Bank Lawyer's Blog

Barney Bites Bernie (And Neel)

Now that hell has frozen over, I find that all kinds of amazing things are occurring, one of which has created the danger of ripping a huge hole in the space-time continuum: I find myself in agreement with Barney Frank.

While watching the PBS News Hour this past Thursday night, who should pop up but the former House Banking Committee Chair and favorite Bank Lawyers Blog Bullseye, Barney, who was interviewed by Jeffrey Brown about Frank's reaction to statements by Neel Kashkari, currently president of the Federal Reserve Bank of Minneapolis and former Bush Bailout TARP Toolmaker, and the ever-cranky Bernie Sanders, Gen Y's favorite "Democratic Socialist," about "To Big To Fail Banks." Sanders also alleged that the way to break up big banks is to reimpose the Glass-Steagall on commercial banks. Frank, now that he's out of the political arena and no longer feels compelled to be what every politician feels he or she must be, i.e., a caster of shade upon of the truth, was remarkably critical of two gents who are spouting the Democrat Party line about the evils of Wall Street's "TBTF" banks.

Barney may have gained some objectivity, but he's lost none of the pungent-tongued arrows from his verbal quiver.

In the first place, both Senator Sanders and Mr. Kashkari continue to evade the biggest question. That is, how big is too big? The crisis which touched off when Lehman Brothers couldn’t make its payment, Lehman Brothers was about $650 billion in assets. We have banks four and five times that size

And the question is, does everybody have to be smaller than Lehman Brothers is today? But that would have consequences. Getting there would be a problem. By the way, it should be very clear, Glass-Steagall doesn’t do it. There is a disconnect between Senator Sanders insisting that the banks be broken down to the point where they won’t by their own size threaten, if they have too much debt, to undermine it.

And Glass-Steagall — Glass-Steagall would reduce — it wouldn’t do anything to Goldman Sachs and to Morgan Stanley, which are almost Glass-Steagall-ized themselves. But looked at Citicorp, or J.P. Morgan Chase, or Bank of America, Wells Fargo, even if they were subject to Glass-Steagall, they would still be well beyond the size that Lehman Brothers was.

There is just a disconnect between saying we’re going to do Glass-Steagall and getting the banks down to a size where, if there was a complete failure, you would get damaged by it.

The entire response above by Frank is remarkable for the fact that he's right. It's obvious that he's not been spending his time since retirement sampling the wares of Mar Jane-related "legal" businesses in Colorado.

Frank also jumped all over Kashkari's comparison of the 2008 meltdown to the S&L crisis of the 1980s, and Kashkari's statement that the reason the S&L crisis didn't bring the economy down was because none of the S&Ls was "too big to fail." Again, Frank asks why Kashkari won't tell us how big is too big? He also correctly notes that the bailout of the S&Ls cost a lot more than the bail out of big banks in 2008, although he does not also observe that this was because the 2008 TARP allowed the big banks to survive, while the S&L "bailout" allowed them to fail (or most of them, at any rate (outside the Southwest Plan thrifts), and established the Resolution Trust Corporation, staffed by the FDIC, to liquidate their assets. If the politicians, including Frank, had stayed out of it in the 1980s and let the initial bailout template concocted by the former Federal Savings and Loan Corporation play out, there's a chance that the money from that bailout might also have been largely repaid.

Frank says the primary risk is not size but "indebtedness," and on this point he's got a point. However, I disagree with his assertion that his bloated namesake, Dodd-Frank, has dealt successfully with the risk of bank's engaging in excessive borrowing and hinky derivatives that made "The Big Fail" such a hit (his misapprehension of the effect of the Volcker Rule has been lambasted previously), and his assertion that now, no bank is too big to fail. 

If a large institution can’t pay its debts, it fails. It is not too big to fail. It is put out of business, by law. No federal official can advance any money to pay its debts under the law until it is dissolved.

TARP also required legislation to create, and the wide-open authority it provided the federal government to bail out banks was induced by panic among folks at the highest levels of the federal government (including Frank) of immanent widespread economic collapse. We'll see how effective Franken-Dodd is when the next crisis hits, as it inevitably will. There's no prohibition on a future panicked Congress changing the rules on the spur of the moment to do what Frank claims can never again be done.

To prove that I haven't completely turned to the dark side, I think his statements about overturning Citizens United are bunk. Nevertheless, all-in-all, startlingly, he makes a lot of sense.

Banks: Targets of Opportunity

Conservative economist Larry Kudlow claims that while bank-bashing didn't work for the Labor party in the recent UK elections, banks in the US should gear up for a round of groin-kicking from both sides of the US political spectrum as the US presidential election race heats up late this year and next. According to Kudlow, the intellectual dishonesty inherent in this tactic is apparent.

Few will admit it, but unaffordable, undocumented mortgage quotas came out of Washington, not Wall Street. And Fanny and Freddie enforced them. And while the Fed’s ultra-easy money destroyed the dollar, it also caused a bubble in home prices.

 

Yes, banks made risk-management mistakes. But when will the firing squads stop? You know, you can’t have a decent economy without banks.

 

But when will you ever hear a politician say that?

Let me guess.

 

[Sound of crickets chirping]

 

Kudlow lists the usual suspects: Lizzie Warren, Bernie ("The proletarians have nothing to lose but their chains") Sanders, and, lately, Hilarity Clinton, but also notes that Republicans are also jumping on the anti-bank bandwagon.

Of all people, former Florida governor Jeb Bush bashed banks while in New Hampshire.

But wait, didn’t Jeb’s brother preside over the big bank bailout? Oops.

 

Former Texas governor Rick Perry is slamming the banks. So is former HP CEO Carly Fiorina. She actually said, “I agree fully with Elizabeth Warren.”

As Kudlow responds: "Huh?"

 

What's next for Carly? Is she coming out as 1/32 Huron? Will she change her last name to "Simon" and make her campaign song "Nobody Does It Better?"

 

Kudlow thinks that there are valid reasons for a politician to defend banks.

Banks do make business loans, which have picked up quite a bit. They do provide mortgages, though the terms are more difficult. They do offer credit cards, decent ATM machines, car loans, farm loans, and student loans. Even though the Fed has decimated interest rates, they do allow large savings accounts. And they do, after all, connect savings with investment. (I think that was their original purpose.)

Kudlow would get rid of the Ex-Im bank, as well as the "conserved" Aunt Fannie and Uncle Freddie. He doesn't say how he'd finance the US residential mortgage market without Fannie and Freddie, and I'd like to hear his ideas on that issue, because right now, those two broke (yet cash-generating) behemoths are pretty much all there is in the secondary mortgage market in this country, at least for conventional loans.

 

But I digress.

 

While sarcastically claiming that he'd never defend banks, he ends with a warning to pols.

Sometimes British politics leads our politics. And if bank-bashing didn’t work in the U.K., maybe politicians here should let it go, and instead focus on pro-growth measures like flat-tax reform, free trade, deregulation, and sound money. Just for a moment, why not leave banks alone?

Because they're easy scapegoats, Larry. Like lawyers, everybody loves to hate them, and for the cynics we have in D.C., who value power over truth (even those--or, perhaps, especially those--who claim to speak truth to power), they are low-hanging fruit.

Julian Is Julienned

Juilan Castro, the head of HUD, has taken his lumps lately over his amateur-hour performance on The Daily Show. Apparently, he just can't catch a break. Last week, he had the misfortune to appear before the House Financial Services Committee where he suffered the ultimate humiliation. No, not being grilled by Republican hit man Jeb (Clampett) Hensarling. That's a badge of honor with Castro's crowd. Rather, it was having to listen to Maxine Waters publicly praise him that had to cause him to spit up a little bit in his mouth. I know that she had that effect on me.

U.S. Rep. Maxine Waters, D-Calif., Ranking Member of the Financial Services Committee, was one of the few to praise Castro.

"Secretary Castro, although today you will likely take a fair amount of criticism from my colleagues on the other side of the aisle for your decision, I’d like to take a moment to remind them that when the private sector virtually left our struggling housing market during the worst of the crisis, the FHA stepped up and provided the liquidity that kept it afloat. Despite the steps toward recovery the economy has taken since then, the housing sector continues to suffer from a tight lending environment – and a strong FHA is still very necessary," said Waters.

"I would also note that FHA is far from bankrupt, holding approximately $40 billion in reserves, continuing to generate revenue, and taking critical steps to recover its capital reserves, which are projected to show a positive balance in 2015," she added.

You heard that right: when the private sector collapsed, the FHA hung in there. Of course, the FHA had no choice. It couldn't file "bankruptcy" like a private entity, even though it was insolvent, because its insurance is backed by the full faith and credit of the United States, it is required to fulfill its statutory purpose of providing mortgage insurance to back mortgages to qualified borrowers (many of whom turned out to be unqualified, but that's another story), and it has been used by clowns like (the Bridge Over Troubled) Waters to apportion housing credit to a constituency that appreciates the fact that the FHA being the lender that loans where angels fear to tread and votes accordingly. I think that putting Freddie Mac and Fannie Mae into conservatorship and pumping government money into those giant slush funds for progressive housing policy ("A Chicken In Every Pot and An Illegal Honduran Gardner In Every Malibu McMansion") did more to prop up the housing market than FHA insurance. Then again, who am I to argue with a brainiac like Maxine.

Hensarling and his henchman on the Republican side of the far divide are a bit perturbed with recent actions by the Master of the Selfie Stick in the White House, who reduced the annual mortgage insurance premiums for FHA by 50 basis points, from 1.35% to 0.85%, at a time when the FHA has still not restored its capital reserve ratio to the legally mandated level of 2%. In fact, it's 0.41%. The $40 billion that Maxine crowed about is supposed to over $200 billion.

Castro's response was as dynamic and on point as were his masterful responses to John Stewart. [Editor's Note: The previous sentence was sarcastic, for those readers who seem to take everything I write here in dead earnest.] Castro said that everything's great, we've never been better, nothing to see here, let's all fly to Colorado and score some "Hashey Bars."

Hensarling was not amused.

"With all do respect (Castro), we have heard that before, and you are sincere. But this committee has been told that once, twice, three times, and it hasn’t proven true,” said Hensarling. “Once again, you are in violation of the law and that has got to stop."

Except, Jeb, it won't stop. You know it, and so does everyone else with an IQ above that of a chunk of week-old Limburger cheese. The Republican-controlled house could pass legislation to punish the FHA, perhaps even threatening its funding. Even if the majority in the House did pass such an unpopular measure, Democrats in the Senate would likely thwart its progress in that chamber with procedural maneuvers, and the Perpetual Campaigner would veto it even if both houses pass it. By the time that useless exercise has run its course, there will be a new occupant in the house-is-not-a-home at 1600 Pennsylvania Avenue and Castro will be back to doing what he does best: looking dynamite in Armani formal wear.

Yes, we know: this is all about press releases for 2016. Keep up the good work.

FHFA Takes A Baby Step

Even though she managed to lose the governor's race in heavily-Democratic Massachusetts to a Republican (thereby earning the disdain of Democratic strategist David Axelrod), and even though a federal district court last month dismissed her lawsuit against the FHFA and its wards, Fannie Mae and Freddie Mac, on the basis that the court system doesn't have the right to "second guess" the FHFA's business judgement (isn't that a novel concept!), Massachusetts AG Martha Coakley still had the gall to issue a public statement about the FHFA's recent decision to back off its policy of refusing to consent to the write-down of loan principal where a foreclosed house is sold back to the defaulting owners.

“The reversal by FHFA of Fannie and Freddie’s policies, which we have long advocated for and brought suit over in part, alters some of their rigid policies to help keep people in their homes,” she said in a statement Tuesday.

To help keep people in their homes who didn't pay their loans as they agreed to pay them and who are getting a better deal than they originally bargained for, at the expense of Uncle Freddie and Aunt Fannie, both of which have been de facto nationalized. I guess that would be a Progressive's orgasmic night dream were it not for the fact that Coakley had absolutely nothing to do with the policy reversal and, more telling, the "reversal" will not help that many homeowners remain in their homes.

However, the impact of the change could be limited. It will only apply to the 121,000 homes that Fannie and Freddie have already foreclosed on and own, a provision that’s intended to curtail any incentive for borrowers in good standing to default. That narrow scope is unlikely to quiet the drumbeat for the FHFA to make bigger changes intended to help a larger number of borrowers who owe more than their homes are worth.

Foreclosed-upon borrowers will also still need to find the cash or financing to buy the old home back at market value, a tall order for those with tarnished credit histories.

“This is a ‘feel-good’ type of policy. It’s directionally helpful to a small number of homeowners that ran into trouble, but at the end of the day, I don’t look to this to have a major policy impact,” said Clifford Rossi, a finance professor at the University of Maryland.

[...]

The new policy in effect reduces mortgage principal, albeit for a small number of foreclosed-upon borrowers. Some nonprofit groups said that Fannie and Freddie would be better served to reduce the borrower’s principal before a foreclosure.

Fannie and Freddie wouldn't be "better served" by such a policy, although delinquent borrowers, Nanny-State lovers, and the fake Native American politicians they so love to lionize would definitely be "better served."

Speaking of which, the fact that 1/32 Cherokee Princess Fauxcahontas went all "jihad" on Mel Watt last week obviously had more to do with this latest publicity stunt than any dismissed lawsuit by a pol who couldn't beat Abu bakr al-Baghdadi in a race for Prime Minister of Israel. You could see the flop sweat flying off of Watt's brow at that Senate hearing like angel dust in the aftermath of a Lindsey Lohan sneezing fit. It's not pretty when a cougar eats her young.

The FHFA's position has long been that it does not want to engage in any process which encourages borrowers to default in order to gain what are, in effect, write downs of underwater mortgages. This is, in theory, especially important in light of the fact that Fannie and Freddie are in conservatorship and, ultimately, it's the American taxpayer on the hook (leaving aside the fact that both entities have become cash cows pouring their profits into the US Treasury). This is only a baby step toward fulfilling the call for widespread write-downs for political ideological humanitarian reasons, but then, every long journey begins with the first step, no matter how tiny. Between now and 2017, it would not be at all surprising to see the pace quicken and the stride lengthen.

Poison "IvI"

*Kevin LaCroix discussed a recent federal district court decision that adds to the number of court rulings that the "Insured versus Insured" (IvI) exclusion in banks' D&O insurance policies does not preclude officers and directors of a failed bank from making a claim for coverage under the policy based upon claims of the FDIC as receiver against them for their alleged acts and omissions as officers and directors of the bank. This issue has come to the forefront again as a result of the waive of (mostly community) bank failures following the economic collapse of 2008. As was the case in the previous wave of savings and loan and bank failures in the late 1980s and early 1990s, insurance companies have attempted to invoke the exclusion in order to deny liability, arguing that the FDIC as receiver "steps into the shoes of the failed bank."

(As a side note, my Contracts professor in law school asserted that insurance companies have a very simple business model: Collect Premiums. Deny Liability.)

Kevin explains the exclusion in the specific policy.

The IvI Exclusion provided in pertinent part that the policy does not provide coverage for any claim against an Insured “brought by or on behalf of any Insured or Company [including the Bank] in any capacity.” The exclusion had a carve-back that preserved coverage for “a Claim that is a derivative action brought or maintained on behalf of the Company by one or more persons who are not Directors or Officers and who bring and maintain such Claim without the solicitation, assistance or active participation of any Director or Officer.”

The insurance company in the case discussed by Kevin asserted that the IvI barred coverage for claims asserted by the FDIC since the FDIC was itself the "Insured." The judge denied the motion for summary judgment filed by the insurance company and granted the FDIC and defendants' motion of summary judgment on the basis that the exclusion was "ambiguous" and could not, therefore, be used as a basis to deny coverage.

Judge Guilford went on to note that “the insurance company has the ability, as a repeat party to these contracts, to ensure that ambiguities are eliminated over time.” The insurer “had the opportunity to make clear in the Policy that the IvI Exclusion applied to the FDIC-R, and it could have done so with a simple statement.” Judge Guilford noted that, in fact, the carrier “provides an optional regulatory exclusion – not included on the policy here – that explicitly names the FDIC.”

Without thrashing through the weeds in a manner that would interest lawyers rather than bankers (and the lawyers can read the opinion via the link provided by Kevin), the takeaways for officers and directors are as follows:

• Read your policy and obtain professional, independent help to ensure that you understand it and that you get the best possible protection. As the court points out, the "regulatory exclusion" could have left the defendants high and dry if the insurance company had inserted it in the policy, Understand what could bite you in the nether regions and shop around if you have to.
• Get the protection you need before you need it. Your best opportunity to obtain the most favorable policy will be when things are going swimmingly, not when you're taking on water faster than you can bail out the dinghy.
• While the trend of court decisions appears to be in favor of the insureds and against the insurer on the issue of IvI in the context of FDIC receivership claims against former officers and directors, the issue is far from settled. Kevin points out that contrary rulings do exist (one in the Northern District of Georgia, one of the less favorable regions to be from if you plan to run a bank into a ditch) and that there appears to be questionable reasoning in some of the favorable rulings. Therefore, expect insurers to continue to litigate the issue until doing so will open the door to a can of whoop-ass sanctions and a complete failure to pass the lying-with-a-straight-face test.

*Photo's Source: Barrett Insurance Agency

More On A Higher Standard For Bank Directors

Kevin LaCroix has some further thoughts on John Gorman's criticism of the proposal of FRB Governor Daniel Tarullo and certain academics that bank officers and directors should be held to a different (i.e., more stringent) fiduciary standard than officers and directors of other types of corporations. After discussing John Gorman's criticism of Tarullo's proposal (discussed here), LaCroix also discusses recent decisions by a federal district court judge in Georgia and the Georgia Supreme Court, the upshot of which is that while bank officers and directors (in Georgia, at least) are entitled to the protection of the business judgment rule, there may be some basis for holding them liable for ordinary negligence (as opposed to the higher "gross negligence" liability standard that is the "default" standard under FIRREA and the effective standard if the business judgment rule is applied). Kevin is concerned.

It should be emphasized that the academics’ proposal to hold bank directors to a higher standard was limited just to directors of systemically important financial institutions. I share the concerns John Gorman expressed in his American Banker article about this proposal. However, I have additional concerns, which is that there are already theories floating around that bank directors should be held to a different standard than directors of other companies, as shown by Judge Thrash’s remarks in the Buckhead Community Bank case. My concern is that if the idea were accepted that directors of systemically important banks should be held to have expanded fiduciary duties, the idea would quickly expand beyond just systemically important institutions and be applied to many , most, or even all bank directors, without regard to whether or not their institution is systemically important.

This was the same concern I expressed in my earlier post, and it's comforting to know that other observers share your concern about "trickle down" liability.

Kevin is particularly concerned about the spate of litigation directed against officers and directors of failed banks by the FDIC. The FDIC has been attempting to whittle away the business judgment rule wherever possible. The long-range implications are troubling.

There undoubtedly are meritorious lawsuits filed against bank directors, particularly where there is evidence of self-dealing or complete abdication of responsibility. Just the same, the overall level of litigation aimed at bank directors is both excessive and socially inefficient, particularly with respect to the litigation that so often follows after banks’ failures. So often the failed bank lawsuit allegations consist of little more than scapegoating and hindsight second-guessing. Creating a liability regime that would encourage further litigation and expand the potential liabilities of bank directors would accomplish little except enlarging the litigation burden that prospective directors would have to consider before accepting a seat on a bank board.

There is no question that prospective directors of financial institutions (especially community banks) have to think long and hard about the potential liability before agreeing to accept a board seat. For an increasing number of otherwise qualified candidates, the decision may be that if you don't have "a dog in the hunt" (a substantial financial investment in the bank), the benefits of being on the board do not outweigh the risks if (God forbid!) "something bad happens."

De Novo Territory Still A Wasteland

*The collateral damage caused by a non-existent condition that actually exists--the oft-denied FDIC mortorium on de novo bank approvals--includes bank M&A activity. According to the American Banker's Robert Barba and industry participants that he interviewed, a vital portion of the bank "M&A food chain" has been eliminated.

"It was normal for your bank to get bought and, two or three years later, sit around a kitchen table, decide to start a bank, plot to get local shareholders," said Timothy Chrisman, principal of executive the search firm Chrisman & Co. in Los Angeles.

"It was a feeder source," Chrisman added. "It was the process of community banking and that has changed dramatically."

The consequences of this change might be unintended, but are important.

A smaller banking industry facilitated by acquisitions and few new entrants has various ripple effects. In the short term, a lack of second-act opportunities could stymie activity as bankers hold on to what they have. In the long run, it will lead to a consolidated industry with less innovation and a deteriorating customer experience, some advisers say.

Less innovation in an industry not known as "cutting edge" to begin with is not a good thing.

Other observers cite the longer period of strict FDIC scrutiny after formation and higher capital requirements for de novos, and the fact that the costs of regulatory compliance in the post-Franken-Dodd world, as also discouraging potential de novo applicants from proceeding. Spending hundreds of thousands of dollars on an application that stands a slim chance of being approved would call into question the business savvy of a de novo's sponsors. Needing so much capital and asset "heft" to not only secure regulatory approval but to afford the ongoing regulatory burden throws additional wet blankets on the idea of traveling the de novo highway.

"The belief that exists now is that it would be hard to prosper as a de novo," said Wesley A. Brown, a managing director at KPMG Corporate Finance. "Bankers starting a new bank 10 years ago would have done it with enthusiasm. The idea that they can thrive has been shaken."

A FDIC spokesperson quoted by Barba denies the existence of a formal or informal FDIC moratorium,which is consistent with the FDIC's forked-tongue consistent position on the issue. Instead, the FDIC contends that there are so many "weak bank" charters available that starting a de novo is less attractive. That this position serves the FDIC's interests in steering would-be de novo applicants to purchase a marginal existing shop rather than start a new one, thereby rescuing a potential failure from the jaws of a future assisted sale, is purely coincidental.

Because the old paradigm of sell and start afresh appears dead, senior management's impetus to support a sale is often lacking. On the other hand, where the shareholders force a sale, there's also less likelihood of the seller's management jumping ship and starting a competitor. These factors work to lessen M&A activity on the one hand and encourage some M&A activity on the other hand.

While some of the industry participants think we could see a pick-up in de novo activity in two or three years, I heard the same think two or three years ago. Predicting the future is always hazardous business, and I could be surprised that de novo activity eventually resumes. My honest few is that I simply don't see it happening, unless the FDIC and other federal banking regulators have a change of heart, in reality and not merely as a matter of bureau-speak for public consumption. I think that the number of banks will continue to shrink, and that survivors will grow larger and larger in order to not only prosper, but to survive.

*Photo source wolenter.com

Tarullo Intrigued

John Gorman wrote commentary in the American Banker last week that ought to add to community bank directors' already high level of angst. Gorman discussed a recent speech by Fed Governor Daniel Tarullo, in which Tarullo spoke favorably of a paper by two law school professors (the road to hell is paved with such papers) in which the good professors argue that directors of too big to fail banks should be held to a higher fiduciary duty than bank directors are held today. The focus of the professors was on the implied duty of "board oversight" of bank operations. The professors' paper "proposed board oversight responsibility for the level of risk-taking by an institution, and the application of a simple negligence standard to this board responsibility."

Shareholder loss and/or systemic harm in the traditional sense — decline in stock price or bankruptcy, for example — would not be required for a stockholder to sue the board. Rather, the triggering event would be a "significant loss" at the firm resulting from an alleged breach of a board's risk oversight responsibilities. (The example given is the $6 billion "London Whale" trading loss incurred by JPMorgan Chase.) Judges would determine if the board-approved risk management processes, including its assessment of the appropriate level of risk and potential risk outcomes, were reasonable. This broadened fiduciary duty would apply only to those firms "capable of imposing systemic loss."

As Gorman points out, the duty of "oversight" is an adjunct to the duty of loyalty rather than the duty of due care. The business judgment rule (discussed here) generally protects directors from judicial second-guessing as long as they aren't "grossly negligent." As it has been previously interpreted in most jurisdictions, the duty of oversight does not generally provide a sustainable basis for a claim of breach of fiduciary duty unless the directors of the bank , in effect, simply ignored red flags. The professors want to change all that for systemically important financial institutions.

Gorman notes the problem with this approach.

Broadening a board's fiduciary responsibilities with respect to risk oversight would expose a board to liability for good faith judgments as to risk management, and would require boards to function in a management capacity. This would be expensive and inefficient, and would undoubtedly discourage capable persons from serving on bank boards. It will also ultimately be ineffective — risk and adverse risk outcomes cannot be eliminated, just as the business cycle has not and cannot be eliminated. Altering the fiduciary duty of oversight to require board "ownership" of risk management, would merely provide a prima facie basis for the filing of a lawsuit against many boards. As we know from the current corporate litigation environment, shareholder lawsuits that are not dismissed are settled (the risk that a judge or jury will rule against them and impose personal liability, is one that a board absolutely will not assume), and the primary beneficiaries of legal settlements seem to be the attorneys.

Many community bank directors who read this might be tempted to shrug it off. After all, if the enhanced duty of oversight applies only to the systemically important, why should I worry? Because as experience informs us, these heightened duties inevitably trickle down to the rest of the banks, even the "too small to save." And it is a director of the too small to save that is most at risk of the FDIC pursuing litigation against him or her if the bank fails. The too big to fail don't fail. Their directors may face litigation from shareholders, but they've got the policy coverage and financial heft to protect the directors. Community bank directors don't have that near certainty. The only certainty they have is that if failure occurs, the FDIC will push every theory available to find a breach of fiduciary duty and a pot of gold at the end of the D&O policy rainbow.

It's nice that Mr. Tarullo is intrigued by this new theory. However, let's hope that his attention span is short and that his focus soon turns elsewhere. Like to regulatory relief, for example.

The Rule of Lawlessness

Former FDIC Chairman Bill Isaac's recent rant opinion piece in The Wall Street Journal (paid subscription required) was a masterful smackdown of the current administration's handling of the conservatorships of Fannie Mae and Freddie Mac. Basically, Isaac accuses the executive branch of acting illegally.

The FHFA as conservator is a fiduciary—or trustee—for the shareholders of Fannie and Freddie. Its job is to, as the law says, "conserve [the enterprises'] assets and property" for shareholders while Fannie and Freddie rebuild their capital base and eventually exit the conservatorship.

That's not what has happened. When presented with the once-unthinkable reality of Fannie and Freddie making enough money to retire the Treasury's senior preferred stock and build enough capital to meet their financial obligations without government assistance, the Obama administration moved in 2012 to confiscate all Fannie's and Freddie's profits and wind down the two mortgage giants. Investors in Fannie and Freddie have responded by suing in federal court.

The government is trying to deny the plaintiffs the right to discovery (sound familiar?) because, according to Isaac, it's afraid of what might be revealed.

This information could include emails and other documents demonstrating that the government's true intent was to seize current and future Fannie and Freddie profits for itself and leave shareholders with nothing. To justify its position against granting discovery to plaintiffs, the government argues that disclosure of current and future plans for the conservatorship could be "disruptive to the housing market and to the nation's economy." Almost laughably, the government also argues against disclosure because that could "create market perception that the Enterprises are not financially viable," and that "this would have a negative impact on sales of debt and mortgage-backed securities." Putting aside the circularity of these arguments, the real absurdity is that the government's own activities have deprived Fannie and Freddie of capital and kept them too weak to emerge from conservatorship. By taking all of the enterprises' profits, the government has left them undercapitalized and permanently unable to rebuild their capital.

Isaac asks an obvious, important question: what's does this hijacking mean for the future? His answer is sobering.

Given the government's dereliction in its duty to conserve value in Fannie and Freddie, an obvious question arises pertaining to any "reform" of housing lending proposed by the administration and enacted by Congress. If the administration plans to wind down Fannie and Freddie with no recourse for investors, or to nationalize them in creating a new federal housing entity, as a Senate housing reform bill would do, where will the capital come from to finance the new system? What investor would put capital into something so uncertain and so unprotected by law as Fannie and Freddie have proved to be?

There can be varied opinions over which reform is best for our country or what, if any, role Fannie and Freddie will have in a future housing market. But there should be no disagreement about the law. Capital follows the rule of law, and if investors can't count on that in the U.S. and in the housing markets, they will put their money elsewhere.

"Capital follows the rule of law" applies beyond Aunt Fannie and Uncle Freddie, as important as they may be to the housing market and the economy as a whole. It also applies to the entire banking business.

Those of us who've been representing banks for a number of years (October will mark my 40th year of wandering in that desert) can't recall a time, outside of the relatively brief episode surrounding the collapse of the savings and loan business in certain parts of the country, when the federal government has treated adherence to the rule of law with such elasticity. From the envelope-pushing "disparate impact" doctrine's foray into fair lending (and the use of every artifice to prevent the SCOTUS from having an opportunity to strike it down), to Operation Choke Point and its "informal" enforcement through "informal" regulatory examinations and supervisory pressure, to cases like those of Patrick Adams, whose David-vs.-Goliath struggle seems to serve no purpose other than sending a message that due process is a pipe dream if you fail to knuckle under to a brow beating, to the avalanche of regulations following the enactment of Franken-Dodd, I cannot recall a previous time when community bankers and credit union boards and management have had such a sense of anxiety that borders, in many cases, on despair.

I understand why capital would flow to the Too Big Too Fail. They get hit with a few hundred million here, a few billion there, and rarely miss a beat. They take a licking and keep on ticking. The Too Small To Save don't have that status, and they know it.

Perhaps it's cognitive dissonance. Perhaps its the blind hope that "this, too, shall pass." Perhaps it's simply the fact that "this is what I know how to do and it's all I know how to do, so I'm gonna keep on doin' it until they force me to stop." However, if you have options as to where your capital will flow, how long before you cash in your chips on the banking business and take it to a business where the regulators who can shut you down and/or sue you don't have to take remedial educational courses to learn the basics?

I'm not advocating a course of action, I'm merely asking a question.

Martha Makes Good On Her Threat

Well, Martha Coakley gave Mel Watt only a couple of weeks to fold, and when he didn't, she made good on her threat to sue the FHFA.

Coakley followed up on her threat of litigation and filed a lawsuit against the FHFA and the GSEs in Suffolk Superior Court. The complaint alleges that Fannie and Freddie, currently under FHFA conservatorship, are refusing to comply with the Massachusetts law called “An Act to Prevent Unnecessary and Unreasonable Foreclosures.”

[...]

One of the provisions of the law, which was passed in August 2012, prohibits creditors from blocking home sales to non-profits simply because the non-profit intends to resell the property back to the former homeowner. Coakley says these foreclosure buybacks are exactly what the GSEs are preventing.

[...]

In the complaint, Coakley alleges that two of the FHFA’s policies violate state law. The suit alleges that Fannie and Freddie’s “arm’s-length transaction” policy prohibits property sales to non-profits who resell to the original homeowner.

The suit also alleges that the GSEs “make whole” policy has the same effect, as it prevents Fannie and Freddie from accepting anything less than the outstanding loan amount from the former homeowner or anyone seeking to resell or rent to the former homeowner.

Fannie and Freddie are in conservatorship because too many borrowers haven't repaid mortgage loans that Fannie and Freddie bought and packaged into mortgage backed securities that they then sold to investors, including, among other types of entities, pension funds that thought they were buying a safe, "government-backed" investment. The FHFA, which regulates those two entities, has a duty to the investors (and to Fannie Mae's shareholders, who've been shafted by the government's refusal to stop sucking up all of Fannie's profits, even though all of the government bailout money spent on Fannie and Freddie has been repaid in full) to try to recoup the maximum amount possible from the mortgages that it holds. Not letting defaulting homeowners benefit from a less-than-full-repayment liquidation of a loan makes sense from that policy standpoint.

Coakley believes that state legislation that pushes local economic recovery goals (or homeowner relief social policy goals, depending on your perspective) should be able to trump the policies of the a federal regulator regarding two wards of the federal government. This will be an interesting piece of litigation from the perspective of whether or not the FHFA must amend its policies to comply with such a state law. I don't see any upside for Watt to compromise on the current policies until a court tells him he has to back off and comply with Masschusetts law. At that point, he can tell the investors and shareholders that he had no choice: the judge made him do it.

It's also interesting from the standpoint that Watt and Coakley appear to be on the same side of the fence when it comes to social policy. Watt was a liberal Democrat when he was in the House of Representatives. Moreover, he recently gave a speech that indicated that Fannie and Freddie were going to expand their efforts to provide financing to borrowers with less-than-pristine credit. That was a move that caused a blinding flash of "deja vu all over again" to appear before the eyes of critics of the federal government's housing finance policies that many allege led to the subprime housing bubble and the resulting 2008 economic collapse. However, it was also an indication that rather than winding down Fannie and Freddie and creating a different sort of national residential finance market (which was where we seemed to be heading under Watts predecessor, Ed DeMarco), we may be back on the road to officially re-establishing the two mortgage finance giants as the only game in town, something they've unofficially been since the collapse occurred (and prior to that time, to be honest).

Regardless of the way Coakley's lawsuit plays out, we have the sneaking suspicion that the brave new world of residential mortgage finance may look like the brave old world.