The Capital Note

Fannie Mae, Freddie Mac, and John McAfee

Fannie Mae headquarters in Washington, D.C., February 21, 2014 (Kevin Lamarque/Reuters)

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the Supreme Court rules against shareholders of Fannie Mae and Freddie Mac, investors anticipate a capital-gains hike, and the complicated conservatorships of government-sponsored enterprises. To sign up for the Capital Note, follow this link.

Shareholders Lose a Legal Battle over GSEs
Shareholders of Fannie Mae and Freddie Mac — the government-sponsored enterprises (GSEs) at the center of the 2008 financial crisis — lost a high-stakes legal battle yesterday, when the Supreme Court ruled in favor of the Federal Housing Finance Agency (FHFA) that oversees the mortgage giants. The case surrounds the distribution of revenues to the U.S. Treasury from the GSEs, which were put into government conservatorship in 2008. To stem losses from the collapse of the housing market, the Treasury provided Fannie Mae and Freddie Mac with $100 billion in capital in return for preferred shares and fixed dividends.

The FHFA later amended the fixed dividends with a variable structure that required the GSEs to remit virtually all their profits to the Treasury. That amendment increased the dividends by a total of $100 billion, at the expense of Fannie Mae and Freddie Mac’s private shareholders.

Shareholders of the GSEs, primarily hedge funds, argued “that the FHFA exceeded its authority as a conservator under the Recovery act by agreeing to the new variable dividend formula,” reads the majority opinion. The ruling against shareholders sent the GSEs’ stocks down more than 30 percent, clobbering hedge-fund managers including Bill Ackman and John Paulson who had bet that the Court would repeal the amendment. In his majority opinion, Justice Samuel Alito wrote:

The “anti-injunction clause” of the Recovery Act provides that unless review is specifically authorized by one of its provisions or is requested by the Director, “no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator or a receiver.” Where, as here, the FHFA’s challenged actions did not exceed its “powers or functions” “as a conservator,” relief is prohibited.

In other words, Congress gave the FHFA authority sufficiently broad to alter payouts to the Treasury and shareholders. Alito also said that the structure of the FHFA, which is led by a single director removable by the president only for cause, violated the Constitution’s separation of powers.

The White House saw the ruling as an opportunity to take increased control of the mortgage giants. Bloomberg reports:

In a statement released late Wednesday, the FHFA said the White House had named Sandra Thompson the regulator’s acting director. She had been the FHFA’s deputy director of the division of housing mission and goals. Biden hasn’t nominated a permanent successor to Calabria and any candidate would have to be confirmed by the Senate.

While Calabria had moved to shrink Fannie’s and Freddie’s footprint, many housing analysts expect Biden to use Fannie and Freddie to make loans cheaper and easier to get for minority groups and less-well-off borrowers, who historically have found it more difficult to buy a home.

It remains to be seen how and when the government will relinquish control of Fannie Mae and Freddie Mac. While Calabria had moved to privatize the mortgage giants, Biden appears poised to use the GSEs to support mortgagers.

Investors Positioning for a Potential Capital-Gains Hike
The Biden administration’s proposal to hike capital-gains taxes is already starting to move markets. Some business owners have begun selling off assets in order to avoid a potential increase in taxes. For Blackstone’s Steve Schwarzman, that’s a buying opportunity:

“It’s really like an avalanche now of opportunities — people want to sell things before their taxes are much higher for selling the same thing, potentially next year,” Schwarzman said in a virtual panel discussion at Bloomberg’s Qatar Economic Forum. “It’s giving us a lot of opportunities, and what we have to do is be careful, always have a very exciting plan for growth.”

Blackstone, along with Carlyle Group Inc. and Hellman & Friedman LLC, reached an agreement earlier this month to buy a majority of Medline Industries Inc. for more than $30 billion, in what would be among the largest leveraged buyouts of all time. Bloomberg News reported this week that the Mills family was motivated to sell some of their stake in one of the nation’s largest private companies in part because of the threat of additional capital gains taxes.

The Biden plan would take the federal long-term rate on capital gains from 23.8 percent to 39.6 percent for high earners. Including other federal investment taxes, the top rate would total 43.4 percent, not to mention steep state and local taxes in places like New York and California.

The Tax Foundation finds that the plan would shave roughly 0.1 percent from long-term GDP, while reducing federal revenues by roughly $124 billion over ten years.

Around the Web
John McAfee, R.I.P.

Antivirus software pioneer John McAfee was found dead in his prison cell in Spain on Wednesday, from where he was set to be extradited to the U.S. on charges of tax evasion.

A Spanish court had approved McAfee’s extradition hours before his death. McAfee allegedly earned millions of dollars while failing to file tax returns between 2014 and 2018, according to an indictment in 2020. McAfee faced up to 30 years in prison under the indictment . . .

McAfee, an eccentric individual, warned in 2019 and 2020 that if he died in prison it would not be by suicide.

Reddit claims its first hedge-fund kill

A London-based hedge fund that suffered losses betting against US retailer GameStop during the first meme stock rally in January is shutting its doors. White Square Capital, run by former Paulson & Co trader Florian Kronawitter, told investors that it would shut its main fund and return capital this month after a review of its business model, according to people familiar with the fund and a letter to investors.

The move marks one of the first closures of a hedge fund hit by the huge surges in so-called meme stocks. Retail investors, often co-ordinating their actions on online forums such as Reddit’s r/WallStreetBets and in some cases deliberately targeting hedge fund short sellers, drove up the price of stocks such as GameStop and cinema chain AMC Entertainment in January and again in recent weeks. GameStop, for instance, soared from less than $20 at the start of the year to more than $480 at its January peak.

Random Walk
A 2015 report from the FHFA Office of Inspector General highlights the challenges of the conservatorships of Fannie Mae and Freddie Mac:

FHFA has administered two conservatorships of unprecedented scope and simultaneously served as the regulator for these large, complex companies that dominate the secondary mortgage market and the mortgage securitization sector of the U.S. housing finance industry. Congress granted FHFA sweeping conservatorship authority over the Enterprises. For example, as conservator, FHFA can exercise decision-making authority over the Enterprises’ multi-trillion dollar books of business; it can direct the Enterprises to increase the fees they charge to guarantee mortgage-backed securities; it can mandate changes to the Enterprises’ credit underwriting and servicing standards for single-family and multifamily mortgage products; and it can set policy governing the disposition of the Enterprises’ inventory of approximately 121,000 real estate owned properties. Further, the conservator’s actions are not subject to judicial review or intervention.

Oversight has not always been . . .

OIG reports have flagged shortcomings in FHFA’s governance practices as conservator for the Enterprises. These reports highlighted the following:

  • FHFA lacked written criteria and procedures for submitting and reviewing the Enterprises’ annual performance measures and year-end performance assessment data in connection with its oversight of Fannie Mae’s and Freddie Mac’s executive compensation programs.

  • FHFA lacked a formal review process for compensatory fee settlements and significant MSR transfers.

The result:

FHFA, as conservator, at times has failed to independently test the Enterprises’ decision-making and operations, and at times has failed to ensure the effective implementation of its directives.

  • The Enterprises suffered an estimated $158 million in financial harm as a result of reimbursing their servicers for excessively priced lender-placed insurance coverage.

  • Fannie Mae and Freddie Mac erroneously reimbursed servicers in the amount of $89 million and $70 million, respectively.

  • FHFA did not sufficiently verify implementation of the Servicing Alignment Initiative or evaluate its effectiveness.

  • Each Enterprise had different understandings of delegated and non-delegated authorities under the 2008 LOIs, which led to inconsistent decision-making.

But if conservatorship is problematic, its unwinding is even more so:

While there appears to be consensus that government-run conservatorships of the Enterprises are not sustainable in the long-term, there is little consensus in Congress about what the nation’s mortgage finance system should look like and what role, if any, the Enterprises should play in it. Until some resolution is achieved, the Enterprises will continue to operate under FHFA’s conservatorship, which according to FHFA Director Watt, continue to pose “significant challenges,” including serious delinquencies that have declined but remain historically high compared to pre-crisis levels; counterparty exposures; and shrinking revenues from the Enterprises’ mortgage-related investment portfolios.46 The importance of OIG’s close oversight of FHFA’s conservatorship of the Enterprises, through independent fact finding, objective analysis, and reporting, is underscored by the sheer size of the $187.5 billion taxpayer bailout of the Enterprises and their uncertain future.

— D.T.

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