Monday, July 8, 2013

Agency Shit Storm


I’ve been waiting four years for a lawsuit against the government and its handling of Fannie Mae and Freddie Mac. Perry Capital, a hedge fund who has invested in Agency Pref stock,  filed the suit on Saturday. A heavyweight law firm, Gibson, Dunn & Crutcher (GDC), is handling the case. I think this is going to cause a shit-storm in D.C.



The deep thinkers in Washington set this up to happen way back in 2008. Then Treasury Secretary, Hank Paulson, made the fateful decision to put Fannie and Freddie (F/F) into a Conservatorship. The Agencies should have been put into a Receivership; they were broken entities back then. If they had been declared bankrupt in 2008, there would be no Perry lawsuit today.


Paulson had two strong incentives to go down the Concervatorship road:


1) If F/F had declared bankruptcy, then all of the $7 Trillion of Agency debt would have have gone on the Federal balance sheet. Treasury Marketable Debt outstanding at the time was $5,8Tn. It would have gone up 120% overnight.

Hank P made a form-over-substance decision. It would have been (another) shock to the system to see the Federal debt double. The wheels were coming off the cart when the choice was made. So Hank elected to ‘hide’ the debt and kept F/F functionally alive.


2) No one (especially Hank Paulson) thought there was even a remote chance that F/F would ever be able to dig themselves out of the hole. The estimated losses were in the $400Bn range. That assumed outcome meant that there was 100% certainty that the government would never get paid back its bailout of F/F. So it didn’t matter that the F/F shareholders were not legally put out of their misery (as they should have been).


As it has turned out, everyone (including me) was wrong on the actual size of the bailout for FF, and we were way off on how long it would take to pay back the taxpayers in full (with a big return). If allowed to continue to operate as they now are, F/F are capable of returning 100% of the bailout money PLUS a 10% return PLUS a significant equity interest in F/F in under three years. That would be a big win for the taxpayers.

So Hank made a critical choice based on a bad assumption. His decision was driven by the ‘optics’ of shifting the debt onto the balance sheet. The Treasury Secretary made a mistake. When governments pass laws and take actions, there are always negative side effects. When mistakes are made, lawsuits happen and lawyers, and guys with capital make money.


The Perry lawsuit has merit. GDC would not have filed such a high profile suit unless it thought the law was on its side. The Feds set this up to happen, and it happened. By no means is the solvency of F/F a ‘bad thing’ – the taxpayers will make billions.


I expect that the Perry lawsuit goes no place fast; the Feds can delay the process for years. But the existence of the lawsuit will make it much harder for D.C. to take action that results in a shareholder wipe out. The Bob Corker (R-Tn) plan to unwind the Agencies and blow-off the existing stakeholders is now a dead end. (Link)


There is a delicious irony to this story. Go back to the beginning and ask why Paulson could have missed this coming? The answer is that he never, in his wildest imagination, believed that the Fed would keep interest rates at zero for five years and buy Trillions of MBS. Were it not for the unending monetary gas that the Fed has plowed into the system, F/F would be in much different shape today. They would not be able to pay back the taxpayers in full, and the publicly traded equity would be worth zip. (Zero Hedge discussion)


I hope this case does come to a trial. The star witness for GDC will be Ben Bernanke:


GDC – Was one of your goals with ZIRP and QE 1-3 to support the mortgage industry participants?

Bernanke – Yes.


GDC – Was your purchase of $1.2 trillion of Agency MBS a subsidy for the entire mortgage industry?

Bernanke – Yes.


GDC – Are you surprised that F/F have made huge profits as a result of your monetary policies the past five years?

Bernanke – No. It is exactly the outcome that we hoped would happen. The rise of F/F from the ashes is a measure of our success.


GDC- Did you repeatedly communicate your intentions of supporting the mortgage market, and its participants, to the public and in testimony to the House and Senate?

Bernanke- Yes.


GDC - Your Honor, we rest our case. This witness has proven beyond any doubt that the favorable outcome for F/F was the desired, and well communicated policy of one branch of the Government. You can’t now penalize investors who listened, and paid heed to the Chairman of the Federal Reserve.


Like I said, there will be a storm over this one.


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  1. Conscience of a Conservative says:

    I don’t agree. If the government had done nothing, there would have been no liquidity for Fannie & Freddie, and the sheer leverage of both entities would have meant instant failure. The government conservatorhsip bought Fannie & Freddie time , allowed them to continue funding and gave them the ability to survive to where they are today. At the same time tax payers took all the risk, so why should Perry get the upside?

    • why should Perry get the upside?

      That is the question. The argument you make is that he deserves no upside. And that is a valid point.

      The answer it is the courts that will determine this. That result may not be what you think of as “fair”.

      As I tried to explain, this situation exists because F/F were not formally put to sleep 5 years ago. Now it is not possible to euthanize the patient.

  2. Bruce, I agree with your analysis of Bernanke’s testimony. Another thing is that there is an actual finding, early in 2012, from the conservator that under no scenario can Fannie/Fred return to profitability. This was also presented to Congress.

    • Bruce, the point is QE1 and 2 didn’t do it. QE3 was specifically directed at the mortgage market, but it didn’t occur until FHFA (the conservator) had made the decision that Fannie and Freddie wouldn’t couldn’t overcome their problems. The equity sweep accounts were created to allow the Fed to begin QE3 without benefiting the existing shareholders inappropriately.

  3. celebrate uniformity says:

    perry invested in preferred stock and the guv bailed out fannie

    so why is perry suing. the article you’ve written doesn’t say and i can’t figure it out. it would seem that someone who invests in a company that is bailed out has been saved.

    • As it stands today the stock of F/F is technically worthless. There is no legal mechanism to re-establish value to shareholders. The FHFA ruled that 100% of F/F gains go to Treasury forever.

      So the suit is to overturn that ruling by FHFA. If the suit is successful, then the Pref stock will have real value. If the suit is unsuccessful the stock goes to zero.

      The third possibility is some type of settlement, this outcome would also be good for existing pref holders.

      Two ways to win, one way to lose.

  4. Touche. Great arguments. Keep up the great work.

  5. Think of it more in terms of imminent domain and claiming it has no market value to the owners.
    Then making it have value by exploiting your ability to substantially alter the market’s evaluation mechanism.

    It’s a catch-22 scenario with the one fact above all else: F/F now have value. Causation or correlation?

    Settlement with no admission of culpability. The hedge funds use what monies? Pension plans maybe? They’ll take the fast nickel.