Kudos To Judge Lamberth: Bubkis Hedge Fund Claims Against Freddie/Fannie Get Heave-Ho

During the last year or two a passel of crony capitalist hucksters led by hedge fund operatives Bruce Berkowitz and Bill Ackman have been attempting to pilfer upwards of $40 billion from US taxpayers via a raid on Fannie Mae and Freddie Mac. Kudos to US District Judge Lamberth whose Tuesday ruling stopped them cold.

And don't shed a tear for the hedge fund boys. Notwithstanding the collapse shown below, the FNMA stock plunge still has more to go; its real value is bubkis--- just like their claims.

FNMA Chart

FNMA data by YCharts

Like in so many other cases during the post-crisis aftermath, these hedge funds scooped-up the worthless preferred and common stock of Freddie and Fannie----expecting these penny stocks to soar as the Fed's tsunami of liquidity rekindled speculative appetites and its free carry trade financing buoyed the markets for risk assets. In this particular case, the potential jackpot was to be powerfully augmented by an expected legislative or judicial ruling that owners of these beaten down equities were entitled to their pro rata share of the surging but entirely phony profits of Freddie and Fannie.

To its credit, the Obama administration had previously recognized that absent Uncle Sam's bailout of the roughly $6 trillion of Freddie/Fannie mortgage guarantees and debentures, the junior equity securities in their capital structures would have been worthless. In fact, at the time Freddie/Fannie were essentially nationalized by the Bush Administration in September 2008, the thin layer of equity represented by these shares had been leveraged at approximately 100X, and would have been obliterated in a proper bankruptcy. Accordingly, the Obama folks had simply decided to treat the remnants of Freddie/Fannie as a wholly owned government investment fund, and swept 100% of the book profits posted each quarter.

The operative word here is "book". The fact is, the GSEs generate no economic value added whatsoever, and therefore no genuine economic profits. So the claim by Berkowitz & co that they are the victims of an unconstitutional  "taking" is laughable. There were no genuine profits to "take".

The government's quarter-end profits sweep simply represented a remittance of the implicit rental fees paid by main street mortgage borrowers for the privilege of using Uncle Sam's cheap credit. Stated differently, had the GSE's been forced to pay a risk-based premium to the Treasury for its credit backstop----- they would have generated zero profits after the comparatively trivial expense they incur in stamping "guaranteed" on the billion dollar packages of mortgages they process.

In truth, the government housing guarantee programs at Freddie and Fannie have been an abomination from the very beginning. Not only did they inappropriately subsidize home mortgages by upwards of $60 billion annually-----most of which went to affluent middle class households not entitled to taxpayer help in the first place----but they were also based on the kind of Washington artifice upon which today's rampant crony capitalism thrives. Namely, the specious claim that the GSEs are unique, creative "public-private partnerships" that enable a "secondary market" for home mortgages, and thereby remedy the alleged failure of the free market to provide cheap 30-year housing loans to the public.

In fact, the so-called secondary market for mortgages was no such thing. Freddie and Fannie have always been a de facto branch office of the US Treasury and their securities have been just another variant of treasury bonds. That finally became official when the U.S. Treasury threw them a $180 billion lifeline on the eve of the financial crisis.

The reason that became necessary, of course, is that the GSE's had been minting fabulous book profits over several decades by drastically under-reserving for losses, confident that Uncle Sam would bail them out if a crisis ever came. In fact, when the mortgage meltdown did come, Freddie and Fannie had virtually no accumulated reserves and capital and would have exposed investors to tens of billions of losses. Needless to say, the implicit "call" on the US Treasury that had always been embedded in the below market rates on Freddie/Fannie paper was instantly exercised by Wall Street's then plenipotentiary in Washington, former Goldman CEO and US Treasury Secretary Hank Paulson.

To be sure, the proper course would have been to force investors ranging from the sovereign  wealth fund of China to Norwegian fishing villages and Wall Street hedge funds to take their lumps for not reading the indentures (which contained no legal US guarantee), and to prosecute Freddie and Fannie and their executives for blatant and monumental accounting fraud. But the latter was never even contemplated owing to the beltway fiction that the GSE's are "off-budget" public-private partnerships.

This convenient scam was first invented by Lyndon Johnson to magically shrink his "guns and butter" fiscal deficits, but it has since metastasized into a giant business fairy tale---namely, that behind the imposing brick façade of Fannie Mae there is a real company generating value-added services that are the source of its reported profits.

In fact, there is nothing behind those walls except a stamping machine that embosses the signature of the American taxpayer on every billion dollar package of securitized mortgages it guarantees and on all the bonds it issues to fund a giant portfolio of mortgages and securities from which it strips the interest.

Stated differently, Freddie and Fannie typically booked 90% gross profit margins owing to the fact that they have essentially no cost of production beyond the trival expense of their automated underwriting systems and highly computerized back-office operations. Their real cost of goods would be the large provisions for losses that would be required were they not wholly guaranteed by the US Treasury.

If we wanted to have honest socialist mortgage finance, of course, a handful of GS-14s could run Freddie and Fannie out of the U.S. Treasury building. Civil servants could emboss the taxpayers' guarantee on every family's home mortgage just as proficiently as the make-believe business executives who populate the GSEs today; and in the process we could dispense with the sheer waste involved in applying GAAP accounting to the operations of a mere government bureau.

I laid this out more fully in the Great Deformation, yet the mythology about the GSE's is virtually immune to these obvious truths.  Indeed, the discourse has been so corrupted that the very speculators who were trying to raid the treasury in this instance postured themselves as the benefactor of America's middle class homeowners.

There is no viable alternative,” to Fannie Mae and Freddie Mac, Ackman said today in a Bloomberg Television interview with Stephanie Ruhle after the Sohn presentation. “Preserving the 30-year prepayable fixed-rate mortgage -- it’s like the bedrock of the housing system -- is critical. We think the only way to do it is by preserving Fannie and Freddie...... Ackman said mortgage rates would jump without the government-sponsored enterprises.

Puleeese!  If evidence was ever needed that massive statist interventions like Washington's subventions for homeownership end up generating random income distributions and windfalls to the politically mobilized, the hedge fund campaign to "rescue" Freddie and Fannie is surely it.

In an alternative political universe not corrupted by crony capitalist mythology about the elixir of homeownership, of course, there would be no need for a Treasury Bureau of Home Mortgage Finance. The decision to own or rent would be made by 115 million American households based on their best lights, not the inducements and favors of the state.

Markets would clear the interest price of mortgage debt and set credit terms and maturities consistent with the risks involved. Undoubtedly, rates would be a few hundred basis points higher and 30-year fixed rates mortgages quite rare. And like in the seemingly prosperous precincts of Germany, the home-ownership rate might be 55% or any other number not selected by pandering politicians of the type who pinned the 70% disaster on the wall during the Clinton-Bush era.

At the end of the day, having 40 million renter-households and 25 million mortgage-free owner-households provide (in their capacity as taxpayers) trillions of subsidized credit to upwards of 50 million mortgage-encumbered households is absurd. Yet it could be dismissed as just another expression of the capricious and random shuffling of income among American citizens that is the tradecraft of the Washington puzzle palace.

Unfortunately, as underscored by this attempted hedge fund raid on the treasury, the reality is not so anodyne. In order to hide this random redistribution mischief, the Treasury Bureau of Home Mortgage Finance has been gussied-up to form the simulacrum of a profit-making enterprise. In that posture, the GSEs have been repeatedly plundered by insiders like Franklin Rains, the 90 million dollar man who drove Fannie off the cliff; and by fast money stock speculators who managed to drive the combined market cap of Freddie and Fannie to the lunatic level of $140 billion during their hay-day at the turn of the century; and by the Wall Street dealers and so-called fund managers who inventory trillions of GSE debt securities in order to scalp profits from the economically pointless spread between regular treasury bonds and the GSE variant of the same thing.

All of these hundreds of billions were pocketed by adept cronies and speculators in the various debt, equity and preferred securities of the GSEs during the decades culminating in the 2008 financial crisis. Given the trauma of those events, Secretary Paulson's desperate and ill-disguised nationalization of Freddie and Fannie should have put an end to the plunder.

But it hasn't because there is no end to the zero cost-of-goods carry trades by which speculators scoop-up and fund financial assets---busted and not---during the Fed's money printing marathons. Likewise, there is no end to crony capitalist marauders like Berkowitz, who have the temerity to demand make-wholes from the state. Nor is there any shortage of K-Street hirelings---lawyers, accountants and consultants--- who are skilled at the manufacture of specious public policy rationalizations for outright thievery.

So during the last year came the patented crony capitalist rush. At the peak of the speculation, the equity shares of Freddie and Fannie had risen from 10 cents to $6, and the preferreds had erupted from $0.25 per share to $12, meaning that some speculators had garnered a paper returns of 45-60X.

And why did this revival miracle transpire? Quite simply because Berkowitz's Fairholme Capital and his posse of punters----John Paulson, Perry Capital and Pershing Square, among others---have taken turns bidding up the paper, and then laying the legal and political groundwork for overturning the Obama Administrations correct decision to sweep the profits.

For the moment, Judge Lamberth has thrown a monkey wrench into the works---at least on the judicial front. But the hedge funds are not done, and will now surely revive a legislative drive to accomplish their egregious plunder of America's innocent and unaware taxpayers.

That will come in the form of their deplorable scheme to swap these bogus Freddie/Fannie equity securities for those of a new taxpayer underwritten, mortgage guarantee stamping machine. Yet the latter has but one objective---that is, to put a statutory floor under the current plummeting share prices  of Freddie and Fannie and enable them to dicker with Capitol Hill staffs for an ultimate take-out at par($25) on the preferreds under the guise of "privatization". The larceny intended here is not modest: the payday for Berkowitz and his hedge fund posse would amount to $35 billion on toxic paper which was purchased for rounding errors.

To be sure, Berkowitz and his sharpies blather that Freddie and Fannie have now returned $230 billion to the US Treasury, thereby repaying the original $180 billion drawdown, with some change to spare. But what hay wagon do they think even the clueless officialdom of Washington rides upon?

Roughly $50 billion of that was for writing-up a "tax asset" that had earlier been written-down, owing to the fact that absent nationalization the GSEs had no prospect of booking even accounting income in the future. And the remaining $170 billion represents dividends paid to the Treasury since 2009 based on using Uncle Sam's credit card to issue the bonds and guarantees which fund the assets from which these so-called GSE dividends are scalped.

In other words, the Berkowitz Gang wants to be paid a king's ransom for ownership shares in what amounts to a bureau of the US Treasury. And yet these con men pound the table demanding that Washington exercise its "fiduciary responsibility" to distribute billions in paper profits that have not been earned and are not owed. Indeed, so shameless are Wall Street's princes of plunder that Berkowitz told a skeptical CNBC questioner last fall "we've helped before with AIG", and that he now merely seeks a "win-win" to "help with jobs, help with the economy, help with the dream of homeownership"!

That gibberish is the measure of the crony capitalist deformation that has infested the nation's financial markets and system of political governance. The obvious thing for Washington to do is close the doors at Fannie and Freddie and allow their remaining $5 trillion portfolio to run-off in the manner of any liquidation.

And, if it must subsidize home mortgage credit, just bring back the metal filing cabinets in the Treasury Building where the so-called "secondary mortgage market" was birthed in 1938. Yet what it dare not do is succumb to the bogus bombast of the punters and sharpies who troll the financial wreckage inexorably created by the Fed's serial bubble machine.

Judge Lamberth has now given Congress an opportunity to stop one of the most egregious crony capital plunders of recent times. If it doesn't, perhaps the people will find their pitchforks and torches-----one of these days.

David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.

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