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Richard Epstein Archives



Today, the momentum is growing for fundamentally restructuring the national residential mortgage market in the wake of the earlier collapse of the Federal National Mortgage Association (FNMA, or "Fannie Mae") and Federal Home Loan Mortgage Corporation (FHLMC, or "Freddie Mac). These two government-sponsored enterprises (GSEs)--so-called in recognition of their hybrid public/private nature--have long written large chunks of the residential home mortgage market, to the tune of trillions of dollars. The current legislative fixes now on the table include a bipartisan proposal from Tim Johnson and Mike Crapo, coupled with an earlier entry by Maxine Waters. The Johnson-Crapo proposal follows on earlier entries from Jeb Hensarling on the House side and Bob Corker on the Senate side. Each of these proposals seeks simultaneously to unwind the past and to redefine the future. To evaluate them requires understanding the historical linkage between past events and future prospects.

To begin, some background. In response to the brewing subprime mortgage crisis in 2008, Congress in late July of that year passed the Housing and Economic Recovery Act (HERA). That legislation, inter alia, created a new Federal Housing Finance Agency (FHFA), which on September 7, 2008 placed into a conservatorship both GSEs. These conservatorships were intended to keep both entities alive in order to facilitate their return to the private market. They were not receiverships whose object is the orderly liquidation of the two businesses. The basic plan called for an infusion of up to $200 billion in fresh cash into Fannie Mae and Freddie Mac under a Senior Preferred Stock Purchase Agreement (SPSPA) that gave the government warrants, exercisable at a nominal price, to acquire a 79.9 percent ownership stake in each enterprise. In exchange for that advance the senior preferred stock carried a 10 percent annual dividend payment, which went up to 12 percent if the GSEs delayed their dividend payments on the senior preferred.

The terms of that deal were radically altered in August 2012, when the United States, acting through the Treasury Department, imposed, through the Third Amendment to the 2008 SPSPA, a "net worth sweep" that entitled the government to 100 percent dividends on future earnings. That one bold stroke effectively made it impossible for the GSEs to repay their loans and rebuild their capital stock. Both the junior preferred stockholders and the common shareholders could under this agreement never receive a dime from either GSE, even after the entities returned to profitability. Assessing this gambit requires understanding two things: first, the relationship between the Third Amendment and the original 2008 SPSPA; and second, the relationship between the Third Amendment and efforts to revitalize the housing market. Both relationships are widely misunderstood today.


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On November 22, 2013, the Food and Drug Administration flexed its regulatory muscle by sending a warning letter to a genetic-testing company that goes under the stylish name of 23andme. The object of FDA scorn was a diagnostic kit that the tech company, backed by among others Google and Johnson & Johnson, sold to customers for $99. The kit contained an all-purpose saliva-based test that could give customers information about some 240 genetic traits, which relate to a wide range of genetic traits and disease conditions. The FDA warning letter chastised 23andme in no uncertain terms for being noncooperative and nonresponsive over a five-year period in supplying information that the FDA wanted to evaluate its product as a Type III device under the Medical Devices Act.

Legal Regulation of 23andme There is no doubt that the FDA is on solid legal ground. This case is not like the processes involved in Regenerative Sciences, LLC v. United States, where the FDA asserted that physicians' use of certain stem-cell procedures for joint disease involved the use of a drug that required FDA approval before it could be approved for use. In an earlier essay for the Manhattan Institute, I argued that this classification was in fact both legally incorrect and socially mischievous. In this case, the legal arguments are not available to 23andme because the current definition of "medical devices" covers not only those devices intended for use on the human body, but also those used for the diagnosis of disease. The Type III classification means that this device has to receive premarket approval from the FDA, which in turn requires that it be shown to be safe and effective for its intended use. Getting approval under this standard is arduous business, because any such approval must be for each of the tests separately. 240 tests thus require that number of approvals. The costs are prohibitive, and the delay enormous.

The FDA Warning Letter is significant both for what it says and for what it does not say. On the former, it details all the various steps that the FDA has taken in order to help shepherd 23andme through the FDA's processes, including the types of warning that the products should contain, and the various modifications that could be introduced in order to mitigate the risks of its use. It then notes that 23andme has done little to take advantage of the assistance offered to it. Indeed, worse, it has simply gone about its business selling the kits, without so much as a bow in the direction of the FDA.



On Thursday, July 18, Texas Republican Congressman Jeb Hensarling will hold hearings on his "Protecting American Taxpayers & Homeowners Act." The PATH Act contains many forward looking proposals, on which I have no comment. But on this occasion, I want to focus on one key feature of the Act, which is only obliquely revealed by the statutory title. Mr. Hensarling shows great solicitude for American taxpayers and homeowners. But in a telling omission, he gives the back-of-the-hand treatment to the preferred and common shareholders of Fannie Mae and Freddie Mac, (commonly called Government Sponsored Entities or GSEs). In the interest of full disclosure, let me state for the record that I have advised several hedge funds on the merits of the PATH Act, and on the parallel bipartisan legislation that Tennessee Republican Senator Bob Corker called the Housing Finance Reform and Taxpayer Protection Act of 2013, both of which are designed to wind down the operations of Fannie and Freddie.

Liquidating Fannie and Freddie The source of my concern with Mr. Hensarling's proposed legislation involve sections 103 and 104 of the Act, which, according to its legislative summary provides for "Termination of Conservatorship," such that "Five years following the date of enactment mandates the appointment of the Federal Housing Finance Agency (FHFA) director to act as receiver for each Enterprise (i.e. Fannie Mae and Freddie Mac) and carry out receivership authority." Section 104 then provides for declining maximum amounts that GSEs shall be entitled to own over the five-year transitional period before these entities are liquidated.

In one sense, the demise of Fannie and Freddie should not be lamented, after the long and sorry history of massive government intervention in their internal affairs that created serious dislocations in the marketplace in 2008, including, most notably, the Congressional insistence in 2007 that Fannie and Freddie issue some $40 billion in subprime loans. As a result of these actions, both GSEs suffered major losses during the early part of 2008, not unlike those suffered by other private companies. The nature of these actions are outlined in a complaint attacking the various government actions filed in Washington Federal v. U.S. in June 2013.



The Supreme Court's five-to-four decision in favor of the landowners in Koontz v. St. Johns River Water Management District counts as a victory of sorts for the property rights movement. The case involved an all-too common exercise of state permit power. Koontz had applied for a permit to develop some 3.7 acres of his waterfront property and for that privilege he was prepared to offer the state a conservation easement that would make it impossible for him to develop the remaining 11 acres of that parcel. The official reply was that the permit would be denied unless Koontz acceded to one of two conditions. By the first, he had to agree to cut down the site development to one-acre and to make other costly modifications to his project. By the second, the District requested that he hire, for an uncertain sum, contractors to replace culverts or fill in ditches on other parts of the land. Koontz balked; the District stuck to its guns, and nothing happened. In his subsequent law suit, Koontz claimed that the exactions imposed by the District offended the various tests for an appropriate nexus between the permit and condition that had been developed in the important Supreme Court cases of Nollan v. California Coastal Commission (1987) and Dolan v. City of Tigard (1994).

Harms v. Benefits One unfortunate aspect about this case was that Koontz, bending to the current legal realities, had been prepared in his application to deed over some portion of his land to the Water District to get the permit in the first place. But the antecedent question is why he should be required to make any such concession in the first place. In dealing with this issue, Dolan put the right framework on the question by insisting that the condition in question be linked to either a benefit that the state provided or to a harm that the developer's project would create--in that instance additional runoff into public waters.

The implicit subtext of the Koontz application was that the failure to mitigate so-called environmental damage counts as a harm which the Water District is entitled to redress without compensation. But there is no reason why that should be the case. In dealing with the harm/benefit distinction in other private law contexts, it is clear that the operative distinction runs as follows. The defendant engages in harm to the world when he pollutes it. The state demands a benefit from the landowner such as insisting that the land be used as a nature preserve. It ties the English language into impossible knots to say that the defendant harms any plaintiff to whom he does not supply a benefit. That would mean that all landowners harm their neighbors by refusing to allow them to graze their cattle in the fields or to bed down at night on the front lawn. And it would mean that every person in the world has conferred a benefit on all individuals whom they do not summarily execute or rob. It is only if the terms "harm" and "benefit" are placed within a coherent framework of preexisting property rights that they can be used in a coherent sense that makes legal intervention the exception for a targeted case, not a universal imperative in any case where any landowner attempts any development at all.

 

 


Isaac Gorodetski
Project Manager,
Center for Legal Policy at the
Manhattan Institute
igorodetski@manhattan-institute.org

Katherine Lazarski
Press Officer,
Manhattan Institute
klazarski@manhattan-institute.org

 

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.