Americans were angry when Wall Street’s greedy and risky behavior triggered a global financial crisis in 2008. They were angrier still when the government had to borrow and spend hundreds of billions of dollars to rescue mortgage giants Fannie Mae and Freddie Mac, the largest banks and the insurance company AIG. They were outraged when they found out that executives at those enterprises were continuing to receive big salaries and bonuses.
“An absurdist comedy . . . worthy of the Marx Brothers or Mel Brooks,” wrote John Cassidy, the New Yorker’s economics correspondent.
For taxpayers, it looks to be another example of the old adage that no good deed goes unpunished.
In two separate cases, the government now stands accused of overstepping its authority when it took extraordinary measures to prevent a financial meltdown in the fall of 2008. The Wall Street figures who are suing say their property was seized without compensation, in violation of the Constitution. One case was brought by Maurice “Hank” Greenberg, the legendary former chief executive of AIG who built it into the world’s largest insurer. Filing the other case is a group of hedge funds that bought Fannie and Freddie stock for pennies per share after the companies were put in government conservatorship.
Federal district court judges in Washington and New York initially dismissed both challenges. Their opinions noted, somewhat pointedly, that the Wall Street plaintiffs were not only unharmed but actually came out better off as a result of the government rescues. Yet both groups have now found a more sympathetic hearing a stone’s throw from the front gate of the White House, at a little-known brick courthouse called the U.S. Court of Claims.
There, Greenberg is asking the court to award him and other AIG shareholders at least $23 billion from the Treasury. He says that’s to compensate them for the 80 percent of AIG stock that the Federal Reserve demanded as a condition for its bailout. Judge Thomas Wheeler has repeatedly signaled his agreement with Greenberg. A decision is expected any day.
In the Fannie and Freddie case, the decision is further off, with the trial set to begin in the fall. The hedge funds are challenging the government’s decision to confiscate all of the firms’ annual profits, even if those profits exceed the 10 percent dividend rate that the Treasury had initially demanded. This “profit sweep” effectively prevents the firms from ever returning the government’s $187 billion in capital and freeing themselves from government control.
Earlier this year, Judge Margaret Sweeney refused to dismiss the case and gave lawyers for the hedge funds the right to sift through the memos and e-mails of government officials involved. Within weeks, Fannie and Freddie shares, which had been trading at about $1.50, started trading as high as $3 based on rumors that the documents revealed inconsistencies in government officials’ statements. The hedge funds are asking for the return of as much as $100 billion in profits and an end to the Treasury-imposed profit sweep. In her comments, Sweeney has shown sympathy with their argument that the government can’t hold them indefinitely in a legal limbo in which they have no claims to assets of the company they ostensibly own.
When these cases were filed, many legal observers thought they were a long shot, even frivolous. But from their procedural rulings and comments from the bench, said David Zaring, a professor of legal studies at the Wharton School of Business, both judges have indicated they are at least open to the plaintiffs’ legal theories and willing to hold the government accountable for what it did during the financial crisis.
“I think people’s views have changed,” Carl Tobias, a professor at the University of Richmond Law School, said of the AIG case. Greenberg’s lawyers, he said, “were able to present evidence and persuade the judge that there were some serious issues here. It’s possible the judge could rule in their favor in some way.”
Even before the final papers for AIG’s bailout were signed, in September 2008, one shareholder was already agitating against it.
Hank Greenberg had been forced out as chairman and chief executive in 2005 after state and federal regulators uncovered that the company had been engaged in sham transactions that allowed AIG and its corporate customers to manipulate reported earnings, avoid taxes, evade regulatory requirements and hide risks and liabilities from shareholders. Ever since, Greenberg has been on a mission to restore his reputation and regain control of the company that he had ruled over with an iron hand for 37 years.
Even in exile, Greenberg remained AIG’s most important shareholder, controlling 20 percent of the company’s stock. He successfully sued some AIG executives in court and recruited away others to build his own rival insurance company. He also agreed to pay $15 million to settle civil charges brought against him by the Securities and Exchange Commission, though he refused to acknowledge any wrongdoing.
Greenberg has repeatedly claimed that if he’d still been in charge, AIG would never have gotten into the mess it did. But that is impossible to know.
What is known, however, is that when Greenberg was in charge, he ran the company “as if it were a feudal state . . . disdainful of modern concepts of internal controls and regulatory compliance,” according to one person with intimate knowledge of the company’s management. After his firing, AIG paid $1.6 billion to settle multiple counts of accounting fraud brought by the SEC.
What is also known is that the two lines of business that were the source of AIG’s major problems during the 2008 crisis were launched on his watch. He helped to create their risky business models and strategies, which were based on playing one regulator off another and engaging in complex financial arrangements between regulated subsidiaries and a largely unregulated parent company. And both business lines took root in the same clever rules-bending corporate culture that had always been Greenberg’s trademark.
“The AIG which came begging to the Fed’s doorstep was the AIG that Hank Greenberg built,” said James Millstein, the Treasury official who oversaw AIG’s restructuring. “It’s capital structure was opaque, it was heavily dependent on short-term funding, with a highly leveraged financial products subsidiary that had been organized to evade effective regulatory oversight.” Greenberg, he said, “ran the parent company like a hedge fund with a triple A rating.”
As the financial crisis unfolded, AIG’s fundamental flaws were finally exposed. On the same week Lehman Brothers collapsed, desperate executives went to the Treasury and the Federal Reserve looking for a loan. Dozens of Fed officials were dispatched to AIG headquarters on Pine Street in lower Manhattan. Within days, they were convinced that without a substantial cash infusion, AIG would be forced to file for bankruptcy, threatening the solvency of a number of big banks in Europe and the United States.
To avoid such a meltdown, the Fed agreed under its emergency authority to act as a lender of last resort, lending AIG an initial $85 billion. The terms were to be the same as AIG’s investment bankers had offered the previous week, without success, to private lenders — a 14 percent interest rate and ownership of 80 percent of the company. With lawyers sitting in the next room ready to file a bankruptcy petition, AIG directors reluctantly agreed to the terms.
In his current suit against the government — which has generated 300 docket items, 70 depositions, 4,600 exhibits, 36 million pages of documents and testimony from two former Treasury secretaries and the former Fed chairman — Greenberg has relied on the legal advice and representation of super-lawyer David Boies. Boies gained his megawatt status in the 1980s successfully defending IBM against the government’s effort to break it up, and in the 1990s prosecuting the government’s case to break up Microsoft. He also represented Al Gore in the Supreme Court case over the contested 2004 election. But few clients have been as lucrative as the litigious Greenberg, whom he has also represented in earlier disputes: Disputes with the New York attorney general. Disputes with the SEC. Disputes with AIG itself. Even a slander suit against former New York attorney general Eliot Spitzer. Published estimates of Boies’s legal fees in all these cases run to well over $100 million.
In challenging the government takeover, Boies has tried out a number of legal theories in different courts, spinning what federal judge Paul Engelmayer in New York mockingly called a tale of “plunder . . . and treachery worthy of an Oliver Stone movie.”
In Boies’s retelling of the AIG rescue, government officials deliberately set out to coerce and punish the giant insurer while offering cushy bailouts to big banks like Citigroup, Morgan Stanley and Goldman Sachs. That “equal protection for billionaires” argument had largely fallen on deaf ears, perhaps because the government’s treatment of AIG turned out to be hardly punitive. Once interest rates on the government’s loan were reduced and the whole arrangement renegotiated three years later, the government wound up earning less than 4 percent a year on what grew to become a $182 billion bailout. That’s not very different than its deals with the banks.
The argument that finally caught Judge Wheeler’s attention, though, was more narrowly legalistic: the law authorizing the Fed to make emergency loans to private firms mentions charging interest but contains no explicit authority to take compensation in the form of stock.
“If we’re right on that, we win,” Boies said in an interview last week. “If we aren’t, we lose.”
By basing his case on a challenge to the Fed’s authority, Boies told Wheeler that he doesn’t need to consider how things have turned out for AIG shareholders since the rescue. He need only ask the narrower question, what was AIG’s stock worth on that day in September 2008, when the stock was “illegally” transferred to the government? Based on that day’s trading price on the New York Stock Exchange, that would be about $23 billion.
Not so fast, replied the Justice Department lawyers.
For one thing, they said, there was no coercion — AIG directors voluntarily agreed to hand over the stock. Their choice that day was clear: They could either accept the Treasury’s terms and wind up with 20 percent of something, or decline help, go bankrupt and get 100 percent of nothing. Reluctantly, they chose 20 percent of something.
And as to the $23 billion loss that Greenberg and other shareholders claim to have suffered, government lawyers pointed to the same stock market tables but drew a different conclusion. In the hours before the rescue terms were announced, AIG stock was trading as low as $1.25. After the announcement, the stock had tripled to $3.75. Greenberg should be thanking the government, they said, not suing it.
But what seemed to government lawyers like a slam-dunk argument seemed irrelevant to Wheeler. If the government didn’t have the authority to take the stock in the first place, he asked during final arguments, then doesn’t the law require the government to return it?
When Treasury Secretary Hank Paulson decided the government needed to take over Fannie Mae and Freddie Mac in August of 2008, he too had a choice: Under the law governing the federally chartered mortgage giants, he could either put them in receivership, under which they would be shut down and their assets used to pay off their creditors, or put them into conservatorship, under which the government would attempt to stabilize them and nurse them back to financial health. He chose conservatorship but urged Congress to take steps to ensure they never again emerged in a form giving shareholders all the profits and taxpayers all the risk.
Both Paulson and the man who succeeded him, Timothy Geithner, have testified that it never occurred to them during the crisis that Fannie and Freddie might one day be able to fully repay the government or that there would be anything left over for shareholders by the time the conservatorship ended. But things turned out differently than they expected.
Because of the success of the government rescue, and the near-total retreat of private lenders and guarantors from mortgage finance, Fannie and Freddie returned to profitability and solvency by the end of 2012 — perhaps not coincidentally, at the very time the government swept all of their profits into the Treasury.
What Paulson and Geithner also didn’t anticipate was that, despite a bipartisan consensus that the mortgage giants should be wound down, Congress would be unable to agree on a system to replace them. Democrats and their industry allies insist that some limited form of government guarantees are necessary to ensure the availability of affordable 30-year mortgages at fixed rates. Tea party Republicans are just as adamant they will not agree to any government guarantees that once again put taxpayers on the hook.
While it is three hedge funds — Perry Capital, Fairholme Fund and Pershing Square Capital, led by William Ackman — that have sued the government, the outcome will likely affect all shareholders. These include a number of small banks that were encouraged by the Paulson Treasury to buy preferred shares in the months before Fannie and Freddie’s downfall, and tens of thousands of small, individual holders of common stock, including many former employees and retirees in the Washington area. Their claim is that Congress and the White House are using Fannie and Freddie to fund the federal budget.
But James Parrott, a fellow at the Urban Institute, says the idea that these companies will ever emerge from conservatorship and be able to earn profits for their shareholders is a fantasy. Parrott helped conceive of the profit sweep while working in the Obama White House. He says that even if Fannie and Freddie were allowed to use current profits to pay back the Treasury’s $187 billion investment, they would still have to raise hundreds of billions more to have the capital to operate independently.
Other government officials say Fannie and Freddie’s profits are themselves a fiction, because they would not exist but for the government standing behind all of their financial obligations. If the Treasury were to charge them anything close to a market rate for its guarantee, there would be no profits.
But that’s always been the case for Fannie and Freddie. From the beginning they were set up to be a unique hybrid: government-backed enterprises with private shareholders and private capital. Until Congress comes up with another arrangement, say lawyers for the shareholders, the profits are real and the shareholders are entitled to use them to pay down the Treasury’s investment and begin recapitalizing the company and paying themselves a dividend. By some estimates, that could happen in the next several years if profits continue at current levels.
Government lawyers and officials dismiss such speculation. Under the law setting up the conservatorship, they argue, Fannie and Freddie’s shareholders are entitled to nothing. They have no right to sue in court. They are not entitled to vote on any corporate decisions. They are not entitled to a penny of the companies’ profits or any proceeds from the sale of company assets. Not now, not ever. In effect, the government is claiming the right to operate Fannie and Freddie however it wants, for as long as it wants, until it’s ready to close them down for good.
In an opinion last fall, Judge Royce Lambert of U.S. District Court in Washington ultimately ruled that that was what Congress intended when it wrote the laws governing Fannie and Freddie but acknowledged that such a sweeping assertion of government powers may “raise eyebrows or even engender a feeling of discomfort.” It will now be up to Sweeney and the Court of Claims to decide whether what Congress intended amounts to an illegal and unconstitutional taking.
One thing is already known, however. In deciding whether shareholders or taxpayers will profit from government bailouts, judges Sweeney in the Fannie and Freddie case and Wheeler in the AIG case are unlikely to have the last word. With so many billions of dollars at stake, their decisions are almost certain to be appealed all the way to the Supreme Court.