Some of the hedge funds that long ago made bets on the recovery of Fannie Mae and Freddie Mac have greatly benefited in the first few weeks of 2019 as a Trump appointee ascended to become the acting chief of the regulator in control of mortgage giants.
Joseph Otting, head of the Office of the Comptroller of the Currency (OCC), was tapped to be acting director of the Federal Housing Finance Agency (FHFA) in late December. At the time, the common shares of Fannie and Freddie were trading around $1.14. As of Thursday, shares of each company were trading around $1.80, a nearly 60 percent rise in just a few short weeks.
Otting has renewed hopes among investors that the government could end the now decade-long conservatorships of Fannie and Freddie, saying it is the administration’s goal to achieve their “complete release.” Fannie and Freddie were taken into conservatorship by the FHFA in 2008 and provided with a bailout from the U.S. Treasury that ultimately required hundreds of billions of dollars.
Otting is a former banking executive and associate of U.S. Treasury Secretary Steve Mnuchin. Sources close to the White House say he is part of the “banker/globalist/Davos” wing of the Trump administration.
“He’s not deep state, but he’s deep Wall Street,” one Trump administration official told Breitbart News.
Otting spent more than 30 years as a banker. Prior to becoming the chief at OCC, he was chief executive officer of OneWest, the California lender started by Mnuchin after the 2008 housing crisis. OneWest was built from the ashes of the failed California lender IndyMac. Along with Mnuchin, investors included billionaire hedge fund manager John Paulson and left-wing donor George Soros. OneWest was sold to CIT Group in 2015.
In exchange for their bailouts, Fannie and Freddie initially granted warrants giving the U.S. Treasury the right to buy nearly 80 percent of their common stock for a nominal fee. In addition, the government got preferred shares that initially paid a fixed ten percent dividend. After both companies repeatedly failed to earn enough to pay the fixed dividend, it was changed in 2012 into a floating rate dividend. This required the companies to essentially pay all of their profits above a minimum cushion to the Treasury but relieved them of any obligation to pay in quarters where they lost money.
Shareholders, including some of the best-known fund managers in America, balked at this arrangement and sued in numerous federal and state courts. They argued that the new dividend arrangement, known as the “net worth sweep,” unfairly and illegally deprived them of the benefiting from their ownership of the stock of the companies. The government pointed out that the hedge funds and other shareholders had contributed no new capital to the company since their 2008 failures and that, since all of the new funding had come from taxpayers, the arrangement was sound.
Courts have almost universally sided with the government, repeatedly pointing out that the statute that authorized the bailout of Fannie and Freddie also transferred any shareholder rights to the FHFA when it took over as conservator. Several of the dismissals have since withstood appeals, and the Supreme Court last year declined to review a case in which the hedge funds had lost on most issues.
The recent run-up in Fannie and Freddie shares appears to be based on the hopes that Otting’s leadership could result in a turnaround in the FHFA’s policy and legal strategy. Former FHFA Director Mel Watt, who was appointed by Barack Obama and whose term ended in January, often said he did not think the conservatorships should last forever but also added it was the administration’s policy that the necessary reforms needed to be enacted by Congress before the status of Fannie and Freddie would change. This frustrated some advocates of Fannie and Freddie’s release who continued to urge the FHFA to act on its own to release them.
Otting has not officially reversed this stance. But with Congress divided between a Republican Senate and a Democratic House, it looks increasingly unlikely that lawmakers will be able to work together to pass a comprehensive housing finance reform bill. Previous efforts failed to garner enough support even in a much less divided Washington, DC, and despite the fact that they had the support of President Obama.
But Otting has already reversed one of his predecessor’s positions. In a legal filing this week, the FHFA said it would no longer defend the constitutionality of its own structure. This had been challenged by shareholders who argued that the FHFA is unconstitutional because it has a single director who can only be removed “for cause,” a set up they say usurps too much of the president’s executive authority. Last year, an appeals court panel agreed with the plaintiffs and the government has now asked the decision be considered by the entire Court of Appeals for the Fifth Circuit.
“To the extent the Court concludes it is necessary to reach the constitutional issue, FHFA will not defend the constitutionality of [the] for-cause removal provision and agrees … that the provision infringes on the President’s control of executive authority,” the supplemental brief filed this week by the Otting-led FHFA says.
Legal experts say it is possible, perhaps even likely, that the court will appoint someone to defend the position that the FHFA has now abandoned. Alternatively, the court may decide that the issue is no longer relevant to the case.
The investors argue that if the court agrees the agency’s structure is unconstitutional, the 2012 New Worth Sweep it agreed to with the Treasury should be set aside. The government argues that even if the FHFA’s single director structure is unconstitutional, the agreement should be upheld because there is no reason to think a less-independent FHFA would have put up more resistance to the Net Worth Sweep.
Most likely, the court will shy away from any decision that required all of the decisions made by the FHFA since its creation in 2008 were unconstitutional.
That is Otting’s revised position, giving up defending the structure of the agency but continuing to defend the New Worth Sweep.
In their challenge to the structure of the FHFA, the investors have another powerful ally. When he was a circuit court judge, Brett Kavanaugh authored an opinion that ruled that a similar structure rendered the Consumer Finance Protection Bureau unconstitutional. Kavanaugh’s opinion, however, was overruled when the full court reviewed it en banc. But now that he sits on the Supreme Court, Kavanaugh’s reasoning could once again prevail.
Otting is the acting head of the FHFA. Trump has named Mark Calabria to be the next head of the agency but that nomination awaits Senate hearings and confirmation. It’s not clear if Calabria backs Otting’s stance on the constitutional status of the FHFA. Calabria had a hand in writing the legislation that created the FHFA, so it would be surprising if he now believed it was unconstitutional. But Calabria, like Otting, is viewed as friendly to shareholders and has said in the past that he thinks the ongoing conservatorship violates the spirit of the law and past precedent.
The Trump administration would face a fierce backlash if it tried to quickly privatize Fannie and Freddie by releasing them to the control of hedge funds and other investors. Such a move would require the administration to surrender hundreds of billions of dollars of taxpayer assets in exchange for nothing, in effect creating a huge corporate welfare program for the hedge funds who own much of the equity in the companies. Some of those hedge funds are managed by Wall Streeters who supported Trump’s campaign, including John Paulson of Paulson & Co.