GSE Recap/Release: HERA's "Best Interest" Provision is a Two-Way Ratchet. Obama Administration Used It To Destroy GSE Shareholder Value. Trump 47 Can "Reverse The Ratchet" in a GSE Recap/Release.

SCOTUS interpreted HERA to authorize the government to act “in the best interests” of GSEs or itself. The Obama administration chose itself. Trump 47 can and should choose the GSEs in a recap/release.

“Fool me once, shame on you. Fool me twice, shame on me!”

This seems to be the unspoken subtext to how many GSE investors are assessing the relative risks/rewards of an investment in GSE common stock as opposed to junior preferred stock.

The Net Worth Sweep adopted by the Obama administration’s FHFA and Treasury (the “Obama NWS”) fooled GSE investors in 2012 by benefitting Treasury to the exclusion of GSE shareholders. Unwinding it in any GSE recap/release during Trump 47’s administration in a manner that likewise benefits Treasury over GSE common shareholders would be a “shame on us” event.

Matthew Halbower, of Pentwater Capital, alluded to this risk on CNBC just last Thursday in an interview with David Faber, which can be viewed here.

As a heuristic, there is much to recommend a “once bitten, twice shy” GSE investment thesis. But let’s be clear about what Treasury’s options are in connection with any Trump 47 GSE recap/release:

• There is no legal obligation for Treasury to convert its GSE senior preferred stock (SPS) into common stock, as opposed to cancelling the SPS by declaring it (more than) fully paid in accordance with its original terms (which is the economic reality).

• If Treasury decides to convert its SPS into common stock in any Trump 47 GSE recap/release, it will do so because it can under HERA, and not because it has to.

  • Put bluntly, by converting the SPS into common stock even after the SPS has been economically (more than) repaid, Trump 47 would be espousing and furthering the Obama administration’s treatment of GSE shareholders in connection with the Obama NWS.

    • The Obama administration never understood the GSE conservatorship to be a pathway to eventually restoring GSE shareholder value, even though Treasury owned 79.9% of the GSE common shareholder interest through warrants. This is why the Obama administration adopted the Obama NWS, to obliterate GSE shareholder value so that the GSEs could be replaced with….something the Obama administration never identified and could never effectuate.

    • The Trump 47 administration is under no legal obligation to adopt the Obama administration’s anti-GSE shareholder value orientation. Indeed, in any GSE recap/release that is intended to reconstitute GSE shareholder value via conservatorship release, it would be absurdly counter-productive to perpetuate such an Obama anti-GSE shareholder value mindset.

      • Trump’s channeling of Obama would be a remarkable and regrettable turn of events!

• Even if Treasury decides to screw the GSE shareholders a second time, there is substantial legal peril that FHFA/Treasury may incur by doing so.

  • FHFA has already been found by a federal district court to have breached its implied duty of good faith and fair dealing in connection with entering into the Obama NWS.

  • If Trump 47‘s Treasury and FHFA insist on crediting full value to the Obama NWS by converting its (more than) fully repaid SPS into common stock, this may become a predicate for an additional claim for breach of implied duty of fair dealing.

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HERA, the federal statute governing the GSEs’ conservatorship, endows FHFA as conservator with the “incidental power” to “take any action…which [FHFA] determines is in the best interests of the [GSEs] or the Agency.” 12 U.S.C. § 4617(b)(2)(J)(ii).

The Agency is defined in HERA as FHFA.

HERA modeled FHFA’s powers after the FDIC’s powers to act in its own best interests where the FDIC had expended substantial sums to resolve failed financial institutions. Even though FHFA expends no funds in conservatorship and is not authorized by FHFA’s incidental powers to act in the best interests of Treasury, SCOTUS so held in the Collins case.

SCOTUS held in Collins that FHFA has the statutory authority under HERA to adopt the Obama NWS in order to eliminate all GSE shareholder value and provide Treasury all future GSE earnings…a windfall for Treasury that was tantamount to a nationalization of the GSEs.

The “once bitten twice shy” GSE investment thesis assumes that there is either a prudential or legal requirement for Treasury under Trump 47 to convert its SPS into common stock.

As a prudential matter, it is patently absurd for Trump 47 to proceed with a GSE recap/release process, which is intended to restore GSE shareholder value (80% of which will inure to Treasury’s own benefit as a GSE warrant holder), by giving full economic effect to the Obama NWS, which was intended to destroy GSE shareholder value.

Treasury’s SPS liquidation balance is the financial legacy bequeathed by the Obama NWS to Trump 47. If Trump 47 gives the GSE SPS full economic effect by converting the SPS into common stock, this would only enshrine the Obama administration’s attempt to destroy GSE shareholder value as a Trump 47 bookend accomplishment.

I am unaware of any prudential reason for Trump 47 to become the Obama administration’s handmaiden and effectuate the economic terms of the Obama NWS in connection with a GSE recap/release, where the SPS has been more than repaid in accordance with its original terms.

As a legal matter, let’s be clear at the outset about the legal status of the SPS owned by Treasury.

The SPS is not debt, and does not represent a claim for money owed.

The SPS is an equity investment that does not entitle Treasury the right to force redemption or conversion, or demand repayment in accordance with its terms under any circumstance.

There should be no doubt about this, especially when one reviews the GSEs’ balance sheets, which sets forth the SPS clearly as equity, not debt.

I am unaware of any legal obligation for Trump 47’s Treasury to convert the SPS into GSE common stock as opposed to cancelling it as fully repaid.

31 U.S.C. § 3711 does apply limitations to a federal agency’s actions to collect upon a “debt or claim”. This provision does not apply to Treasury’s SPS.

The SPS is clearly not a “debt” instrument under 31 U.S.C. § 3711.

It is clear from 31 U.S.C. § 3711 et seq that “claim” refers to an obligation of another party to pay the government money, such as a contractual claim, that constitutes an enforceable liability.

The SPS is not an obligation that constitutes a liability on the part of the GSEs.

Treasury cannot send the GSEs a demand for repayment of the outstanding SPS.

31 U.S.C. § 3711 does not apply.

Breitbart financial journalist John Carney has argued that the Anti-Deficiency Act, 31 U.S.C. §1341, prevents Treasury from cancelling the SPS because this would involve a federal government expenditure that has not been appropriated by Congress.

The federal government has repeatedly restructured, exchanged or extinguished equity investments (such as the GSE SPS) arising from emergency financial interventions (for example, occurring during the Great Financial Crisis) without Congress appropriation.

With respect to the GSEs, FHFA and Treasury have broad statutory authority under HERA to enter into and modify support agreements, including the authority to adjust, waive, or release its claims once the risk and original investment have been satisfied. HERA explicitly gives Treasury and FHFA powers to “determine the terms and conditions” of support, and to “take such action as may be necessary” for the GSEs’ safety, soundness, and preservation of assets.

There are no legal impediments to Treasury’s cancellation of the SPS as fully repaid.

As for potential legal peril relating to Treasury’s conversion of the SPS as another transaction that breaches FHFA’s implied covenant of good faith and fair dealing, I wrote about this previously at If Treasury Doesn't Cancel the SPS in a GSE Recap/Release, Will GSE Shareholders Have a Second Breach of Implied Covenant of Fair Dealing NWS Case?

To be clear, I am not talking my book in advocating for Treasury cancellation of the SPS. Full disclosure, my GSE investment portfolio is approximately 90% GSE junior preferred stock and 10% GSE common stock. This split suits my investment objectives. As a predominantly junior preferred investor, I would be insulated from dilution by SPS conversion into common stock.

My argument for SPS cancellation is normative, not financial.

The Obama NWS was a financial abomination as a matter of American financial practice, resembling third world government financial expropriation. The Obama NWS was a sin upon America’s financial soul.

Trump 47 must end and renounce the ongoing financial legacy of the Obama NWS by eliminating the SPS by cancellation in any GSE recap/release.

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As always, this substack provides investment analysis, not investment advice. Do your own due diligence.