Why the Supreme Court Case Draining Fannie and Freddie of All Equity Is Such A Travesty

The conservatorship of Fannie and Freddie is different from others, writes Justice Alito in Collins v. Yellen, which is why their regulator, the Federal Housing Finance Agency, can drain them of all equity in perpetuity. His reasoning relies on two kinds of illiteracy, financial illiteracy and an inability to read statutes.

Here’s a quick explainer for those who may not be financially literate. It never makes sense to drain a company of all equity before the final stage of shutting it down, because up until then you don’t know that all obligations have been met. Similarly, it never ever makes sense for an undercapitalized financial institution to pay out cash dividends because you don’t have sufficient confidence that it will be able to easily meet all obligations in the future. There are statutes and legal doctrines against imprudent cash dividends.

Everywhere else in the capitalist world, undercapitalized companies pay out preferred dividends in kind, rather than in cash, because dividends in kind do not reduce corporate equity. Which is why the idea of a conservator like FHFA directing two undercapitalized financial institutions to pay out cash dividends is absurd beyond belief. All cash dividends reduce finite resources, in this case Fannie and Freddie’s equity and the U.S. Treasury’s commitment to supplant any equity shortfalls.

In 2012 FHFA and Treasury revised the dividend rate on its senior preferred stock, from 10% to 100% of all earnings, which would be paid in cash every quarter. Finally — forgive me for belaboring the obvious — cash dividends diminish the viability of the corporation for the benefit of the shareholder, which in this context means the U.S. Treasury.

Which brings us to the problem of reading comprehension, as it pertains to the governing statutes. Here’s the key passage from Judge Alito’s decision:

An FHFA conservatorship, however, differs from a typical conservatorship in a key respect. Instead of mandating that the FHFA always act in the best interests of the regulated entity, the Recovery Act authorizes the Agency to act in what it determines is “in the best interests of the regulated entity or the Agency.” §4617(b)(2)(J)(ii). Thus, when the FHFA acts as a conservator, it may aim to rehabilitate the regulated entity in a way that, while not in the best interests of the regulated entity, is beneficial to the Agency and, by extension, the public it serves.

I’m surprised I need to spell this out; but the distinction seems to have escaped Justice Alito and his colleagues. This net worth sweep does nothing to benefit the Agency, which is FHFA. In fact it does the opposite, because it limits FHFA’s latitude in managing the companies’ finite resources. The cash dividends are for the benefit of one shareholder, the Department of Treasury. So Alito’s discussion of the facts is patently false.

Again, a quick explainer of what should be obvious to anyone who ever went to law school. FHFA and Treasury are two separate legal entities. If they weren’t, then would never have bothered to negotiate and execute any contracts pertaining to Treasury’s support of Fannie and Freddie.

There are plenty of other misleading representations in Alito’s opinion, which I’ll get to later. But conflating FHFA with Treasury and claiming that the net worth sweep “is beneficial to the Agency and, by extension, the public it serves,” is the main reason why his opinion is such a travesty.