After the Deal: Fannie, Freddie and the Financial Crisis Aftermath
University of California, Berkeley – School of Law
University of Pennsylvania – Legal Studies Department
August 20, 2014
The dramatic events of the financial crisis led the government to respond with a new form of regulation. Regulation by deal bent the rule of law to rescue financial institutions through transactions and forced investments; it may have helped to save the economy, but it failed to observe a laundry list of basic principles of corporate and administrative law. We examine the aftermath of this kind of regulation through the lens of the current litigation between shareholders and the government over the future of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). We conclude that while regulation by deal has a place in the government’s financial crisis toolkit, there must come a time when the law again takes firm hold. The shareholders of Fannie Mae and Freddie Mac, who have sought damages from the government because its decision to eliminate dividends paid by the institutions, should be entitled to review of their claims for entire fairness under the Administrative Procedure Act – a solution that blends corporate law and administrative law. Our approach will discipline the government’s use of regulation by deal in future economic crises, and provide some ground rules for its exercise at the end of this one – without providing activist investors, whom we contend are becoming increasingly important players in regulation, with an unwarranted windfall.
This article is about what happens when bedrock principles of corporate governance – in particular, the fiduciary obligations that managers and controlling shareholders must observe when they deal with the other owners of the firm – conflict with government regulatory policy. During the financial crisis, corporate governance conflicts were resolved in favor of the government and the niceties of legal rules and norms circumvented when regulators, as they did on a number of occasions, forced a transaction on tottering financial institutions, or obligated them to receive an investment of funds from the Treasury.
The crisis is now over, but the conflicts remain. They have come to a head most saliently over the future of the quasi-nationalized mortgage banks Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). Fannie Mae and Freddie Mac shareholders, which include the hedge funds Perry Capital LLC, Pershing Square Capital Management, and Fairholme Funds, Inc., have claimed that the federal government is illegally seizing the profits of the two government service entities (GSEs). Consumer advocate Ralph Nader has begun a crusade to allow shareholders to share in Fannie and Freddie’s new-found riches. Congressional hearings have been held over the matter and a stellar roster of legal talent has assembled to prosecute and defend the litigation.4 Multi-billion dollar judgments have been sought, too.
All of this makes the dispute important in its own right, as its resolution will have a real bearing on the future of housing finance in the country, and housing finance is the sort of finance that has been blamed for the financial crisis in the first place.6 But the dispute also represents a new front in the debate over how, and who, should be able to hold the government accountable for its actions during, and in the aftermath of, an economic emergency.
Fannie Mae, Freddie Mac: After the Deal 2014
We think that these lawsuits are compelling, even if the plaintiffs are not particularly attractive. The suits represent both opportunistic behavior by the funds that swooped in to purchase Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) shares after a bailout and a serious effort to identify constraints on the way the government has managed the financial sector in the wake of the crisis. Dramatic government interventions in the economy, which elsewhere we have dubbed “regulation by deal,” are part of the regulatory toolkit, given that our economy remains unhappily prone to disasters. These deals are a function of some legal constraints that the government faces (including constraints against other ways the financial sector might be rescued) but those constraints are limited, making regulation by deal a policymaking tool that is temptingly flexible. What to do about semi-seized firms like Fannie Mae and Freddie Mac, therefore, likely exemplifies the sort of problems that we will see during the next crisis, and the attendant calls for a government takeover or investment.
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