Insider's Game

In his speech at the Richmond Fed last May, Edward DeMarco declared these truths to be self-evident: “Restoring Fannie Mae and Freddie Mac is not the solution. 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.”

Have any doubts? Don’t, says the former acting director of the Federal Housing Finance Agency. “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,” said DeMarco. In fact, “there was broad consensus at that time that not only had Fannie Mae and Freddie Mac failed, but the GSE model had failed.”

He redefined failure in a very specific way. By excluding the standard criteria — such as loan performance, the flow of funds, impact toward stabilizing the mortgage market and other data used by business executives — DeMarco’s claim, that the GSE model had failed, may not seem implausible. By redefining “failure,” he framed FHFA policy to preempt any discussion about restoration of the GSEs.

Which was quite a feat. It’s one thing for DeMarco to insist that “restoring Fannie Mae and Freddie Mac is not the solution.” It’s quite another to act on that belief, because DeMarco’s job, and the statutory mandate of FHFA, was to make the GSEs as healthy as possible.

But when he was in office, DeMarco doubled down. He went beyond redefining “failure.” He also redefined his job description and the statutory meaning of “conservatorship.” That way, he could do whatever he wanted, and no judge could tell him otherwise. DeMarco’s verbal sleights of hand teach us an important lesson: Corruption in finance is often rooted in corruption of language.

DeMarco’s job as regulator is supposed to promote the GSEs’ safety and soundness. FHFA’s job of the conservator is to:

“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.”

The primary metric for measuring a GSE’s safety and soundness is its level of capitalization, which shall be classified as adequately capitalized, undercapitalized, seriously undercapitalized, or critically undercapitalized.

And the law specifically prohibits any distribution of capital (dividend) whenever a GSE is undercapitalized. The statute would indicate that any senior preferred dividends should be accrued in arrears. This makes perfect sense. Who would be so reckless as to send cash dividends out of an undercapitalized financial institution? How could any conservator, tasked with putting the companies in a sound and solvent condition, authorize such distributions? The whole idea seems oxymoronic.
Which may be the point. If you divorce words from their original meanings, you end up in an endless loop of doublespeak. “Contrary to what Fannie and Freddie apologists claim, the GSEs have yet to repay any of the taxpayer-funded bailout funds they received,” said Rep. Ed Royce, R-Calif., last week. You know what they say, money talks, doublespeak walks.

Using his self-defined powers, DeMarco announced in August 2012 that the GSEs would distribute to Treasury all available cash as part of Treasury’s plan to wind down the GSEs. From then on, the GSEs would pay out cash dividends equal to 100% of reported earnings. This change, he believed, would prompt Congress to act on his advice. DeMarco wanted to abolish the GSEs’ charters as part of a broader legislative package of housing finance reform. So he translated, “restoring soundness and solvency,” into “draining the companies of the maximum amount of cash possible,” while preempting any opportunity to build up equity or capital. In exchange for $187 billion in government outlays, the GSEs have so far returned $219 billion in cash dividends.

It’s funny. DeMarco’s definition of “conservatorship” looks, sounds and smells like a fraudulent conveyance scheme, which improperly transfers assets out of a company so as to impede the rightful legal claims of other stakeholders. Not surprisingly, shareholders of Fannie and Freddie stock filed lawsuits, arguing that FHFA had no right to authorize the 100% dividend sweep. Cases are pending in several different courts.

But on Sept. 30, 2014, DeMarco’s actions got an unqualified endorsement from U.S. District Court Judge Royce Lamberth, who ruled that, under the “plain meaning” of the of the Home Equity Recovery Act of 2008, his court had no authority to second guess any of DeMarco’s decisions. Lamberth’s legal analysis is drenched with unintended irony.

Lamberth noted what FHFA noted, which was that 12 U.S.C. § 4617(a)(2), of, “HERA permits a conservator to ‘reorganize’ or ‘wind up’ the affairs of a GSE. [Ergo] the court has no occasion to decide whether the conservator is empowered to wind down the GSEs.”

Oh really? That’s not how I read the statute. HERA sets forth FHFA’s “powers as conservator,” as noted above. HERA also sets forth FHFA’s “additional powers as receiver,” which allow the receiver to liquidate the entity. And § 4617(a)(2) says:

“The agency may, at the discretion of the director, be appointed conservator or receiver for the purpose of reorganizing, rehabilitating, or winding up the affairs of a regulated entity.”

If Lamberth were familiar with, say, the difference between a Chapter 11 trustee and a Chapter 7 trustee, he might appreciate how things are supposed to happen sequentially. Hence, “winding up a company’s affairs” is a task of the receiver, not the conservator. Under the proper sequence of winding up a company’s affairs, company operations are shut down and creditors are repaid before any equity distributions are ever allowed.

In Footnote 20 Lamberth explains how, in his eyes, the “plain meaning” of the statue gives FHFA unlimited discretion:

“Even if FHFA has explicitly stated an intent to eventually wind down the GSEs, such an intent is not automatically inconsistent with acting as a conservator. There surely can be a fluid progression from conservatorship to receivership without violating HERA, and that progression could very well involve a conservator that acknowledges an ultimate goal of liquidation. FHFA can lawfully take steps to maintain operational soundness and solvency, conserving the assets of the GSEs, until it decides that the time is right for liquidation.“

Except the role of a conservator, of carrying on a business and restoring solvency, is inconsistent with the role of a receiver that winds up a company’s affairs. This so-called prerogative of a conservator — to wipe out GSEs equity so as to make receivership a self-fulfilling prophecy — fits the plain meaning of “doublespeak.” Once again, money talks, doublespeak walks.

It remains to be seen how the cases will proceed in the courts.