More nonsense embedded within Perry v. Mnuchin, the "new capital paradigm"
In my takedown of Perry v. Mnuchin, I mentioned that the D.C. Circuit gave short shrift to the statutory requirement to maintain adequate capital at the GSEs. That issue is fleshed out in further detail below.
The D.C. Circuit Court judges who wrote the majority (2-1) decision in Perry v. Mnuchin focused on the distinction between the words "may" and "shall." The statute, 12 U.S.C. § 4617(b)(2)(D), says the conservator may take steps to restore the soundness and solvency of Fannie and Freddie. But no statute expressly dictates that the conservator shall restore the companies' soundness and solvency. Which, according to the judges, must mean that the conservator may do any number of other things, such as draining the companies of all equity in perpetuity.
The court basically ignored the limitations that are set by the regulator, which in this instance is also the conservator. Under 12 U.S. Code § 4513(a), "The principal duties of the Director [of the regulator, FHFA] shall be--(A) to oversee the prudential operations of each regulated entity; and (B) to ensure that  each regulated entity operates in a safe and sound manner including maintenance of adequate capital and internal controls..." So, one would presume, the conservator shall not do anything disallowed by the duties of the regulator.
And consider the statutes on minimum capital. According to 12 U.S. Code § 4612(a), the minimum capital requirement for the GSEs is 2.5% of balance sheet assets, and 0.5% for guarantee obligations. But 12 U.S. Code § 4612(b) says that, notwithstanding those minimums, "the Director may, by regulations issued under section 4526 of this title, establish a minimum capital level for the enterprises... that is higher than the level specified in subsection (a) for the enterprises."
So we know the FHFA Director may increase the minimum capital ratios. Does it follow that the Director may also reduce the minimum capital amounts? Why, yes, argued FHFA's outside counsel Howard Cayne before the D.C. Circuit judges. On October 9, 2008, when both companies were adequately capitalized, FHFA declared that, "the existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship." Nothing in the law says FHFA may suspend statutory requirements during conservatorship. But then again, nothing in the law said the regulator shall not suspend statutory requirements. So FHFA decided that it may suspend statutory requirements whenever it deemed appropriate.
With artful flourishes of doublespeak, Cayne argued that the 2008 announcement created a whole new "capital paradigm." Though there seems to be no contemporaneous document expressly stating so, Cayne said that FHFA decided to use Treasury's unused commitment to support the GSEs as a substitute for GSE capital. Cayne's performance--he used close to 2,000 words to make his point--was a tour de force, a symphony of sophistry. Here are some brief excerpts:
So, what we have here at the outset in 2008 at the time the institutions were put into conservatorship, a new capital paradigm was established, and that capital paradigm said as long, by the Director of the Agency as regulator, and that capital paradigm said as long as these institutions are not forced into mandatory receivership they may operate.
And the new paradigm was rather than requiring them to maintain eight percent, five percent, six percent capital, whatever the standard was as a normal banking institution, it was determined that as long as the Treasury commitment was out there ready to come in to cure any insolvency, which as the Court knows if the institutions were insolvent for more than 60 days the Agency would have been forced to place them into mandatory receivership, so the new paradigm was we'll have the 100, 200, eventually Treasury committed to 467 billion, nearly a half a trillion dollars to support these enterprises, and the regulator made the regulatory decision that we will, the Agency will allow that to satisfy capital standards.
...what the statute says is that this action by the Agency as regulator to establish a new capital paradigm for the duration of the conservatorships may not be affected by injunction or otherwise in any manner...
Again, there is no statute that says FHFA as regulator may establish "a new capital paradigm" during conservatorship.
Judge Douglas Ginsberg wanted to be sure he heard right. He said:
There seems to be in the statute [referencing 12 U.S.C. Sec. 4614] a whole typology of classifications, adequately recapitalized, and then under-capitalized, and within that significantly under-capitalized, critically under-capitalized, okay?
Your Honor, that entire system by virtue of the Director's action was set aside, there is an issuance by the Director that says this system doesn't apply.
Proving, once again, that clever people can rationalize away anything.
So, let's recap the government's position. The conservator may, in the absence of any prohibition stating otherwise, drain the GSEs of all equity, and the regulator may, in the absence of prohibition stating otherwise, suspend a statutory requirement for minimum capital. And, because of anti-derivative statutes--which limit shareholders' ability to bring suits alleging wrongs inflicted on the company, as opposed to wrongs directed specifically against the shareholders--FHFA's decision to drain the companies of all equity in perpetuity shall not be challenged on grounds tied to any fiduciary duty owed to the corporation.
However the Court did allow shareholders to litigate their direct claim. The idea behind that claim is that, because Treasury is taking cash dividend distributions today, it is reducing the availability of assets that may be allocated at the time of corporate liquidation. And, by taking away assets available for distribution at liquidation, the government is impairing the value of the junior preferred shares today. Which is why the claim is ripe.
This idea leads to several anomalies. If you add back the cash dividends distributed, in excess the the pre-existing 10% coupon, the GSEs would then be adequately capitalized, or at worst, undercapitalized under the classifications set by 12 U.S.C. Sec. 4614. In which case FHFA would have no statutory grounds, under 12 U.S.C. § 4617(a)(3), to place the the companies in receivership. (The GSE would need to be critically undercapitalized for FHFA to impose receivership.) If FHFA declares a GSE to be undercapitalized, the company has 45 days to come back with a plan to recapitalize before any further action may be taken.
(The original stated grounds for conservatorship used in 2008, "operating in an unsafe and unsound condition," per 12 U.S. Code § 4617(a)(3)(C), can no longer apply. Even in September 2008, FHFA had perverted the meaning of "an unsafe and unsound condition," in order to justify taking immediate control of the companies.)
As for shareholder rights under any liquidation preference, the GSEs situation seems to be an anomaly. It is almost unheard of to liquidate a company when it has substantial positive equity, and has prospects for continuing positive earnings. Moreover, a number of former officials involved in executing the Third Amendment sweep--former acting FHFA director, Edward DeMarco, former Obama White House advisors Gene Sperling and James Parrott--advocate a course of action that is very different from liquidation.
All of the housing finance reform proposals currently touted by James Parrott at the Urban Institute are remarkably similar. They all seem to eschew the concept of liquidation. Instead, they advocate abolishing the GSEs, while appropriating the GSEs' operations and infrastructure to be used in a new government-owned mortgage insurance company. These proposals look, sound and smell like nationalization. Of course, the same might be said about a plan to drain the companies of all equity in perpetuity. "Conservation is not a synonym for nationalization," wrote Judge Janice Rogers Brown in her dissent.
4 comments - More nonsense embedded within Perry v. Mnuchin, the "new capital paradigm"
Here what perplexes most people.
If any other regular Gov Agencies/Officials or any private entities were to do the same things as FHFA Regulator/Conservator did with FnF, then courts would have declared them as unlawful and unconstitutional. Congress and Administration would not have allowed Gov Agencies/Officials or Private entities to engage in such activities. Courts would not have allowed laws like HERA empowering Gov or private entities with such unchecked broad authorities without checks and balances.
Then how courts are allowing independent Gov agencies to engage in such gross lawlessness?
Are the definitions of physician and conservator so “malleable” (to use judge Brown's term) that they are allowed to switch roles from Dr. Jekyl to Mr. Hyde when it is convenient.
I think of it more analogous to a physician slashing the wrists of a hemophiliac. But yes, if you accept the majority's reasoning, then I suppose you arrive at that outcome.
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