The WSJ’s Improbable Defense of Judge Lamberth’s Indefensible Decision in Perry Capital

By Richard Epstein on October 3, 2014

This post originally appeared on Forbes:

My recent post on, written in my capacity as a consultant to several institutional investors, expressed my deep dissatisfaction with the thunderbolt that Judge Royce Lamberth launched (without argument or discovery no less) in Perry Capital LLC v. Lew  against the private shareholders of Fannie Mae and Freddie Mac when he sustained the 2012 full dividend sweep under the Third Amendment to the original 2008 Senior Preferred Stock Purchase Agreement. This morning, Judge Lamberth’s decision received a full-throated defense that reads as if it was published in Revolution Magazine, but which in fact appeared on the normally level-headed editorial page of the Wall Street Journal.  Ominously entitled, Godzilla Defeats the Thing, the Journal heaps lavish praise on Judge Lamberth for exposing the shareholder scam that in its words combined dubious legal reasoning with junk economics.

Really?  The gist of the Journal’s argument was that both Fannie and Freddie would have been dead in the water without the $188 billion bailout that they received from the United States Treasury.  The real question is what follows next.  In the eyes of the Journal, once the original bailout was given, the government could have, and should have, have taken over the entire operation lock, stock and barrel. Yet that was exactly what the Government decided not to do at the time when it opted for a conservatorship that let the Treasury take two pieces out of the Fannie and Freddie pie. The first was its senior preferred that carried with it a 10 percent dividend rate, which increased to 12 percent if Fannie and Freddie deferred payments on their obligations.  The second was an option to purchase some 79.9 percent of the common stock for a nominal price of $0.00001 per share.

Most notably, the SPSPA did not contain any provision that said, In the event that this infusion of cash rescues Fannie and Freddie, the United States Treasury reserves the right to modify this agreement so as to claim all the profits that the business generates at any future time. It does not take an advanced degree in finance to explain why this provision was conspicuously absent from the 2008 deal.  Put it in and all of a sudden the two previous clauses are irrelevant to the terms of the deal. 10/12 percent is no longer the dividend rate, and the warrant to purchase the common stock at a nominal price is equally worthless.  Why should the government pay even a dollar to get common stock that with a stroke of the pen it could acquire for free?  And why should anyone bother to trade in shares which the government has announced in advance will be worthless to them no matter how valuable the company?

The Wall Street Journal, unhappily, was unable to let go of the past when it lauded the service that Judge Lamberth did for the taxpayers in Perry.  Unfortunately, like Judge Lamberth, the Journal never bothers to cite a single word of the statutory provision that explains exactly how the Treasury was supposed to represent the United States, which is set out in Section 1219(g) of Banking Code, which tells a rather different story than their newly imagined narrative.  I urge all readers to examine the section in full.  Its gist is that Treasury is authorized to offer assistance, but nothing in it allows Treasury to force the corporation to accept its offer.  The mutual agreement between the Secretary and the Corporation is required.  The clear intention of the section was to allow for a negotiation between the directors of the covered corporation and Treasury over terms of the deal.

The banking statute then indicates the considerations that Treasury should take into account in making the loan in order to protect the taxpayer’ interest during the course of the negotiations with any private corporation.  Among these are the need to secure the appropriate preferences and priorities of the government and [t]he corporation’s plan for the orderly resumption of private market funding or capital market access.

It was just this process that was invoked in dealing with the AIG bailout arrangement that is currently being attacked by Starr International.  But there is a huge difference between the two cases.  As is well explained by Judge Paul A. Engelmayer in his 2012 opinion in Starr International v. Federal Reserve Bank of New York AIG was under the control of its own independent board of directors, which accepted the deal that the current litigation is now attempting to unwind.  In that case, as Engelmayer recognized, the government is in the strong position of insisting that the terms of the original deal should be observed”terms which no private firm was prepared to offer AIG at the time.  The acute difficulty with Starr’s case is that the government did not amend the case when it exercised its option to purchase 79.9 percent of the common in a deal that resulted in returning AIG to the private market.  Indeed that deal left AIG shareholders better off than they would have been without the bailout.  The tough terms of the initial deal were a reflection of the difficult financial position.

The situation with Fannie and Freddie is world’s part from AIG.  The first point to note is that the Third Amendment was not negotiated by an independent board of directors, as was the case with the AIG bailout. Instead, the control over both companies was taken over by the Federal Housing Finance Agency (FHFA) under the control of Edward Demarco, himself a former high-level official at Treasury.  The Third Amendment was not intended to return Fannie and Freddie to the private market.  It was designed to insure that they would never be able to return to the market no matter how profitable their operations had become.  What fiduciary would ever consent to a deal that left his client penniless no matter what happened? It is painfully clear therefore that the Third Amendment rests on double whopper.  First, FHFA sold out its fiduciary duties as conservator to the Fannie and Freddie Shareholders. Second, Treasury disregarded its obligations in ordering the dividend sweep, which if upheld, would render the stocks of the two companies worthless.

In defending the high-level power grab the Journal relies on threadbare legal and economic arguments.  On the former, it defends the ‘plain meaning’ interpretation of the 2008 statute, which says:  no court may take any action to restrain or affect the exercise of powers or functions of the company’s conservator.Â  But as I noted in the previous article, this meaning ignores the well-established judicial exception that this provision does not apply when the government’s action is hopelessly conflicted, as it is in this case of massive self-dealing.  Indeed, this conflict of interest exception has to be read into the statute otherwise the ostensible conservatorship is a simple expropriation of all shareholder value by allowing the government to take over control of the company and pay out all dividends and capital to itself on a whim. At this point, no private company is ever safe.

To back up this extraordinary power grab, the Journal cites the work of Larry Wall of the Federal Reserve Bank of Atlanta to the effect that the companies were worthless in 2008 without the government bailout. Wall and I have sparred on this issue before.  The incurable weaknesses in his argument are two.

The first is that any analysis of the 2008 situation is irrelevant to the Third Amendment which was entered into nearly four years later when the financial situation had changed, as there is strong evidence that the companies had returned to profitability.  Indeed, it is on just this question that Judge Margaret Sweeney in the Court of Federal Claims is allowing discovery in Fairholme’s case against Treasury which, if allowed to go forward, is likely to reveal that Treasury and FHFA both knew that of the change in market conditions when they organized the massive money grab under the Third Amendment.

The second is Wall is wrong to rest the case for the Third Amendment on the ground that the government had given an implicit guarantee of all of Fannie and Freddie’s activities that allowed it a favorable position in the marketplace.  Any attack on that policy has to be paired with something that neither Wall nor the Journal mentions, namely, the heavy obligations that Congress had imposed on Fannie and Freddie under the Housing and Community Development Act of 1992, as amended in 2007, which attempted to accomplish the impossible by asking Fannie and Freddie to aid affordable housing while maintaining its strong financial condition in ways that would allow it to earn a reasonable economic return.  There is no way to go deeper into the mortgage pool without assuming extra risks of default.  It is incorrect, therefore, to talk about the issue of subsidy without pairing it with the heavy costs of the federal mandate.  All of these issues, moreover, were in play in 2008, and none of them justify wiping out the preferred and common shareholders of Fannie and Freddie in ways that Treasury did not dare to do in AIG.

In dealing with the current litigation, it is a huge mistake for the Journal to think that what is on trial is the oft-lamentable lending practices of Fannie and Freddie and need to make sure the market does not expect an implicit unpaid for federal guarantee.  There is no question that these need to be reformed in the future to avoid the debacles of the past.  But the key point to notes is that any such reform will be impossible if the government thinks that it can just repudiate its own agreements entered into at a time of financial stress in 2008, by entering into phony amendments when the crisis is long past in 2012, that render its original deals a mockery.

The point to ponder is this.  What private party will ever rely on government assurances or guarantees if the Third Amendment is allowed to stand?  Unfortunately, the Journal gets this point exactly backwards as well when it denounces in shameless populist fashion big-money speculators who hope to make a killing on the upside if the politicians revive Fan and Fred.Â  The Journal should know that the rule of law, which is critical to the proper functioning of free markets, has no meaning if it can be suspended when applied to unsympathetic parties like big money speculators.

What the Journal should have said is that it is imperative to reform Fannie and Freddie to prevent a repeat of the debacle.  But that reform will not be done with private money, ever, so long as the Third Amendment remain as an ominous reminder that no investment, speculative or not, is safe, so long as the government can engage in the most blatant forms of self-dealing to wipe out private corporate wealth with the stroke of a pen. If Judge Lamberth decision is allowed to stand, it will deal a deadly blow to rational regulatory reform of the residential housing market.