What’s behind Trump’s enthusiasm for GSE reform?

Louise Bowman
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Reprivatizing Fannie Mae and Freddie Mac is high on the agenda of the new Trump administration – its close ties to the hedge funds that were hit by their conservatorship and subsequent cash sweep could explain why, and is just one example of the murky incentives that have followed Donald Trump into the White House.

Trump rubik cube-600

Trump’s nominee for Treasury secretary Steven Mnuchin sparked an eye-catching rally in government-sponsored enterprise (GSE) stocks in the immediate aftermath of the US election last year.

"We have got to get Fannie and Freddie out of government ownership," he declared on November 30. "It makes no sense that they are owned by the government and have been controlled by the government for as long as they have.

"We’ll make sure that when they’re restructured they’re absolutely safe and they don’t get taken over again. But we have got to get them out of government control."

Shares in both firms soared 30% immediately after these comments. On Friday, as the US witnesses Trump’s inauguration, it’s worth asking who has benefited from the Treasury secretary nominee making such unusually overt comments on future policy and why Mnuchin might have been so emphatic on the need for the GSEs to be returned to the private sector.

Reform of US housing finance has been an elusive goal since the financial crisis. Residential mortgage securitization was at the centre of the maelstrom following the collapse of Lehman Brothers, and finding a way to re-establish a functioning, safe and private sector mortgage market has proved fiendishly difficult.

The two main stumbling blocks to reform are the US GSEs Fannie Mae and Freddie Mac, which together hold a portfolio of around $6 trillion of securitized mortgage assets – by far the lion’s share of the entire market.

The GSEs have always made the US market an anomaly: mortgage lending is essentially a nationalized industry. GSE guarantees enable both US homebuyers to take out fixed rate, 30-year mortgages and US banks to shed their risk-weight heavy mortgage assets – and thus require less capital – by securitizing them. 

According to a financial disclosure statement associated with his presidential campaign, Trump is understood to have invested between $3 million and $15 million in Paulson’s funds 

Following the financial crisis, the two firms’ huge exposure to residential mortgages saw them bailed out by the government and taken into conservatorship.

In 2008, the US government injected $188 billion into the GSEs in return for senior preferred stock with a 10% cash dividend. Existing preferred shareholders were moved to junior preferred stock and the Treasury was given warrants that entitle it to 79.9% ownership of the firms – which it has never exercised.

In 2012, the US government enforced a third amendment to their preferred stock purchase agreements, which effectively diverted all quarterly profits from those junior preferred shares into the Treasury’s coffers. This 'net worth sweep’ began in January 2013 and, so far, has contributed more than $245.6 billion to the federal government’s finances.

This arrangement has been a fruitful one for the government, but the holders of those preferred shares have contested its legality since it was put in place. Hedge funds including Perry Capital, Paulson & Co, Fairholme Capital Management and Carlyle-owned Claren Road Asset Management immediately launched legal action against the government which has been rumbling through the courts ever since.

The investors argue that the cash sweep was in effect illegal asset stripping. The government’s position is that the US taxpayer bailed out the firms and therefore would like to see some of its money back – although the profitability of the firms since 2013 has probably surprised even them.

The investor suits were thrown out in 2014, but shareholders took their case to the US Court of Appeals in Washington in April last year.

When the GSEs were taken into conservatorship, their shares became largely worthless: in January 2012, Fannie Mae traded at 24c and Freddie Mac at 25c. In October 2007, the former had been trading at $66.04 and the latter at $63.43. Fannie Mae was trading at $1.64 and Freddie Mac at $1.55 on November 8.

Steven Mnuchin-R-600
Trump’s nominee for Treasury secretary Steven Mnuchin

However, since the election of Trump, spurred on by Mnuchin’s comments, they have staged a spectacular recovery to around $4 by the end of January this year.

Paulson & Co has been one of the most active preferred shareholder litigants and with a presumably large stake in the junior preferreds will have been hit hard by the net cash sweep.