The Biggest Remaining Risk in Today's Financial System, Hiding in Plain Sight
“If the housing market tanks, so does the stock market. No matter who you are, this is hugely impactful. And no one is talking about it. No one realizes it.”
—Ryan Israel, partner at Pershing Square Capital Management.
On a bitterly cold gray day in December 2014, there was a strangely large crowd at the United States Courthouse in Des Moines, Iowa, where Senior District Judge Robert Pratt was hearing arguments in Continental Western Insurance Company v. FHFA. The title gave few hints as to why the room, the goings-on of which rarely transcend local interest, would be packed close to standing-room-only, filled with representatives of the country’s top investment firms, including a slew of New York hedge fund types, along with prominent Washington lawyers, including a George W. Bush-appointed former U.S. Attorney and a Department of Justice lawyer.
FHFA, often pronounced “FOO-fa,” is the acronym for the Federal Housing Finance Agency. It’s an obscure government regulator whose major business is overseeing Fannie Mae and Freddie Mac, the mortgage giants that guarantee the payments made by a broad swath of American homeowners, and which were taken over by the U.S. government during the financial crisis. Continental Western is an Iowa-based insurance company that coordinated its case with Fairholme Capital Management, the famous investment firm founded by Bruce Berkowitz. The case in the Iowa court is one of many that investors including Fairholme have brought against the government for the way it has handled Fannie and Freddie.
The government lawyers were sputtering with outrage about the nerve of the investors to bring a lawsuit at all. It’s not just that investors are accusing the United States government of misdeeds, which in and of itself is obviously a pretty big deal. But on the surface, the lawsuits seem to fail to appreciate the stunning amount of money—$187 billion, or about six times the annual budget of the National Institutes of Health—that taxpayers have put into the rescue of Fannie and Freddie. And taxpayers still could have to contribute more. Said the FHFA’s lawyer, “Your honor, even with that $187 billion already infused, at this very moment, Treasury . . . is on the hook to infuse another—if it is required—in excess of another $250 billion of taxpayer dollars, a quarter trillion dollars . . . all this federal money was put in and [the investors] want to avail themselves of that federal money.”
A news service called the Capitol Forum described the Iowa case as a “match-up between the Obama Administration and hedge funds.” And the legal battles over Fannie and Freddie’s fate do pit the most powerful office in the land against some of the country’s wealthiest investors. In total, the lawsuits, if successful, could result in the payment of tens of billions of dollars for securities that originally cost pennies; Bloomberg called it “one of the biggest potential paydays in history.” But overall, the lawsuits are about much more than one side’s victory or loss. They have reverberations for all of us. What some investors really want is a say, and a stake, in the ultimate fate of Fannie and Freddie—and that, in turn, will decide the future structure of the American housing market.
A Contrarian Call
If not for the involvement of powerful investors, not just Fairholme, but Perry Capital, Paulson & Co., Blackstone, Claren Road, and Bill Ackman’s Pershing Square, the government would basically have a free rein with Fannie and Freddie. The investors are a huge thorn in the side of the government, not just because of the lawsuits, but because of all the noise they make in Washington. It all begs a question. Given the enormous losses suffered by Fannie and Freddie in the wake of the crisis, it makes zero sense that some of the country’s supposedly smartest investors would have bought Fannie and Freddie’s securities.
To understand why they did it, you have to understand the façade of convenience involved in the 2008 bailout, as well as its unique and punitive terms.
When the government put Fannie and Freddie into conservatorship, it got the right to take 79.9 percent of the common stock of both companies. Why not just nationalize them and take 100 percent? “If the U.S. government were to own more than 80 percent of either enterprise, there was a sizable risk that the enterprises would be forced to consolidate onto the government’s balance sheet,” explained housing analyst Laurie Goodman in a report. In other words, the government certainly could have wiped out investors, thereby preventing the problem it has today. But if Fannie and Freddie were nationalized, the federal government’s debt would have skyrocketed.
Because any money the government put in would become so-called “senior preferred stock,” which would have to be paid before anyone else got anything, it looked like the existing preferred stock and common shares would be worthless. But they still traded on the New York Stock Exchange, albeit for pennies.
The bailout also required Fannie and Freddie to draw money from the Treasury based on an accounting concept called net worth. A positive net worth helps the market have confidence in financial institutions like Fannie and Freddie, so they were required to draw money from Treasury to keep their net-worth positive. But “net worth” is an accounting concept that factors in estimates of future losses as well as current losses. Fannie and Freddie were required to draw money based on estimates that they would lose billions in the future. In addition, while financial institutions in trouble never pay cash dividends, Fannie and Freddie were required to pay a 10-percent dividend back to Treasury on any money they took.
This had some perverse consequences. Because the dividend payment further reduced their net worth, they also had to draw additional money from Treasury to fill the hole caused by the dividend payment. According to a FHFA official, around $45 billion of Fannie and Freddie’s $187 billion bailout consisted of draws that took money from Treasury only to round-trip it right back to Treasury as a dividend payment. (Other analysts think the figure is lower, around $30 billion.) “It was a complete payday lender situation,” says someone close to the situation. “It was like borrowing from a loan shark.”
Ultimately, Fannie Mae took $116.1 billion and Freddie Mac $71.3 billion from the U.S. Treasury, a total of $187.5 billion. One analysis done on behalf of a major investor shows that most of the losses were caused by non-cash charges such as provisions for loan losses—losses that never materialized. During the period in which the GSEs lost money, from 2007 to 2011, the provisions for losses exceeded the actual losses by $141.8 billion. Put another way, if Fannie and Freddie had only reported their cash losses, and had kept their deferred tax asset instead of writing it off, they would have lost $64.1 billion, according to this analysis. Considering the amount of equity they held heading into the crisis, their combined equity deficiency would have been only about $10 billion.
Because the GSEs had to pay the dividend on the full amount they drew, Tim Howard, Fannie Mae’s former CFO, would later calculate that Fannie was obligated to make $11.6 billion in dividend payments for every year in the future—more than Fannie had earned in any single year in its history. “Seemingly it was a death sentence,” Howard wrote in his book "The Mortgage Wars: Inside Fannie Mae, Big Money Politics, and the Death of the American Dream."
The Greatest Accounting Fraud Ever
When almost everyone was gnashing his teeth about the apparently mounting losses at the GSEs, some investors began to do the math, and they found that Fannie and Freddie weren’t doing nearly as poorly as it seemed. One of the first people to call it publicly was an Australian hedge fund manager named John Hempton. In an August 2009 blog post, he noted that the actual cash losses Fannie and Freddie had reported to date were “simply not large enough to have caused problems.” After going through filings, he noted that the estimates of future losses were “extremely harsh.” Hempton would later call Fannie and Freddie’s post-bailout financial report the greatest accounting fraud he’d ever seen. He didn’t mean fraud in the usual sense of fraud, in which a company understates its losses, thereby making the financial picture look prettier. He thought Fannie and Freddie were overstating their losses, thereby making the financial picture look uglier.
Some investors also noticed that despite all the rhetoric about killing Fannie and Freddie, when the government put them into conservatorship, Jim Lockhart, who was then the head of FHFA, had said that the goal was to return Fannie and Freddie “to normal business operations” and that “both the preferred and common shareholders have an economic interest in the companies . . . and going forward there may be some value in that interest.”
Eventually, if the housing market began to recover, accounting laws would require that the estimated losses that had never materialized be reversed and booked as profits. The deferred tax assets would have to be reinstated, because after all, if the GSEs were profitable again, then the deferred tax assets would have value. The numbers would be gigantic.
And so, in late 2010, Perry Capital, a multibillion dollar hedge fund run by former Goldman Sachs executive and Democratic power player Richard Perry, bought, for 3 cents a share, supposedly worthless Fannie and Freddie junior preferred stock. Other funds that, like Perry, had made fortunes betting against, or shorting, subprime mortgages in the run-up to the crisis (a trade documented in the book The Greatest Trade Ever) also bought securities. Paulson & Co., run by John Paulson, who personally made almost $4 billion from shorting subprime securities, bought. So did a hedge fund called Claren Road that is majority owned by the Carlyle Group, the politically connected Washington, D.C.-based asset management firm.
For a long time, the investors thought Fannie and Freddie were like normal companies. Conservatorship wasn’t supposed to be forever. Fannie and Freddie required restructuring—they would need huge amounts of additional capital to get back in business, and the government would have to revise the terms of its senior preferred stock—but restructuring is what happens when companies run into trouble. “We are used to distressed financial companies,” one investor says. “We do not shut it down and vilify the management teams. We figure out what works, what is salvageable.” He points out that when General Motors declared bankruptcy, its plants didn’t all get shut down.
“We expected the political rhetoric,” says another investor. “We thought, ‘It’s easy for you to say you want to kill them, and that they are an endless black hole.’ But once they were profitable, we thought the rhetoric would change.”
In one way, the investors were right. Fannie and Freddie have indeed produced immense profits—in total, they have paid $239 billion to the government over the last three years. But they were very wrong in another respect. We are now past the 7 year anniversary of the conservatorship, and the financial crisis, and the rhetoric has not changed. The government still says it wants to kill Fannie and Freddie.
In a recent note, Bank of America Merrill Lynch analyst Ralph Axel wrote this: “The fate of government-sponsored enterprises (GSEs) is not only of critical interest to home buyers, home builders and mortgage bankers but also to almost every investor class across the globe. For a market that thrives on being considered a substitute for Treasury debt, turbulence and uncertainty is the worst case scenario. But unfortunately, the fate of the GSEs is still very much in flux, and more so today, in our view, than ever before.” The housing market—and as a result, the financial system—remains on shaky ground.