Joseph H. Marren, CEO and Chief Compliance Officer of KStone Partners LLC, describes why the 5th Circuit erred in upcoming Supreme Court case Collins v. Mnunchin due to Agency misrepresentation...
On December 9, 2020 argument is scheduled for Collins v. Mnuchin at the Supreme Court. The case originated in the Fifth Circuit and the Court of Appeals issued an en banc opinion on September 6, 2019. The primary questions before the Court are whether the Federal Housing Finance Agency’s structure violates the separation of powers and whether it should strike down certain of the Agency’s actions when it was unconstitutionally structured?
Unfortunately, the entire Fifth Circuit has misunderstood the key facts and issues in the case. The Fifth Circuit can be compared to the umpire in a famous baseball game in 2010 between the Detroit Tigers and the Cleveland Indians. The Detroit pitcher nearly threw a perfect game but with two outs in the ninth inning, a ground ball led an umpire to declare that the batter was safe at first, when, in fact, he was clearly out. The game was important as there have been only twenty perfect games in over one hundred years of play. Everyone watching knew the importance of the umpire’s bad call, and the instant replay made certain that everyone knew the umpire made a lousy call. In 2010 baseball only used instant replay to judge the veracity of home runs. Major League Baseball corrected the injustice to the Detroit pitcher in 2016.
In Collins v. Mnuchin each of the several Fifth Circuit opinions are the equivalent of calling interference with the ground ball by a fan sitting in the bleachers in center field. It appears that the Fifth Circuit has been watching a different ballgame than the one that was played. But there is a reason why the Fifth Circuit has erred. The Treasury Department and the FHFA appear to have misled them in their pleadings about the circumstances surrounding Fannie Mae and Freddie Mac being placed into conservatorship in 2008.
The purpose of this article is to slow down the action so that everyone understands what the real facts and issues are in the case. Hopefully, the United States Supreme Court may conclude in its upcoming review of the case that:
- The Agencies pleadings were in bad faith and that Federal Rule of Civil Procedure 11 has been violated; and
- The Agencies have committed a fraud on the court under FRCP 60.
There appear to be numerous material misrepresentations and omissions when one compares the pleadings of the Treasury and FHFA in Collins v. Mnuchin and certain material facts described by former Treasury Secretary Hank Paulson, and Phillip Swagel, formerly Assistant Secretary for Economic Policy at Treasury from 2006 to 2009. Recently, Swagel was appointed Director of the Congressional Budget Office.
The Lower Courts were focused on the Agencies’ motions to dismiss for lack of jurisdiction and failure to state a claim. In ruling on these motions, the Lower Courts were obligated to take the well-pleaded facts as true. However, given that there is publicly available evidence that appears to directly contradict the Agencies pleadings SCOTUS should consider directing the return of the litigation back to the District Court to determine whether the Agencies’ pleadings are in bad faith or determine, sua sponte, that the pleadings are in bad faith.
In reviewing the material misrepresentations and omissions it is important to incorporate them into a summary as to what was really going on during the initial transactions putting two Government Sponsored Enterprises into conservatorship. In September 2008 why did Treasury elect to put the GSEs into conservatorship and structure the initial Preferred Stock Purchase Agreements as they did? The answer to this question completely undermines the Treasury’s “high ground” position that they were the “good guys” saving the nation from financial ruin. It appears that the Treasury was executing transactions in a structure that was politically motivated.
There appear to be at least eight important facts that the Agencies either misrepresented or did not mention in their pleadings.
First, the Combined Statement of Receipts, Outlays and Balances is the “official” Statement and Account required by Article I, Section 9 clause 7 of the Constitution. In the 1950s passages in several of the Combined Statements describe how parties to a 1953 Agreement, subsequent regulations issued by certain parties to the agreement, coupled with legislation passed in 1950, effectively hijacked that report from its role as a required constitutional financial statement to become another supporting document for the President’s Budget. The agreement was made on October 5, 1953 among the Secretary of the Treasury, the Director of the Bureau of the Budget which is now the Office of Management and Budget, and the Comptroller General who was head of the General Accounting Office which is now the Governmental Accountability Office.
It appears impossible to reconcile the repurposing of the Combined Statement with Article I, Section 9, clause 7 which contains two clauses that are commonly known as the Appropriations Clause and the Statement and Account Clause. The Supreme Court has never reviewed the implications of the repurposing of the Combined Statement, how the Statement and Account clause interacts with the appropriations clause, the right to financial information described in the statement and account clause, or the duty that it places on Congress to publish financial information.
Second, Congress reorganized Fannie Mae as a private company in 1968 in order to remove it from the federal budget. The Senate Budget Committee’s “Budget Perspectives for Fannie and Freddie” published on July 14, 2016 indicates that:
The 1967 Presidential Concepts Commission established criteria for determining whether a GSE should be included in the federal budget…The commission recommended that entirely privately owned GSEs should be omitted from the budget. Despite their government originations, both Fannie and Freddie had become entirely privately owned. Consequently, the two GSEs met the standard for exclusion from the budget, which remained the case in the budget until the housing-finance crisis of the latter-2000s.
It is understandable why the Agencies have not disclosed this fact to the Lower Courts given that they were trying to perpetuate a fact pattern that they believed allowed them to continue the accounting practices that they began following the sale of one hundred percent of Fannie’s common stock. After this sale in 1968, the President’s Budget and the Combined Statement no longer included the operations of Fannie.
Third, Congress’ actions in 1968 put a very small fig leaf in place to justify its putting Fannie Mae and, later, Freddie Mac off the government’s budget. However, in 1968 this should not have resolved the constitutional issue of how Fannie should be accounted for on the government’s books. A recommendation of the President’s Commission on Budget Concepts in 1967 followed by legislation based on that recommendation does not override an explicit directive in the Constitution. The Agencies pleadings omitted to state that the GSEs were spending public money that should have been reported in the Combined Statement both before and after being placed into conservatorship.
Fourth, the Agencies pleadings did not appropriately describe how Congress had passed extensive legislation to control the GSEs after the sale of Fannie’s common stock in 1968. This legislation created substantial ambiguity in the marketplace regarding whether the federal government had agreed to guarantee the GSEs obligations. The marketplace correctly believed that the federal government would never let the GSEs fail. The implied guarantee was incredibly valuable and represented a significant expenditure every year of “public monies.” The failure of the GSEs to adequately describe the off-balance sheet guarantees of the GSEs that Congress created is another important omission especially considering the federal government’s preferred accounting for the GSEs. In addition, Fannie Mae and Freddie Mac were unique among privately-owned publicly traded corporations including having their own regulator. The equity of Fannie and Freddie were only a fraction of what other real publicly owned financial services companies were required to have by their regulator. These facts were not disclosed in the Agencies pleadings.
Fifth, Paulson and Swagel have indicated that the GSEs were insolvent when they were put into conservatorship. Immediately after the Housing and Economic Recovery Act of 2008 was passed on July 24, 2008 Paulson directed Treasury to hire financial advisors to assist in evaluating whether the GSEs were solvent. It hired Morgan Stanley. After examining the GSEs financial records in August 2008 the Federal Reserve, Office of Comptroller of the Currency, as well as Treasury’s financial advisor Morgan Stanley, and Blackrock, a financial advisor with a long-term relationship with Freddie concluded, that both Fannie and Freddie had, in Paulson’s words “true, economic capital holes amounting to tens of billions of dollars.” The Treasury Secretary indicates in his book On the Brink that, due to their insolvency, he wanted to put both GSEs into receivership in August 2008. Swagel describes in his article The Financial Crisis: An Inside View that “The Morgan Stanley team came back several weeks later in August with a bleak analysis: both Fannie and Freddie looked to be deeply insolvent with Freddie the worse of the two…..the Treasury worked with the GSEs’ regulator…to set out an air-tight case of insolvency…”
Meanwhile, the Agencies pleadings indicate that the GSEs were solvent at the time they were put into conservatorship. Various courts, including the Fifth Circuit in its en banc opinion of the court have adopted Treasury’s fact pattern that the GSEs were solvent. This apparent misrepresentation that the GSEs were solvent is material because, if the GSEs were insolvent, their existing common and preferred shareholders should have been wiped out in any restructuring. The Federal Reserve Bank of New York Staff Report No. 719 “The Rescue of Fannie Mae and Freddie Mac” explicitly states that in the authors’ opinion an optimal intervention would have involved: “[t]he value of the common and preferred equity in the two firms would have been extinguished, reflecting their insolvent financial position.”
It is important to note that neither the plaintiffs in this litigation nor similarly situated plaintiffs in any of the cases filed in any of the circuits have or had any motivation to unearth facts that would support the notion that the GSEs were insolvent and that the existing common and preferred shareholders of Fannie and Freddie should have been wiped out. All plaintiffs focused on arranging facts and legal arguments designed to maximize any potential recovery. Pleading the additional facts described herein would likely limit their recovery to the purchase price paid for applicable GSE securities.
Sixth, Treasury elected to structure the PSPAs and opted for conservatorship instead of receivership because it did not want the GSEs consolidated on the government’s balance sheet for an entirely practical reason. If the GSEs were consolidated the ratings agencies might downgrade the debt of the United States Government. In the middle of a financial crisis, this was an outcome that Treasury wanted to avoid at all costs. According to Swagel:“[E]ven putting the GSEs into conservatorship raised questions about whether their $5 trillion in liabilities would be added to the public balance sheet…..But the prospect that ratings agencies might respond by downgrading U.S. sovereign debt was unappealing.” This is the reason why common and preferred stockholders’ interests were not eliminated. This material fact is omitted from the Agencies pleadings.
The PSPAs were specifically structured to keep in place a meaningful equity stake by existing shareholders in order to maintain the ruse that the GSEs should remain off-budget and off the Combined Statement. In order to put the GSEs into conservatorship rather than receivership Treasury simultaneously used and ignored the financial analysis completed by various advisors as well as the Agencies. Treasury had to take the position that the public’s common and preferred equity in the GSEs still had value at the time of the conservatorship, despite the federal government having conclusive evidence in its possession that their equity holdings were worthless.
Seventh, given the 1967 Commission’s recommendation the only practical roadblock to maintaining the preferred off-budget accounting treatment in the conservatorship structure was that the Treasury bought warrants for 79.9% of the common stock of each GSE. Swagel stated “The U.S. Government ended up as a 79.9 percent owner of the GSEs, receiving preferred stock on terms that essentially crushed the existing shareholders. (The precise level of ownership was chosen in light of accounting rules that would have brought GSE assets and liabilities onto the government balance sheet at 80 percent ownership.)” Unfortunately, no such accounting rule existed that the government had to consolidate the GSEs if they owned 80% of their equity. Therefore, Treasury just made up the accounting rule. The Agencies pleadings omitted to state the fact that there is absolutely no accounting literature from any authoritative source involving publicly traded entities, federal or state municipalities that supported its proclaimed accounting rule.
Eighth, Paulson indicated that President Bush told him that he did not want to nationalize the GSEs. The FRBNY Staff Report also referenced the notion that “[A]s Paulson (2010) describes in his book, the Bush administration was opposed to nationalization or anything that looked like open-ended government involvement.” This material fact is omitted from the Agencies pleadings. If Treasury had elected to go the receivership route it would have nationalized the GSEs resulting in ownership of one hundred percent of their equity. Under this scenario, it would be unlikely that the ratings agencies would not factor the GSEs consolidated results into their projections for the U.S. Government.
It is time for SCOTUS to call a halt to the federal government’s pleading practices that appear designed to mislead the federal courts. Congress and the Administration have disregarded the directive in Article I, Section 9, clause 7 for a very long time. This violation is ongoing, and Congress and the Administration are still at odds over the proper accounting for the GSEs. The facts suggest that the nation may not have the informed electorate that the Constitution mandated and, thus, no longer may have the republic we wanted to keep.
Joseph H. Marren is President, Chief Executive Officer and Chief Compliance Officer of KStone Partners LLC.
Suggested Citation: Joseph H. Marren, Is the Fifth Circuit En Banc Opinion a Bad Call or Have the Treasury and FHFA Perpetrated a Fraud on the Court in Collins v. Mnuchin?, JURIST – Professional Commentary, October 19th, 2020, https://www.jurist.org/commentary/2020/10/joseph-marren-collins-v-mnunchin/.
This article was prepared for publication by Brianna Bell, a JURIST Staff Editor. Please direct any questions or comments to her at firstname.lastname@example.org
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