12 U.S. Code § 4617(a)(3)(A)-(L) as it Relates to the Regulated Entities.

Question:

On September 7, 2008, did the Regulated Entities meet the grounds for discretionary appointment of conservator or receiver? 

BlackRock August 25, 2008 Feddie Mac Confidential Capital Review

October 2008 PWC Freddie Memo

October 2008 FHFA Presentation

September 2008 PWC Freddie Memo

November 2008 FHFA Presentation

October 2008 Grant Thornton Notes

August 2008 Draft Treasury Summary

A Pattern of Deception – J Timothy Howard

HERA Statute as Written:

12 U.S. Code § 4617(a)(3)(A)-(L) Grounds for discretionary appointment of conservator or receiver

The grounds for appointing conservator or receiver for any regulated entity under paragraph (2) are as follows:

(A) Assets insufficient for obligations

The assets of the regulated entity are less than the obligations of the regulated entity to its creditors and others.

(B) Substantial dissipation

Substantial dissipation of assets or earnings due to—

(i) any violation of any provision of Federal or State law; or

(ii) any unsafe or unsound practice.

(C) Unsafe or unsound condition

An unsafe or unsound condition to transact business.

(D) Cease and desist orders

Any willful violation of a cease and desist order that has become final.

(E) Concealment

Any concealment of the books, papers, records, or assets of the regulated entity, or any refusal to submit the books, papers, records, or affairs of the regulated entity, for inspection to any examiner or to any lawful agent of the Director.

(F) Inability to meet obligations

The regulated entity is likely to be unable to pay its obligations or meet the demands of its creditors in the normal course of business.

(G) Losses

The regulated entity has incurred or is likely to incur losses that will deplete all or substantially all of its capital, and there is no reasonable prospect for the regulated entity to become adequately capitalized (as defined in section 4614 (a)(1) of this title).

(H) Violations of law

Any violation of any law or regulation, or any unsafe or unsound practice or condition that is likely to—

(i) cause insolvency or substantial dissipation of assets or earnings; or

(ii) weaken the condition of the regulated entity.

(I) Consent

The regulated entity, by resolution of its board of directors or its shareholders or members, consents to the appointment.

(J) Undercapitalization

The regulated entity is undercapitalized or significantly undercapitalized (as defined in section 4614 (a)(3) of this title), and—

(i) has no reasonable prospect of becoming adequately capitalized;

(ii) fails to become adequately capitalized, as required by—

(I) section 4615 (a)(1) of this title with respect to a regulated entity; or

(II) section 4616 (a)(1) of this title with respect to a significantly undercapitalized regulated entity;

(iii) fails to submit a capital restoration plan acceptable to the Agency within the time prescribed under section 4622 of this title; or

(iv) materially fails to implement a capital restoration plan submitted and accepted under section 4622 of this title.

(K) Critical undercapitalization

The regulated entity is critically undercapitalized, as defined in section 4614 (a)(4)of this title.

(L) Money laundering

The Attorney General notifies the Director in writing that the regulated entity has been found guilty of a criminal offense under section 1956 or 1957 of title 18 or section 5322 or 5324 of title 31.

Summarized Key Points of HERA

In total, HERA provided for 12 circumstances (summarized points) in which FHFA could place the Regulated Entities into Conservatorship or Receivership:

  1. If a Company’s assets were insufficient to meet its obligation;
  2. If a Company’s assets or earnings were substantially dissipated due to unlawful conduct or unsafe or unsound practices;
  3. If a Company was in an unsafe or unsound condition to transact business;
  4. If a Company willfully violated a cease and desist order;
  5. If a Company concealed books and records from the FHFA Director;
  6. If a Company became unlikely to be able to pay its obligations or meet the demands of its creditors in the normal course of business;
  7. If a Company incurred, or became likely to incur, losses that would deplete substantially all of its capital with no reasonable prospect of becoming adequately capitalized;
  8. If a Company violated the law;
  9. If a Company’s board of directors or shareholders passed a resolution consenting to a conservatorship or receivership;
  10. If a Company became undercapitalized or significantly undercapitalized, as defined by the governing statute, and could not or would not take corrective measures;
  11. If a Company became critically undercapitalized, as defined by the governing statue; or
  12. If a Company engaged in money laundering.

These are the arguments against the Discretionary Appointment of Conservatorship or Receivership. In my opinion, the burden of proof of placing GSEs under conservatorship should be upon the FHFA as Regulator.

(A) Assets insufficient for obligations

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. As of June 30, 2008, the date of most recently reported financial results for the last quarter immediately preceding Fannie Mae’s conservatorship, which were not filed with the SEC until August 8, 2008, Fannie Mae had assets of $885.9 billion and liabilities of $844.5. Thus, Fannie Mae assets exceeded its liabilities by more than $41 billion just shortly before the conservatorship was imposed. In fact, Fannie Mae’s assets had exceeded its liabilities by approximately $40 billion for each of the past three calendar years. Thus, no factual basis existed for asserting that the Regulated Entities’ assets were less than their obligations and; therefore, the statutory ground set forth in section 4617(a)(3)(A) was not satisfied.

(B) Substantial dissipation

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. From December 31, 2005, to June 30, 2008 Fannie Mae’s assets grew from $834.1 billion to $896.6 billion. Thus, company assets were increasing. Fannie Mae earnings had no substantial dissipation; although, Fannie Mae’s earnings decreased from 2005 to 2007, they increased in the first half of 2008 over earnings in the second half of 2007. Furthermore, Fannie Mae’s decline in earnings in 2007 was not attributable to either a violation of law or to any unsafe and unsound practice; but rather, the decline was largely attributable to the following:

>A narrowing of the interest spread earned by Fannie Mae resulting from higher borrowing costs during a period of turmoil in the financial markets;

>The need to increase reserves to offset expected future credit losses stemming from the general decline in the housing market which was negatively impacting all financial firms at the time; and

>Discrete one-time losses on derivatives contracts with corresponding offsetting gains that were not simultaneously recognized.

None of these circumstances reflected either a violation of law or an unsafe and unsound practice on the part of Fannie Mae. Furthermore, there has never been any allegation that the Companies engaged in a violation of any law resulting in the substantial dissipation of assets or earnings. On September 7, 2008, public announcement of the conservator, Director Lockhart strongly emphasized that the management and directors of the Companies had done nothing wrong, noting that any difficulties they were facing were the result of extenuating circumstances.   On the same day, Secretary Paulson emphasized that; “I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction. Fannie Mae’s and Freddie Mac’s management and their Boards are responsible for neither.”

(C) Unsafe or unsound condition

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. Neither GSEs were engaged in any unsafe or unsound practice or was in danger of incurring losses that would caused their capital to fall below regulatory capital requirements. Moreover, the GSEs had capital substantially in excess of their regulatory capital requirements. Accordingly, the GSEs were not operating in an unsafe or unsound condition. The GSEs were subject to capital requirements contained in HERA, which, by definition, were engineered to ensure that the GSEs remained in a safe and sound condition. To that end, HERA specifically provides that the risk-based capital requirement shall “ensure that the enterprises operate in a safe and sound manner, maintaining sufficient capital and reserves to support the risks that arise in the operations and management of each enterprise.” To be clear, both of the Regulated Entities substantially exceeded the applicable risk-based requirements, and this has always been the case. Thus, by definition, the Entities were in a safe and sound condition.

“Stress test”, commonly referred to as the “100-year storm” test, required that the GSEs total capital was sufficient to withstand a 1-year period of extreme economic instability and adverse market conditions.

As of June 30, 2008, Fannie Mae’s core capital exceeded both the FHFA-directed and statutory minimum capital requirement and its total capital exceeded its minimum capital requirement by $14.3 billion, or 43.9%, and its total capital exceeded its statutory risk-based capital requirement by $19.3 billion, or 53%. Regulated Entities would have passed any reasonable risk-based capital stress test that could have been applied at that time. Therefore, GSEs were not operating in an unsafe or unsound condition and, therefore, the statutory ground for appointing a conservator set forth in this subsection was not satisfied.

(D) Cease and desist orders

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. Neither GSEs were in violation of a cease and desist order. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(E) Concealment

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. Neither GSEs at any time concealed their books, papers, records, or assets, or any refusal to submit the books, papers, or records for inspection to any examiner or to any lawful agent of the Director. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(F) Inability to meet obligations

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. The regulated entities were likely to be able to pay its obligations or meet the demands of its creditors in the normal course of business. As of June 30, 2008, Fannie Mae had $344.8 billion of short-term assets, comprised chiefly of cash, cash equivalents, and investments in publicly traded securities. This far exceeded the company’s $247 billion in short-term liabilities. Fannie Mae’s holdings of investment securities were carried on the company’s balance sheet on a fair value basis, and thus represent a market valuation for those assets. Both GSEs had sufficient assets to meet their obligations and any demands of their creditors in the normal course of business. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(G) Losses

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. During the period leading up to the imposition of the conservatorship, neither regulated entities had incurred losses that substantially depleted their capital let alone all of their capital. From December 31, 2007, to June 30, 2008 Fannie Mae’s total capital increased from $48.7 billion to $55.6 billion, and its core capital increased from $45.4 billion to $47 billion. Thus, Fannie Mae capital had not been depleted. Losses were primarily reflected the Entities’ recording of substantial reserves for potential future credit losses. These losses are not actually realized until future periods (if they are ever realized at all), and they can be offset by correlating deferred tax assets that have a reasonable expectation of being realized in the future (based partly on a lengthy history of largely positive financial performance), Thus, they are added back into the calculation of total capital and do not actually impact total capital. Moreover, Fannie Mae had access to substantial capital in the public equity markets. In December 2007, Fannie Mae raised approximately $7 billion through an issuance of Series S preferred stock; in May 2008, Fannie Mae raised almost $2.1 billion by issuing Series 2008-I preferred stock; and also raised an additional $2.25 billion by issuing Series T preferred. At around the same time, Fannie Mae also raised $2.59 billion by issuing 94.3 million shares of common stock at a price of $27.5 per share. The original 82 million shares offering was oversubscribed by 12.3 million shares. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(H) Violations of law

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. Neither Companies violated any law or regulation, or any unsafe or unsound practice or condition that is likely to—

(i) Cause insolvency or substantial dissipation of assets or earnings; or

(ii) Weakening of their condition.

Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(I) Consent

The Regulated entities did not by resolution of its board of directors or its shareholders or members voluntarily consents to the appointment of conservator. Any consent purportedly obtained by the Companies’ board of directors was coerced and/or otherwise improperly obtained, rendering any such consent invalid. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(J) Undercapitalization

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. At all relevant times prior to and including the time the FHFA was appointed as conservator, the Companies were “adequately capitalized.” To qualify as “adequately capitalized,” a company is required to have:

(a) “Total Capital” (as defined at 12 C.F.R. § 1750.11(n)) equal to or in excess of its “Risk-Based Capital” (as defined at 12 U.S.C. § 4611 (a)(1)); and

(b) “Core Capital” (as defined at 12 C.F.R. § 1750.2) equal to or in excess of its “Minimum Capital” (as defined at 12 C.F.R. § 1750.4).

At the time the conservatorships were imposed, not only were the Companies adequately capitalized with both of these requirements, and each company’s capital was substantially in excess of its capital requirements. Moreover, each company’s ability to raise capital from the public equity and private capital markets was more than sufficient to allow it to absorb any potential future losses, particularly if the Companies had been allowed to offer terms to potential investors as favorable as those demanded by the Government in exchange for the extremely costly capital it provided upon taking control of the Companies. And the Companies always had more than sufficient assets and capital to satisfy all obligations to their creditors. See 10K filing. Because both Companies were more than adequately capitalized, as defined under law, they were not undercapitalized or significantly undercapitalized. Therefore, the FHFA Director lacked any justification or legal authority to appoint a conservator for the Companies.

In addition to the statutory capitalization requirements, Fannie Mae was, during parts of 2007 and 2008, subject to a consent order from OFHEO under which it was required to keep core capital at a level 30% higher than the minimum capital requirement. This 30% requirement was lowered to 20% for the first quarter of 2008, and lowered again to 15% for the second quarter of 2008 in accordance with the provisions of the consent order. Fannie Mae had sufficient surplus capital such that it was always in compliance with this additional capitalization requirement. As a note, in the months leading up to the decision to appoint the FHFA as conservator for the GSEs, Companies’ regulators repeatedly emphasized that the Companies were adequately capitalized.

Moreover, even if one of the Companies was undercapitalized, Director Lockhart would have been required to provide the undercapitalized company an opportunity to submit and comply with a capital restoration plan, and to demonstrate that it could have raised private capital if and as needed. Specifically, under 12 U.S.C § 4615(a) (entitled “Mandatory actions”), as amended by HERA, “the Director of the FHFA shall” impose on an undercapitalized Regulated Entity a capital restoration plan. Had such a plan been required of either company, both GSEs would have been capable of meeting such a requirement and, further, would have been able to raise additional capital from the private markets if and as needed. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

(K) Critical undercapitalization

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. As alleged above, at all relevant times, both GSEs had total capital and core capital in excess of all applicable regulatory requirements.   Therefore, at all relevant times, neither GSEs were critically undercapitalized. As such, the ground for appointing a conservator set forth in this subsection was not satisfied.

(L) Money laundering

Neither of the Companies fell within the purview of this subsection at the time they were placed in Conservatorship. Neither GSEs were ever been found guilty of a criminal offense under section 1956 or 1957 of title 18 or section 5322 or 5324 of title 31. Therefore, the ground for appointing a conservator set forth in this subsection was not satisfied.

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