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Sideways: Trump cronies need GSE intervention now

A US federal appeals court ruling on February 21 effectively ended a legal attempt by a group of hedge funds to stop the government from collecting billions of dollars of profits made by Fannie Mae and Freddie Mac in recent years.

Mnuchin Trump-R-600
US treasury secretary Steve Mnuchin keeps an eye on Donald Trump

Now hedge fund managers, including John Paulson and Bruce Berkowitz, who helped to finance the election of Donald Trump, will have to hope that he and his treasury secretary, Steve Mnuchin, deliver political reform that allows their bets on shares of the government sponsored enterprises (GSEs) to pay off.

The ruling did not completely close down potential further suits relating to the government’s move to sweep all profits from the mortgage agencies into the treasury starting in 2013, which has generated almost $250 billion for taxpayers.

Its rejection of the core argument made by the hedge funds was nevertheless enough to push stock prices for both Fannie Mae and Freddie Mac down by almost 40% soon after the ruling emerged, reversing the price rally seen after comments by Mnuchin on November 30 that called for the two agencies to be removed from government ownership.

Mnuchin later backed away from this stance during his confirmation hearings, when he said the return of the GSEs to the private sector, where they appeared to prosper until their bailout during the 2008 crisis, was not a priority. 

Mnuchin is now in place so his actions in the many areas where he has potential conflicts of interest will be more keenly watched

Mnuchin has particularly close ties to Paulson, so policy regarding GSE reform will be a key test of whether the crony capitalism that Trump critics fear actually delivers for his capitalist cronies.

With Republican majorities in both the House of Representatives and the Senate, GSE reform that helps hedge fund holders of regular and preferred shares in the GSEs should be feasible.

The issue for the funds is whether Mnuchin and Trump can be persuaded that GSE reform should be prioritized when the main domestic goals in Congress are a planned replacement of Obamacare and an overhaul of the tax code.

Gary Cohn, who like Mnuchin is a former Goldman Sachs partner, seemed to be making the running in economic policy in the early weeks of the Trump administration, because his role as head of the National Economic Council gave him a high profile while Mnuchin was awaiting confirmation as treasury secretary. 

Mnuchin is now in place so his actions in the many areas where he has potential conflicts of interest will be more keenly watched, as will his ability to cooperate with Cohn.

Trump trade

The simplest Trump trade – going long US equities – is still working very well, as stock indices repeatedly hit new highs. This may have been helped by faltering in the second leg of the Trump trade as initially adopted by many investors, which involved shorting bonds on the assumption that pro-growth policies would prove inflationary.

Yields for treasuries have instead stabilized and were little moved by a warning from Federal Reserve chair Janet Yellen that US rates may rise sooner than futures markets are projecting.

That debt market stability and low accompanying equity volatility seem to be encouraging investors to steadily push up stock prices. While the VIX measure of S&P stock index volatility remains at an unusually low level around 12, there has been a mild increase in dispersion between stocks, however.

That could translate into improved performance for some of the hedge funds that tout their ability to single out particular stocks for gains. Identifying the winners in a market with falling correlation can nevertheless involve significant guesswork and risk. Many funds are accordingly sticking to simplistic momentum strategies or just easing up on their hedging activity.

This shows a deplorable lack of imagination, when managers could instead be emulating bolder investors such as Paulson and Berkowitz, who have put in the time and effort to place people who can make their trades pay off at the very heart of government.