with robust equity have limited cash, so they incur additional debt to fund cash dividends. Also, there are companies like the GSEs, with nominal equity but abundant cash. But  the "dividend-driven downward debt spiral," is an absurdity. Because the round-tripping phenomenon that bothered the judges--Treasury sends cash to the GSEs, which immediately return cash to Treasury--had nothing to do with debt whatsoever. (None of the bailout funds were ever used for traditional bailout purposes. The taxpayer draws were never used to cover cash shortfalls or operating expenses.) 

Indeed, the round-tripping described above reveals something that should be obvious to everyone. These cash dividends served no legitimate purpose. They served no business purpose for the benefit of the GSEs; nor did they improve the government's cash or income position, and they imposed additional burdens on taxpayers while further reducing the size of the government's commitment to support the GSEs.  Though the cash dividends did have a markedly negative impact on the GSEs' ability to rebuild capital and thereby improve the safety and soundness of their operations.

The judges seem to conflate debt with equity and thereby confuse the reader into thinking that cash dividends are some kind of fixed obligation imposed on the GSEs. There is no such thing as a legal obligation to pay dividends within any timeframe. Any investment with a fixed obligation to pay cash within a deadline fits the definition of debt, not equity. The senior preferred dividends could always be paid in kind. True, payments in kind bumped up the dividend coupon from 10% to 12%, but cash dividends reduce equity, whereas dividends in kind leave corporate equity unchanged.

 What really happened 

The only way to grasp the full story of the GSE conservatorships is to follow the money, which in this context means cash, or the f!ow of funds. For a large financial institution, the chasm—between cash versus earnings, or between liquidity and solvency—may seem wider than the Grand Canyon. Every financial institution's earnings and equity are driven by non-cash provisions, timing differences under Generally Accepted Accounting Principles, which are always subject to dramatic revision. These companies need to build up capital as a cushion to withstand any future downward revision.

The facts are beyond dispute. On September 5, 2008, the day the government announced its plans to put both government sponsored enterprises in conservatorship, the companies generated positive cash flow,  maintained adequate regulatory capital, robust liquidity, and unfettered access to the unsecured debt markets. (Many people state that the GSEs suffered liquidity problems prior to their takeover. These people are either misinformed or dishonest.)

Under HERA, the Department of Treasury had recently been given special temporary powers to invest in the GSEs, on terms accepted by GSE directors, in order to bolster the companies' liquidity and capital. These special powers were given by Congress for the purpose of forestalling the possibility that the GSEs might be placed in conservatorship. Indeed, one of the purposes of these special powers was to protect the taxpayer, which was defined to mean, among other things, preserving the GSEs as private shareholder companies.

Of the many possible grounds that enabled FHFA to impose immediate conservatorship on the GSEs, set forth in 12 U.S.C. § 4617(a)(3), only one had anything close to a veneer of plausibility. It was:

(C) Unsafe or unsound conditionAn unsafe or unsound condition to transact business.

Again, this phrase has a very specific meaning within the CAMELS methodology; it means that an institution has received a CAMELS rating of 5 or possibly 4, and it also indicates that the institution is approaching a state of collapse. FHFA director James Lockhart distorted that meaning of the statute to justify his agenda to apprehend the GSEs sooner rather than later. He declared that the government takeover was necessary in order to address, "safety and soundness concerns," which were also characterized as, "safety and soundness issues." If the distinction isn't apparent to you, think of it this way: just because a person has health concerns or health issues, it does not necessarily follow that he is currently ill. (As I've written elsewhere, the FHFA document used to justify conservatorship is packed with lies and distortions.)

Nothing about conservatorship compels FHFA to force out the management and the directors. Though FHFA, in collusion with Treasury, demanded that top management and directors leave immediately. That way, Treasury could negotiate the terms of its equity investments in the GSEs by dealing with FHFA instead of GSE management. The Senior Preferred Stock Purchase Agreement (PSPA) negotiated by Treasury was designed to subvert federal statutes, which were drafted to assure the FHFA's independence as a regulator.  The PSPA disallows FHFA from taking any significant action with regard to the GSEs without first securing Treasury's approval.

FHFA's actions prior to execution of the Third Amendment sweep fit a pattern. its distortion of statutory wording as a pretext for placing the GSEs in conservatorship, its removal of GSE directors so that FHFA itself would negotiate the terms of the PSPAs, its agreement to give Treasury veto power over its regulatory prerogatives, its suspension of capital classifications, its payouts of cash dividends that serve no legitimate purpose, all fit a pattern. They all demonstrate a concerted effort by FHFA to subvert the legislative intent of HERA. The Third Amendment sweep to the PSPA is consistent with that pattern.    

After being placed in conservatorship, the companies continued to operate as before, generating positive cash flow, and of course, maintaining their robust liquidity and unfettered access to capital markets, with the further enhancement of government support.

Subsequent to the announced conservatorship, the companies changed their methodology for calculating loan loss reserves; and in short order the companies' non-cash provisions skyrocketed. For fiscal years 2008-2011, the two companies recognized non-cash losses that wiped out all equity, and which necessitated a federal bailout of $151.5 billion. In addition, the companies drew down $36 billion in taxpayer funds to cover the unnecessary and imprudent cash dividend payments of 10% coupon on the U.S. Treasury's senior preferred stock. The grand total of taxpayer draws equaled $187.5 billion.

Those non-cash loss provisions were eventually reconciled with cash outcomes, as distressed loans were liquidated off the books. Beginning in 2012, GSE earnings began to skyrocket as overly conservative loss provisions were reversed. Fannie's annual income for 2012 was $17 billion, more than twice its previous annual record. In 2013 Fannie earned $84 billion, which set an all-time record for the highest annual income reported by any Fortune 500 company ever. (The $84 billion amount is almost twice the amount that Fannie earned over the entire decade preceding the 2008 government takeover. Total earnings during 1998 -2007 were $43 billion.)

On August 17, 2012, nine days after Fannie reported a record $7.8 billion in six-month earnings,  FHFA and Treasury announced the Third Amendment to the Senior Preferred Stock Purchase Agreement. Going forward, the cash dividend coupon would be upsized, from 10% of the initial investment, to 100% of all corporate earnings generated in perpetuity. By early 2014, both GSEs had repaid the entire $187 billion drawn down from Treasury's coffers.

With 20/20 hindsight, we know that the GSEs never needed the massive bailouts they received, because the non-cash loss provisions, booked during 2009-2011, proved to be wildly over-inflated. If FHFA and the GSEs' auditors were clairvoyant, so that loss provisions predicted cash losses with great precision, the GSEs' need for government bailout funds would have been close to zero.

But, according to the government, FHFA began to fear a GSE "death spiral" right at the point when evidence suggested the companies would experience a robust recovery. Out of "fear" that the companies would not be able to fund cash dividends in the future, FHFA and Treasury agreed that, going forward, cash dividends on senior preferred stock would be no more than 100% of quarterly earnings, irrespective of whether that amount was higher or lower than 10% of the initial $187.5 billion "bailout" amount.

Rudiments of financial literacy

Then there are the reasons why the government's story fails the laugh test. First, the cash dividends paid prior to 2012 served no legitimate business function. They did not improve the GSEs' equity or cash positions; nor did they provide the government with additional cash or reduce the likelihood of future bailout drawdown .

So, at the risk of belaboring the obvious, let's recap those distinctions. No company is legally required to pay cash dividends by a specified date, ever. If there's a firm obligation to make a cash payment by a date certain, that obligation is debt, not equity. A company always has the option to pay preferred dividends in kind, which is an accounting accrual for later payment. Unlike cash dividends, dividends in kind do not reduce shareholder equity.

The judges seem to have forgotten some principles of contract law, specifically, enforceable contracts require consideration, which can be one party's forsaking of his legal rights. But Treasury never had a right to receive cash dividends. Which is why it extended no consideration to the GSEs in exchange for a permanent upsizing of cash dividend payouts. The prior purchases of senior preferred stock don't count, because past consideration is no consideration.

Government documents in the public domain

Treasury was perfectly obvious about its agenda, which was never about protecting anyone from an imaginary death spiral. The August 17, 2012 press release to announce the third amendment sweep was titled, “Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac.” Though the press release was dishonest—it insinuated that Treasury and FHFA held a nonexistent right to wind down the GSEs—it accurately reflected Treasury’s intent, which was to put the GSEs out of business by draining them of all equity. More specifically, Treasury misrepresented an earlier document—its Report to Congress released on February 11, 2011, which offered recommendations to Congress—as something that gave it some imaginary authority to wind down the two companies. The press release says Treasury was, “[a]cting upon the commitment made in the Administration’s 2011 White Paper that the GSEs will be wound down and will not be allowed to retain profits, rebuild capital, and return to the market in their prior form."

To spread the word, White House advisor James Parrott alerted  two leaders iof a multi-year disinformation campaign against the GSEs, Peter Wallison and Edward Pinto. Since late 2008, Wallison and Pinto kept spreading the false meme that GSE underwriting standards, specifically those set forth under affordable housing goals, had poisoned the well of housing finance. It was nonsense, for the simple reason that GSE loan performance was always exponentially superior to every other player in the market. The Wallison/Pinto thesis was based class bigotry, some cherrypicked factoids, and an adamant refusal to ever talk about comparative loan performance. 

The Financial Crisis Inquiry Commission reviewed Pinto's "research" in the context of comparative loan performance and found that his risk categorizations were all but meaningless. Neither Pinto nor Wallison could offer any response, so Wallison, a Republican member of the FCIC, defamed the Commission when he lied and said that the Commission refused to review Pinto's work. The Wallison/Pinto meme, which is still promoted to this day, is frequently characterized as The Big Lie about the financial crisis. And yet a wide assortment of observers treat these dissemblers as bona fide experts in housing finance. Indeed, Parrott considered them his "fellow travelers," and offered to walk them through the mechanics of the Third Amendment sweep to show them how they were designed to drain the the companies of all equity. This email correspondence was made public many months before the Circuit Court handed down its decision.

The acting FHFA director who negotiated and signed the Third Amendment sweep, Edward DeMarco, has made no secret of his stalwart opposition to the GSEs accumulating additional capital. "The GSEs are failures." seems to be his mantra. "Restoring Fannie Mae and Freddie Mac is not the solution," he said after leaving office. "They failed and their business model failed. Going backwards to an obviously failed model cannot be dressed up with some promise of higher capital or explicit rather than implicit guarantees." He drives home his points by pandering to those unfamiliar with timing differences under GAAP by saying, "There should be no doubt that this set of events [leading to conservatorship of the government-sponsored enterprises] and the billions of dollars in subsequent losses meant that Fannie Mae and Freddie Mac had failed...[indeed]  there was broad consensus at that time that not only had Fannie Mae and Freddie Mac failed, but the GSE model had failed."

And of course, in mid-2012 GSE management and FHFA were fully aware that the companies were likely to see a huge spike in earnings once the companies overly-inflated loss provisions were reversed. Testimony by key witnesses and contemporaneous documents, still mostly under seal, described in plaintiffs' motions, prove that FHFA never believed in any kind of specious "death spiral."

Judges Ginsberg and Millett turn a blind eye to all of this. Which brings us to the final category.

Common sense

There is one, and only one, reason why Fannie and Freddie do not maintain $250 billion in capital. FHFA engineered it that way. The economic substance of FHFA's actions, taken in its role as conservator, speak for themselves.  The $250 billion cash dividend distributions, justified by non-cash reversals of non-cash provisions, speak for themselves. 

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