The lawsuit brought by the hedge fund Perry Capital against the federal government over the Fannie Mae and Freddie Mac bailout may be the case that finally subjects the government’s bailout practices to closer outside scrutiny.
The Fannie Mae and Freddie Mac bailouts were two of the biggest and earliest of the financial crisis. In September 2008, a government team led by the Treasury secretary at the time, Henry M. Paulson Jr., placed the companies into a conservatorship and provided them with hundreds of billions of dollars in backstop financing. In return, the government required the companies to issue super-preferred stock to the Treasury Department, stock that would pay the government before all other creditors, at a 10 percent rate.
As part of the rescue, the common stock and some classes of preferred were rendered worthless, or so the government assumed. It was a punitive act meant to penalize these security holders for failing to properly supervise the two government-sponsored entities.
But as was often the case in the bailouts, the government cherry-picked creditor classes. Senior debt holders went unharmed, mainly because the government thought to impair their investments would further spook markets.
The bailout was borne out of the government’s desperate attempts not to put the two companies’ trillions of debt on its books. Even though the government thought they were worthless, the common stock and preferred stock were left outstanding, so it could be argued that the two government-sponsored enterprises were still independent. At the time, the government likely thought this wouldn’t be a problem because Fannie and Freddie were thought to be insolvent.
But by 2012, Fannie and Freddie unexpectedly turned back into profitable firms. Seeking a way to keep the common and preferred stock worth nothing, the government changed the way the two paid their dividends in a fashion that meant all dividends went directly to Treasury - that any remaining common and preferred-stock holders would receive nothing.
Perry Capital has accumulated both common and preferred stock in the two entities before this change, and now wants those dividends to be paid to those shareholders once the government’s priority preferred stock has received its 10 percent. It argues that the government failed to justify the change in dividend payments.
The firm is now suing, pitting its resources against the federal government. Perry is taking this matter seriously, hiring the superstar litigator Theodore Olson. Mr. Olson has good experience suing governments, and is the lead lawyer representing the bondholders in the big sovereign debt litigation going on in the United States Court of Appeals for the Second Circuit in Manhattan.
The government’s failure to cleanly deal with Fannie and Freddie is coming back to haunt it with Perry Capital’s suit.
During the financial crisis, the government did deals first, and thought about the consequences later. In an article that the two of us published in 2009, we labeled it “regulation by deal,†and observed that it was a form of regulation immune from most of the usual sources of oversight. The deals went unchallenged in court, and were paid for by Congress with little tightening placed on the purse strings.
At the time everyone was too worried to protest much. And to be fair to the government, it was acting on a tight time frame with limited options.
Now, things are calmer, and it is going to be harder for the government to act so quickly or cleanly. Perry Capital’s suit is not aimed at the initial bailout but rather the dividend restructuring last year. It’s clear that the government was merely cleaning up something it failed to put in place back in the financial crisis. The smart people at Treasury likely just didn’t think about it.
But the government’s actions are going to be much harder to justify now that the crisis is receded.
Still, the sailing will not be entirely smooth for Perry Capital. It is not clear that the Housing and Economic Recovery Act of 2008, the statute under which the government has been acting, contemplated these sorts of suits, and that statute is one of the legal bases for the complaint.
Whenever the government is sued, its actions are reviewed deferentially by the courts; when the Treasury Department is engaged in crisis management, that deference, for better or worse, gets even bigger. The question here is whether the courts will even want to wade into this mess, or will instead simply defer to the government.
Moreover, the ordinary remedy if the plaintiff wins in an administrative law case like this one is a remand to the agency, rather than a cash payment to the plaintiff. A remand would give the Treasury Department an opportunity to better articulate its reasons for the change in dividend policy, but would do nothing for Perry Capital’s bottom line.
Finally, the government is likely to argue that the firm has not suffered an injury serious enough to sue over, despite all those billions in dividends diverted. Perry holds both common and private sector preferred stock in Fannie and Freddie. But after the conservatorship, purchasers of the both types of stock could be construed as having some notice that the government might vary the dividend payment. If Perry Capital purchased its stake after 2008, it might not have standing to sue.
A lot of money is at stake. Fannie and Freddie are expected to pay tens of billions to the federal government over the coming years as the housing market recovers. The case also will affect how Congress and the government ultimately restructure these entities, as the government is now more likely to be more considerate of the preferred and common stockholders, if for no other reason than the desire to avoid litigation risk.
Whatever its outcome, though, the case may be more important for offering a look at the government’s drastic action during and after the financial crisis, which until now have been almost completely insulated from judicial oversight. Many have criticized the quiescence in Congress and the courts related to these extremely important and very expensive government programs. This may now be their chance to have this conduct reviewed.
Moreover, Perry Capital’s allegations suggest that the potential abuses often associated with government ownership - a dog that has not yet barked much in the wake of the crisis - are not entirely hypothetical.
The government has kept an arm’s length distance from the car companies it bailed out, and was repaid so quickly by most of the financial firms that received bailout money that it did not have much of a chance to tinker with corporate policy. It may be that, as the government prepares to celebrate its fifth year as the controlling shareholder of Fannie and Freddie, that it is growing increasingly ill suited to its role.
Attempts to fix mistakes made in the depths of the financial crisis are going to be harder now that the courts and Congress are not as scared of challenging the executive branch as they were back then. This is normal cycle of these crises. The executive branch gets more latitude during the time, but afterward there is a demand for accountability.
In other words, now that the government has saved the markets, the markets want them gone. And in the background looms a hard look at the decisions made during those dark days five years ago.
Perry Capital v. Lew - Complaint as Filed
