Tag Archives: preferred stock purchase agreements

Hypothetically Reforming Fannie and Freddie

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Ben Turner

S&P issued a report, Fannie, Freddie, and the FHLB System: Plus Ca Change . . . The report opens, “Despite reform talk in the years since the U.S. housing crisis, Standard & Poor’s Ratings Services believes the likelihood of extraordinary government support for key U.S. housing government­-related entities (GREs) Fannie Mae, Freddie Mac, and the Federal Home Loan Bank (FHLB) system remains “almost certain” in case of need.” (1) Notwithstanding the fact that S&P expects that this extraordinary support will last well into the next presidential administration, S&P “can envisage three “tail risk” scenarios in which such support could become less likely under certain conditions, but view each of these scenarios as improbable.” (1) The three scenarios, which S&P characterizes as plausible, albeit improbable, are

  • An electoral sweep, with favorable macroeconomic conditions and few competing legislative priorities;
  • Court judgments, pursuant to shareholder lawsuits, forcing the legislators’ hand; or
  • A renewed housing market crisis, with one or more of these GREs viewed as more cause than cure. (4)

In the first scenario, “an election gives one party control of all three legislative actors (the president, House of Representatives, and Senate), precluding the need for bipartisan compromise to enact major reforms to Fannie and Freddie via legislation.” (4)

In the second, Fannie and Freddie shareholders win lawsuits that stem from the “U.S. Treasury’s decision to modify, in 2012, the Preferred Stock Purchase Agreements (PSPAs) governing the terms of its financial support to Fannie and Freddie . . ..” (4)

The final scenario,

is a renewed housing market crisis, on a scale at least similar to that of 2008. Like the other two scenarios, we don’t view this as likely, at least in the coming few years . . . perhaps as a result of the unfortunate confluence of several negative surprises- ­­including, for example, overreaction to Federal Reserve monetary policy normalization, terms­-of­-trade shocks (geopolitical conflicts that cause a rapid and dramatic spike in energy costs, perhaps), fresh financial sector  problems that suddenly tighten the sector’s funding costs, and an abnormally long spell of bad weather. (5)

This seems like a pretty reasonable analysis of the likelihood of reform for Fannie and Freddie. But that should not stop us from bemoaning Congressional inaction on this topic. Obviously, Congress is too ideologically driven to bridge the gap between the left and right, but the likelihood that we are building toward some new kind of crisis increases with time. I can’t improve on S&P’s analysis in this report, but I’m sure unhappy about what it means for the long-term health of our housing finance system.

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Where’s Perry? Are Phannie and Freddie Busted?!?

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With all apologies to Perry the Platypus who stars in my sons’ favorite TV show, Phineas and Ferb, today I look at the complaint in Perry Capital, LLC v. Lew et al. Perry Capital has sued the federal government for destroying the value of Fannie and Freddie securities held by Perry and the investment funds it manages. In particular, the complaint (drafted by Theodore Olson and others at Gibson Dunn) states that

Perry Capital seeks to prevent Defendants from giving effect to or enforcing the so-called Third Amendment to preferred stock purchase agreements (“PSPAs”) executed by Treasury and the FHFA, acting as conservator for the Companies. The Third Amendment fundamentally and unfairly alters the structure and nature of the securities Treasury purchased under the PSPAs, impermissibly destroys value in all of the Companies’ privately held securities, and illegally begins to liquidate the Companies. (2)

The plaintiff alleges that the government’s actions violate the Administrative Procedures Act (APA) and the Housing and Economic Recovery Act of 2008 (HERA). The APA governs the decision-making procedures of federal agencies like Treasury and independent agencies like the Federal Housing Finance Agency (FHFA). HERA was passed at the outset of the financial crisis and governs the process by which Fannie and Freddie may be put into conservatorship. (I discuss the enactment of HERA in Fannie Mae and Freddie Mac and the Future of Federal Housing Finance Policy: A Study of Regulatory Privilege, which is also available on BePress.)

[Warning:  necessary but complex details follow.  Those who are not GSE geeks may skip to the end.]

After the two companies were put into conservatorship in 2008,

Treasury and the FHFA executed the PSPAs, according to which Treasury purchased 1 million shares of the Government Preferred Stock from each company, in exchange for a funding commitment that allowed each company to draw up to $100 billion from Treasury as needed to ensure that they maintained a net worth of at least zero. As relevant here, the Government Preferred Stock for each company has a liquidation preference equal to $1 billion plus the sum of all draws by each company against Treasury’s funding commitment and is entitled to a cumulative dividend equal to ten percent of the outstanding liquidation preference. The PSPAs also grant Treasury warrants to purchase up to 79.9% of each company’s common stock at a nominal price. (2-3)

 According to the complaint, the Third Amendment to the PSPA changed the way that profits would be distributed by the two companies:

Under the original stock certificates, Treasury’s dividend was paid quarterly in the amount equal to an annual ten percent of the Government Preferred Stock’s outstanding liquidation preference. In the Third Amendment, the FHFA and Treasury amended the dividend provision to require that every dollar of each company’s net worth above a certain capital reserve amount be given to Treasury as a dividend. . . . Treasury’s additional profits from the Third Amendment are enormous. (5)

This is a very complex case, and I will return to it in future posts.  For now, I would just flag some issues that may pose problems for Perry.

First, is this case ripe for adjudication?  Perry states that they will be harmed when the two companies liquidate, but they are nowhere near liquidation.  Will the harm Perry predicts necessarily come about? The claim that they are harmed as to their expected dividends is stronger. Yet Perry acknowledges that the PSPAs “explicitly prohibit the payment of any dividend to any shareholder other than Treasury without Treasury’s consent.” (16)

Second, to what extent is this matter governed by the APA? I am not an APA expert, and I am wary of second-guessing Olson’s complaint in a blog post. But I would note that the court may not find that the APA even applies in this case and may find that HERA governs this dispute on its own. And even if the APA applies, the court may give great deference to the decisions of Treasury and the FHFA.

Finally, does the language from HERA that Perry relies on really give it much to hang its hat on? I think the crux of Perry’s argument is that the Third Amendment “created new securities”  instead of changing the terms of existing securities. (24) If a court disagrees with Perry on this (and it seems like a bit of a stretch to me), the theory of the case will be severely weakened.

All of this being said, I would agree with Perry that the holders of the Private Sector Preferred Stock — particularly the holders that predate conservatorship — look like they are receiving a raw deal from the federal government.  Various regulations encouraged lending institutions to hold Fannie and Freddie preferred stock over other investments. Those incentives sure looked like an implied guarantee before the subprime crisis knocked Fannie and Freddie off their feet.

Bottom line: this dispute cannot be settled in a late night blog post.  We’ll have to wait and see if Agent P can pull off what may be his most difficult mission yet.