Wall Street billionaires are pushing a new plan to swipe the profits of Fannie Mae and Freddie Mac from U.S. taxpayers–and in the process revive the system of privatized-profits and public-risk that contributed to the severity of the Great Financial Crisis.
Blackstone, the world’s largest private equity group, and the hedge fund Paulson & Co, run by Trump Wall Street supporter John Paulson, last year reportedly hired the investment bank Moelis & Co. to develop proposals to overhaul the two agencies. Blackstone is headed by Stephen Schwarzman, an adviser to President Donald Trump who reportedly has pushed the president to soften his stance on China. The plan went nowhere, in large part because it was dead on arrival in the House Financial Services committee, then run by conservative Republican stalwart and Fannie-Freddie critic Jeb Hensarling.
Hensarling, however, chose not to run for re-election and the chair of the committee will now be occupied by leftwing Democrat Maxine Waters of California. One of the tactics employed by those sympathetic to the Moelis plan has been to claim, without evidence, that government control of Fannie and Freddie somehow benefits the big banks. Wells Fargo, the California based megabank and a frequent target of Waters’ criticism, is often singled out, despite the fact that the bank has played little to no role in the long-running debate over what do to with Fannie and Freddie.
The divided Congress is also seen as an opening for the Trump administration to take action on its own, since it appears unlikely serious housing reform legislation will pass the Democratic House and the Republican Senate. The Trump administration is expected to at least implicitly reveal its plans for Fannie and Freddie when it nominates a successor to current FHFA Director Mel Watt sometime in the next few weeks.
In early November, Moelis once again put forth its plan with some minor changes. The hope is that the change in power dynamics on Capitol Hill may create an opening for the hedge funds to seize control of Fannie and Freddie by ending their conservatorships and obligations to pay dividends to the U.S. Treasury. This would deliver a huge windfall to hedge funds that snapped up junior preferred stock and common stock of the companies that remained outstanding even after they collapsed and needed to be rescued with hundreds of billions of dollars of taxpayer funds.
Lobbyists and political operators have been pushing the plan on Capitol Hill and inside the Trump administration. It has garnered support among some Treasury Department officials, including very high-ranking advisers to Treasury Secretary Steven Mnuchin. Most of the officials who have taken a favorable view of the Moelis plan have close ties to Wall Street firms themselves.
Even before he took office, Mnuchin sent the share prices of the two companies soaring when his comments following the election were seen as a promise to privatize Fannie and Freddie by releasing them from government control. He later walked back those comments, making it clear that he was offering no such promise. This year, Mnuchin said that he expects Congress to enact housing finance reform in 2019 and that the administration could take action on its own if Congress does not act. Some inside the Trump administration fear that could wind up as a push to adopt the Moelis plan.
Mick Mulvaney, the White House’s budget director and the acting head of the Bureau of Consumer Financial Protection, is also viewed as a potential ally of those pushing the Moelis plan. As a Congressman, Mulvaney sponsored a bill that offered “a bonanza for hedge funds seeking to cash in on their investments in Fannie Mae Mae and Freddie Mac—but the cost to taxpayers would [have been] steep.” That bill died on Capitol Hill for lack of support.
When Fannie and Freddie needed to be bailed out in 2008, the U.S. Treasury agreed to fund them in exchange for senior preferred stock and warrants to buy just short of 80 percent of the common stock. Originally, the senior preferred stock paid a 10 percent dividend and the companies agreed to pay a commitment fee on the undrawn backstop. But the companies struggled to pay this dividend for years and were forced to draw down on the Treasury’s backstop, diminishing the amount available to them should they run into financial trouble again.
Eventually, the two companies took a combined $187 billion from the government and Treasury promised to supply up to a total of $400 billion. Both the original bailout and the ongoing backstop remain outstanding.
In 2012, Treasury struck an agreement with the Federal Housing Finance Agency, which has been the conservator for the companies since 2008, to change the dividend from a fixed to a floating rate and cancel the dividend. Under this arrange, they pay a dividend equal to their positive net worth minus a small capital cushion. In quarters when the companies do badly, they pay no dividend at all. When profits roll in, the companies can pay more than the original 10 percent. And, of course, when they find themselves with a negative net worth, they can still draw on the backstop.
Government support for Fannie and Freddie went way beyond these equity investments. The Treasury and Federal Reserve have made huge purchases of the debt securities of the two companies. Treasury purchased $220 billion of Fannie and Freddie’s debt and the Fed purchased $172 billion. Through its quantitative easing program, the Fed has purchased a whopping $3.2 trillion of Fannie and Freddie backed securities, making the central bank by far the biggest customer of their mortgage bonds. These purchases are unique–the Fed and Treasury do not purchase the debt of any other private companies–and undermine the notion that these are essentially private companies under government control.
In the ten years since it became a ward of the state, Fannie Mae has taken in $119.8 billion of bailout funds, including $3.7 billion in 2017. It has paid $171.8 billion in dividends to Treasury, an average of $17.8 billion per year. But this average conceals the fact that the dividends are now far lower than they were in the early years of the post-crisis recovery. Over the last four-quarters, Fannie has paid around $5.5 billion–less than half of what it would have owed under the original 10 percent dividend.
The numbers for Freddie Mac, Fannie’s smaller sibling, tell a similar story: $71.6 billion in draws from the Treasury and around $114 billion in dividends paid. In the last four quarters, however, Freddie has paid just $3.8 billion. Like Fannie, that is less than half of what would have been due under the original 10 percent dividend.
Because these are dividends on an equity investment, the payments do not reduce the balance of bailout funds outstanding–just as dividends ordinary companies pay on their stock do not reduce the amount of their outstanding stock.
The new arrangement was challenged by hedge funds and other investors in the junior preferred and common stock, who argued that it treated them unfairly because they were cut off from the profits of the company. The government pointed out that the arrangement was authorized by a 2008 law. What’s more, the companies had only survived because of the hundreds of billions of bailout dollars supplied by the Treasury. As the only risk-taking suppliers of capital to the firms since the collapse, the taxpayers had a right to the upside, the government argued.
Federal courts at the district court and appeals court level have all agreed that the so-called net worth sweep is lawful. Although new cases continue to be filed and investors still are fighting in some courts, it increasingly appears as if their hoped-for legal channel to a windfall has been foreclosed.
Having failed in court, the hedge funds and other investors are turning to the political branches in hopes of achieving their windfall. Many proposals have emerged to reform housing finance over the years, some better than others but none securing enough support on Capitol Hill to become law.
The Moelis plan stands out as a strikingly bold grab for control of the companies and their profits. It calls for the dividend payments to the Treasury to cease so that the companies can rebuild capital. Shockingly, it also calls for the cancellation of the senior preferred stock altogether–with no compensation for the past risk and future profits currently due to taxpayers. It is as if a company proposed to do a stock buyback by proposing to cancel its shares rather than purchasing them for cash.
This would be an unprecedented giveaway, more akin to government-authorized looting than a “housing finance reform” plan. Even calling it “corporate welfare” would be too generous because the beneficiaries wouldn’t be the companies, which have been prospering under the current arrangement. The beneficiaries would be the owners of the shares of the company, which would receive a massive promotion in the capital structure in exchange for nothing. This is something new–hedge fund welfare.
Taxpayers would surrender an asset–the senior preferred stock–that is expected to return hundreds of billions of dollars, reducing deficits and tax-burdens, over the next decade. And in return they would get nothing except perhaps the gratitude of billionaires. Under the Moelis plan, the government would just deem the entire bailout as fully paid-off–as if it were an ordinary mortgage loan a homeowner could prepay when he wanted to move rather than a $400 billion guarantee of two companies originally created by the U.S. government.
Hedge funds argue that the companies should be released from their obligations to pay dividends because they have paid more than their original bailout. But they should know better: when investors purchase a stock or make a loan, it is not in the hope of getting paid back what was invested. It’s in the hope of making a decent financial return. Why shouldn’t taxpayers earn the profits made possible by their investment? None of the junior preferreds or common shares represent new capital injected into the companies since they entered conservatorship. It’s one-hundred percent taxpayer capital backing them. What’s more, the internal rate of return on the funds invested by the taxpayers has been quite small considering the amount of time that has passed.
This argument that has been rejected by federal judges as well as the Trump Justice Department. It would mark a dramatic change in direction if the Trump administration were to embrace it now.
In any case, the senior preferred stock remains a valuable and outstanding asset that legally belongs to the U.S. Treasury. Giving it away for nothing should be a nonstarter for President Donald Trump, who touted his ability to get the American people better deals.