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Unsealed Saxton Amended Complaint.

Peter A. Chapman wrote:
At the Saxton Plaintiffs’ behest, Magistrate Scoles released the shareholders’ Amended Complaint from seal yesterday.  Copies of the Saxton Plaintiffs’ Motion (Doc. 84), Magistrate Scoles’ Order (Doc. 85), and the now-unsealed Amended Complaint (Doc. 61), are attached.

Story behind the Amended Complaint:

Fannie and Freddie are two of the largest privately owned financial institutions in the world. They insure trillions of dollars of mortgages and provide essential liquidity to the residential mortgage market. The Companies operate for profit, and their debt and equity securities are privately owned and publicly traded. The Companies’ shareholders include community banks, charitable foundations, mutual funds, insurance companies, pension funds, and countless individuals, including Plaintiffs.

Throughout the financial crisis, Fannie and Freddie were capable of meeting all of their obligations to insureds and creditors and were capable of absorbing any losses that they might reasonably incur as a result of the downturn in the financial markets. As mortgage insurers, Fannie and Freddie are designed to generate ample cash to cover their operating expenses—and indeed this was the case for the Companies throughout the financial crisis. In contrast to the nation’s largest banks, the Companies took a relatively conservative approach to investing in mortgages during the national run up in home prices from 2004 to 2007.  As a result, the Companies (i) experienced substantially lower mark-to-market credit losses during the financial crisis than other mortgage insurers, (ii) were never in financial distress, and (iii) remained in a comparatively strong financial condition. Indeed, the Companies’ ability to pay any outstanding claims—a fundamental principle for all insurers—was never in doubt. Despite the Companies’ relative financial health, the Department of the Treasury (“Treasury”) implemented a deliberate strategy to seize the Companies and operate them for the exclusive benefit of the federal government.

At Treasury’s urging, in July 2008, Congress enacted the Housing and Economic Recovery Act of 2008 (“HERA”). HERA created the Federal Housing Finance Agency (“FHFA”) (Treasury and FHFA are sometimes collectively referred to herein as the “Agencies”) to replace Fannie’s and Freddie’s prior regulator and authorized FHFA to appoint itself as conservator or receiver of the Companies in certain statutorily specified circumstances. As conservator, HERA charges FHFA to rehabilitate Fannie and Freddie by taking action to put the Companies in a sound and solvent condition while preserving and conserving their assets. Only as receiver does HERA authorize FHFA to wind up the affairs of Fannie and Freddie and liquidate them. HERA’s distinctions between the authorities granted to conservators and receivers are consistent with longstanding laws and practices of financial regulation.

HERA also granted Treasury temporary authority to invest in the Companies’ stock until December 31, 2009. Congress made clear that in exercising this authority Treasury was required to consider the need for Fannie and Freddie to remain private, shareholder-owned companies.

These limitations on FHFA’s and Treasury’s authority make clear that Congress did not intend for the Agencies to operate Fannie and Freddie in perpetuity, and certainly not for the exclusive financial benefit of the federal government.

On September 6, 2008—despite both Agencies’ prior public statements assuring investors that the Companies were in sound financial shape—FHFA, at Treasury’s urging, abruptly forced Fannie and Freddie into conservatorship. Under HERA, and as acknowledged by FHFA at the time, the purpose of the conservatorship was to restore confidence in and stabilize the Companies with the objective of returning them to normal business operations. As FHFA confirmed in its public statements, conservatorship is necessarily temporary, and FHFA may only act as conservator for the Companies until they are stabilized. At the time, neither of the Companies was experiencing a liquidity crisis, nor did they suffer from a short-term fall in operating revenue. Moreover, the Companies had access to separate credit facilities at the Federal Reserve and at the Treasury, and the Companies held hundreds of billions of dollars in unencumbered assets that could be pledged as collateral if necessary. Nevertheless, Treasury instead coerced the Companies into conservatorship to further the government’s unspoken policy objectives. Indeed, a receivership that sold all of the Companies’ assets and liabilities would have more economic value to the private shareholders than the conservatorship as it was structured and operated in practice. And in any event, Treasury had definitively concluded that the Companies would not be placed into receivership at that time.

Immediately after the Companies were forced into conservatorship, Treasury exercised its temporary authority under HERA to enter into agreements with FHFA to purchase securities of Fannie and Freddie (“Preferred Stock Purchase Agreements” or “PSPAs”). Under these PSPAs, Treasury committed to purchase a newly created class of securities in the companies, known as Senior Preferred Stock (“Government Stock”). In return for its commitment to purchase Government Stock, Treasury received $1 billion of Government Stock in each Company and warrants to acquire 79.9% of the common stock of the Companies at a nominal price.

The Government Stock entitled Treasury to dividends at an annualized rate of 10% if paid in cash or 12% if paid in kind. The Government Stock was entitled to receive cash dividends from the Companies only to the extent declared by the Board of Directors “in its sole discretion, from funds legally available therefor.” If the Companies did not wish to—or legally could not—pay a cash dividend, the unpaid dividends on the Government Stock could be capitalized (or paid “in kind”) by increasing the liquidation preference of the outstanding Government Stock—an option Treasury publicly acknowledged in the fact sheet it released upon entry into the PSPAs. Therefore, the Companies were never required to pay cash dividends on Government Stock. There was never any threat that the Companies would become insolvent by virtue of making cash dividend payments, both because dividends could be paid with stock and because state law prohibits the payment of dividends if it would render a company insolvent. Indeed, unlike most preferred stock that imposes temporal limits on a company’s ability to exercise a payment in kind option, the PSPAs specifically allowed the Companies to utilize this mechanism throughout the life of the agreement, thereby foreclosing any possibility that they would exhaust Treasury’s funding commitment because of a need to make a dividend payment to Treasury.

The Government Stock diluted, but did not eliminate, the economic interests of the Companies’ private shareholders. The warrants to purchase 79.9% of the Companies’ common stock gave Treasury “upside” via economic participation in the Companies’ profitability, but this upside would be shared with preferred shareholders (who had to be paid before any payment could be made on common stock purchased with Treasury’s warrants) and common shareholders (who retained rights to 20.1% of the Companies’ residual value). James Lockhart, the Director of FHFA, accordingly assured Congress shortly after imposition of the conservatorship that Fannie’s and Freddie’s “shareholders are still in place; both the preferred and common shareholders have an economic interest in the companies” and that “going forward there may be some value” in that interest.

Under FHFA’s supervision—and, on information and belief, at the insistence and direction of Treasury—the companies were forced to excessively write down the value of their assets, primarily due to FHFA’s wildly pessimistic assumptions about potential future losses. Despite the Companies’ concerns, FHFA caused the Companies to incur substantial non-cash accounting losses in the form of loan loss provisions. To be clear, tens of billions of dollars of these provisions—recognized by the Companies as expenses—were completely unnecessary since the potential loan losses never materialized into actual losses. Nonetheless, by June 2012, the Agencies had forced Fannie and Freddie to issue $161 billion in Government Stock to make up for the balance-sheet deficits caused by the Agencies’ unrealistic and overly pessimistic accounting decisions, even though there was no indication that the Companies’ actual cash expenses could not be met by their cash receipts. The Companies were further forced to issue an additional $26 billion of Government Stock so that Fannie and Freddie would be able to pay cash dividends to Treasury even though, as explained above, the Companies were never required to pay cash dividends. Finally, because (i) the Companies were forced to issue Government Stock to Treasury that they did not need to continue operations and (ii) the structure of Treasury’s financial support did not permit the Companies to repay and redeem the Government Stock outstanding, the amount of the dividends owed on the Government Stock was artificially—and permanently—inflated.

As a result of these transactions, Treasury amassed a total of $189 billion in Government Stock. But based on the Companies’ performance in the second quarter of 2012, it was apparent that there was still value in the Companies’ private shares. Treasury’s attempt to drown the Companies by extending a concrete “life preserver” had failed. By that time, the Companies were thriving and paying 10% annualized cash dividends on the Government Stock without drawing additional capital from Treasury. And based on the improving housing market and the high quality of the newer loans backed by the Companies, it was apparent that they had returned to stable profitability. This return to profitability made it inevitable that the Companies would be reversing many of the non-cash accounting losses they had incurred under FHFA’s supervision, and the reversal of those paper losses would result in massive profits. Indeed, the Agencies had specific information from the Companies demonstrating that such reversals would take place soon. Given this information and the broad-based recovery in the housing industry that had occurred by the middle of 2012, the Agencies fully understood that the Companies were on the precipice of generating huge profits, far in excess of the dividends owed on the Government Stock. Moreover, when the Net Worth Sweep was suddenly imposed on the Companies in August 2012, the financial crisis had clearly passed and there was absolutely no need for “drastic emergency action” by the Agencies.

Treasury, however, was not content to share the value of the Companies with private shareholders and was committed to ensuring that the Companies were operated for the exclusive benefit of the federal government. Indeed, unbeknownst to the public, Treasury had secretly resolved “to ensure existing common equity holders will not have access to any positive earnings from the [Companies] in the future.” By the middle of 2012, however, it was apparent that even the large amount of Government Stock outstanding—the proverbial “concrete life preserver”—would not achieve this unlawful policy goal for Treasury.

Therefore, on August 17, 2012, just days after the Companies announced their robust second quarter earnings, the Agencies unilaterally imposed the Net Worth Sweep to expropriate for the federal government the value of Fannie and Freddie shares held by private investors. Treasury itself said that the Net Worth Sweep was intended to ensure that “every dollar of earnings that Fannie Mae and Freddie Mac generate will benefit taxpayers.” With the stroke of a pen, the Agencies had nationalized the Companies and taken all the value of the Companies for the government, thereby depriving the private shareholders of all their economic rights, well in excess of the authority granted to the FHFA as conservator. The Companies received no incremental investment by Treasury or other meaningful consideration in return for the Net Worth Sweep. All of this was in blatant violation “the path laid out under HERA,” which, as even Treasury acknowledged internally, was for Fannie and Freddie to “become adequately capitalized” and “exit conservatorship as private companies.”

In attempting to defend the Agencies’ naked expropriation of private property rights against claims by injured shareholders, the government has insisted that the Net Worth Sweep was necessary to prevent the Companies from entering a “death spiral” due to their existing dividend obligations to Treasury. This argument is facially implausible for at least two reasons: first, the timing of the Net Worth Sweep belies this explanation. The Agencies did not impose the Net Worth Sweep at a time when Fannie and Freddie were struggling to earn enough money to pay cash dividends to Treasury, but rather imposed it mere days after the Companies announced that they had earned several billion dollars more than necessary to make such payments. What is more, these earnings, coupled with an improving housing market and the improving quality of loans guaranteed by Fannie and Freddie, made clear that the Companies would soon be considering reversal of the non-cash accounting losses they had been forced to take while in conservatorship, which would generate extraordinary gains commensurate with those losses. Second, Treasury’s Government Stock certificates never could cause the Companies to enter a death spiral, because by their plain terms they provided a mechanism for Fannie and Freddie to pay dividends in-kind rather than in cash.

In light of these facts, there were only two possible explanations for the death spiral rationale: incompetence on the part of the Agencies at the time of the Net Worth Sweep or inaccuracy in describing the Agencies’ reasons for taking action. Discovery in the Court of Federal Claims has ruled out incompetence. Indeed, that discovery has made clear that the reason the Net Worth Sweep was adopted when it was is precisely the opposite of a concern that the Companies’ earnings were going to be too low. Rather, the concern was that the Companies’ earnings would be too high and thus would complicate the Agencies’ plans to keep Fannie and Freddie in perpetual conservatorship and to prevent their private shareholders from seeing any return on their investments.

There is a wealth of evidence that supports this conclusion, and much of it is detailed below. But the most striking evidence relates to a meeting that occurred on August 9, 2012, between senior Treasury officials, including Under Secretary Mary Miller, and Fannie’s executive management team. The Agencies knew in advance of that meeting that the company was likely entering a period of “golden years” of earnings. Indeed, in July 2012 the minutes of a Fannie executive management meeting during which that precise sentiment was expressed were circulated broadly within FHFA, including to Acting Director Edward DeMarco. Projections attached to those minutes showed that Fannie expected that its dividend payments to Treasury would exceed its draws under the PSPAs by 2020 and, more importantly for the “death spiral” narrative, that over $115 billion of Treasury’s commitment would remain after 2022.

Fannie’s projections did not account for reversal of the Company’s massive deferred tax assets valuation allowance. That item alone would add over $50 billion dollars to Fannie’s balance sheet. Treasury was keenly aware of this impending addition to earnings. Indeed, by late May 2012 Treasury was discussing with its consultant the topic of returning the deferred tax asset to Fannie’s and Freddie’s balance sheets, and a key item on Treasury’s agenda for the August 9 meeting was how quickly Fannie forecasted releasing its reserves. At the August 9 meeting, in addition to being presented with projections similar to those provided to FHFA in July, Treasury was given very specific information about the Company’s deferred tax assets: Fannie CFO Susan McFarland has testified that she told Under Secretary Miller that release of the valuation allowance likely would happen in mid-2013 and that it likely would be in the range of $50 billion—a prediction that proved remarkably accurate. It thus is no surprise that Ms. McFarland also has testified that she did not think that Fannie was in a death spiral in mid-August 2012.

The Net Worth Sweep was imposed only days after Treasury’s meeting with Fannie—and email traffic indicates that Treasury was making a “renewed push” to finalize the Net Worth Sweep that very day. In light of all of this, it is wholly implausible for the Agencies to claim that there was any imminent concern of a “death spiral.” Indeed, in an internal document authored the day before the sweep, Treasury specifically identified the Companies’ improving operating performance and the potential for near-term earnings to exceed the 10% dividend as reasons for imposing the Net Worth Sweep.

Treasury’s knowledge of Fannie’s expectations for its deferred tax assets also wholly discredits the declaration FHFA submitted to the public record in another district court asserting that “neither the Conservator nor Treasury envisioned at the time of the Third Amendment that Fannie Mae’s valuation allowance on its deferred tax assets would be reversed in early 2013, resulting in a sudden and substantial increase in Fannie Mae’s net worth, which was paid to Treasury in mid-2013 by virtue of the net worth dividend.” That declaration was signed under penalty of perjury by Mario Ugoletti, who participated in the creation and implementation of the PSPAs while at Treasury, later moved to FHFA, and at the time of the Net Worth Sweep served as the principal liaison with Treasury concerning the PSPAs. And in his deposition, Mr. Ugoletti expressly disclaimed any knowledge of Treasury’s understanding of the deferred tax asset issue, and he also denied knowing what anyone else at FHFA thought about the issue.

The Net Worth Sweep has resulted in a massive and unprecedented financial windfall for the federal government. From the fourth quarter of 2012, the first fiscal quarter subject to the Net Worth Sweep, through the second quarter of 2015, the most recently completed fiscal quarter, Fannie and Freddie generated nearly $180 billion in net income. But rather than using those profits to prudently build capital reserves and prepare to exit conservatorship, Fannie and Freddie instead have been forced to pay $186 billion in “dividends” to the federal government under the Net Worth Sweep (funded by that net income and draining prior retained earnings)—nearly $130 billion more than the government would have received under the original PSPAs. Adding Net Worth Sweep dividends to the dividends Fannie and Freddie had already paid, Treasury has now recouped $54 billion more than it invested in the Companies. Yet, according to Treasury, the amount of outstanding Government Stock remains firmly fixed at $189 billion, and Treasury continues to insist that it has the right to all of Fannie’s and Freddie’s future earnings in perpetuity. At the time of the Net Worth Sweep, the Agencies knew that it would result in a massive financial windfall.

The Net Worth Sweep blatantly transgresses the limits Congress placed on FHFA’s and Treasury’s authority. As conservator of Fannie and Freddie, FHFA is charged with rehabilitating the Companies with a view to returning them to private control. The Net Worth Sweep guarantees that this can never be accomplished. Indeed, contrary to its statutory requirements and statements that it made when the conservatorship was initiated, FHFA has now indicated that it will operate Fannie and Freddie for the exclusive benefit of the government until Congress passes housing finance legislation. Holding the Companies hostage in a perpetual conservatorship while awaiting potential legislative action was never an option for FHFA contemplated under HERA. And Treasury’s decision to exchange its existing equity stake in the Companies for the new and different equity stake granted to it by the Net Worth Sweep years after its temporary authority to acquire the Companies’ stock had expired is a direct affront to HERA’s plain requirements. What is more, on information and belief Treasury compelled FHFA to agree to the Net Worth Sweep despite Congress’s express direction that FHFA exercise its conservatorship authority independently.

By entering the Net Worth Sweep, FHFA violated HERA in at least five ways. First, FHFA failed to act as a “conservator”—indeed it has acted as an anti-conservator—because conservators are not allowed to use the companies under their care as ATM machines. Second, FHFA is required to put Fannie and Freddie in a sound and solvent condition, but the Net Worth Sweep forces the Companies to operate on the edge of insolvency by stripping the capital out of the Companies on a quarterly basis. Third, FHFA is required to conserve and preserve Fannie’s and Freddie’s assets, but the Net Worth Sweep requires the dissipation of assets by forcing the Companies to pay their net worth to Treasury on a quarterly basis. Fourth, FHFA is charged with rehabilitating Fannie and Freddie and seeking to return them to private control, but the Net Worth Sweep is designed to make any such outcome impossible. Finally, FHFA as conservator cannot be subject to the direction and supervision of any other government agency, but, on information and belief, FHFA entered the Net Worth Sweep at the direction and supervision of Treasury.

Treasury’s violation of HERA is straightforward: the Net Worth Sweep, by changing the fundamental economic characteristics of Treasury’s investment, created new securities, and HERA explicitly prohibited Treasury from acquiring Fannie and Freddie securities in 2012.

References and Resources Below

New unsealed court documents from Fannie & Freddie Secrets

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