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.
|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.
Since John Paulson’s rock-star shorting of the subprime mortgage market immediately before the 2007 crash, assets under management at his firm have fallen from $36 billion to $13 billion. The Paulson Partners Fund was down 22% for the year by the end of September 2016 according to Bloomberg. He needs another big win to keep clients happy and privatizing Fannie and Freddie could be it.
The man who could make that happen – Trump – is very aware of this. According to a financial disclosure statement associated with his presidential campaign, Trump is understood to have invested between $1 million and $5 million in three of Paulson’s funds: Paulson Credit Opportunities, Paulson Advantage Plus and Paulson Partners. Whether or not these holdings have now been sold and whether or not Trump still held them at the time Mnuchin made his statement about privatizing the GSEs is, however, not clear. In all Trump disclosed $85 million worth of investments in eight hedge funds in the May 2016 disclosure.
The impact on their share prices – and therefore Paulson & Co’s fund performance – is plain for all to see. Paulson was an economic adviser to the Trump campaign and donated $330,000 (the maximum possible) to it and the Republican Party last year. He also belongs to a lobbying group called the Informal Coalition on Housing Finance Reform, which spent roughly $180,000 in 2016 alone lobbying for change.
Any move to GSE private ownership will be stymied by the need to rebuild capital reserves at the firms, but there are nevertheless many compelling arguments to support a reduction of the role of the government in US housing finance. Taking money from the US Treasury to put it in the pockets of hedge funds with which the US president has close ties is not one of them.
Several suggestions have been put forward: Republican Jeb Hensarling, who leads the House Financial Services Committee, has proposed phasing out the GSEs over the next five years, and senators Bob Corker and Mike Crapo led a bipartisan effort to replace them with a new structure in 2014.
The Trump administration will likely find support for proposals to reform the housing market on Capitol Hill – but probably less enthusiasm for the lobbying that has clearly driven it.
During his confirmation hearing before the Senate finance committee on Thursday, Mnuchin revealed that he held a stake of between $1 million and $2 million in the Paulson Advantage fund at the time his comments about the GSEs were made last November.
According to Bloomberg, the performance of that fund rose 9% after he made them. He has subsequently sold his stake in the fund and perhaps coincidentally is now backing away from his November comments about the need to get the agencies back into private hands quickly, saying at the confirmation hearing that GSE reprivatization is not a priority.