The United States of America: A Banana Republic
In 1904, William Sydney Porter, the author known as O. Henry wrote the short story “The Admiral”, which was set in the imaginary country of Achuria, a small maritime country with one export: bananas. Achuria was ruled by the company that controlled the export of bananas to the rest of the world. The foundation of this tropical paradise was no longer policed by the rule of law and it became known as a “Banana Republic”. From this short story the term “Banana Republic” became synonymous with a country were the rule of law no longer applies. Paradoxically, the term is now being applied to describe the current environment pertaining to the financial crisis in the United States.
As Judge Janice Rogers Brown noted on April 15, 2016 in a passage of her dissent that analyzed the government’s treatment of Fannie Mae and Freddie Mac, “when assessing responsibility for the mortgage mess there is, as economist Tom Sowell notes, plenty of blame to be shared. Who was at fault? ‘The borrowers? The lenders? The government? The financial markets? The answer is yes. All were responsible and many were irresponsible. But that does not mean more irresponsibility is the solution’...What might serve in a Banana Republic will not serve in a constitutional [country]”. Meanwhile, during the Republican National Convention (“RNC”) on July 21, 2016, President Trump was focused on portraying a narrative of being the “law and order candidate”.
The Pendragon Fund has been looking for investment opportunities and the aftermath of the Financial Crisis, as well as the climate President Trump has created in Washington, has created potential. Shareholders may have been wronged by government action and our research suggests that the actions taken by the U.S. government putting Fannie Mae and Freddie Mac into conservatorship and then sweeping all of their profits is a case worth investigating.
Homeownership is ingrained in people’s minds as the American Dream. Citizens from Europe came to North America on the hope of eventually being able to own land. Before the Great Depression, mortgages in the U.S. looked very different than they do today. With single family home mortgages only available for a very short-term, (typically 5 years, and featured bullet or balloon payments at the end of the 5-year period mortgages were not pre-payable) refinancing was out of the question. Initial down payments were 50% and home ownership was only at 45%.
During the Great Depression home values fell over 50%, resulting in mass defaults. Defaults on real estate loans reached 25% and foreclosures were as high as 10%. Interest rates were cut but home owners were not allowed to refinance. Many building and loan societies went bankrupt. In 1933, Franklin Roosevelt created the National Housing Act which then created the Federal Housing Administration (“FHA”). The FHA offers to insure lenders against default on long-term mortgages with low down payments. The National Housing Act contained a provision to create a privatively owned National Mortgage Association that would buy the new FHA issued mortgages from lenders. This allowed banks to turn the loans back into cash.
This program reduced the risk that banks would face in originating mortgages. Down payments were reduced from 50% to 20%, interest rates were fixed, the life of the loan was 30-years and the amortized schedule was set so that at the end of 30-years the loan was paid off. Today, these features are taken for granted, but in the period after the Great Depression, Roosevelt’s plan meant that middle class families could own a home. This program also allowed the middle class the ability to use leverage to create wealth. Forced savings allowed low income citizens to accumulate wealth and home ownership became the foundation of the American Dream.
The mortgage acts as the nucleus of financial products. A 30-year loan has significant interest rate risk, prepayment risk, and credit risk. Roosevelt’s plan could not generate any interest from the private capital markets of banks and he was forced to set up a government entity, the Federal National Mortgage Association (“Fannie Mae”) to fill the critical role. Simply put, the 30-year fixed rate mortgage would not exist if the government did not create Fannie Mae.
In the 1960’s, Fannie Mae was transformed by President Lyndon Johnson under the recommendation of the Budgetary Commission into a private company whose stock could be bought and sold. If Fannie Mae was to remain a government entity, then the debt it guaranteed should have been put on the government books as debt which would increase the budgetary deficit. In 1968, President Johnson signed the Housing and Urban Development Act. Fannie Mae was given special status and the Treasury Department could buy its debt, signaling an implicit government guarantee. Fannie Mae could borrow money at rates offered to the government, an advantage that ensured a functioning mortgage market. In the early 1970’s, Wall Street introduced a new product based on the securitization of loans. This new product allowed Fannie Mae the opportunity to package all the mortgages it purchased into a single product, known as mortgage backed securities or “MBS”. MBS over time became a staple of the global fixed income market. MBS, issued by Fannie Mae, were implicitly backed by the U.S. government, international pension funds and financial institutions. Foreign governments purchased billions, if not trillions, of these securities. MBS offered a 30-year fixed rate mortgage to help workers achieve the American Dream, and evolved into a major part of global finance sold as securities with an implicit government guarantee. Simply put, the mortgage market evolved from a dependency on local banks to absorb all the risk in lending to homeowners, to a system that was implicitly guaranteed by the U.S. government and financially supported by global capital. Homeownership increased to 65%. The American Dream was achieved. Fannie Mae and Freddie Mac were the backbone of global financing in the U.S. housing market. What could go wrong?
During the Global Financial Crisis in 2008, Fannie Mae and Freddie Mac were put into conservatorship by the Bush Administration. Secretary of Treasury Hank Paulson’s thesis was these two companies needed a temporary time-out to help them rebuild capital. The assumption was that all of the mortgages that Fannie Mae and Freddie Mac guaranteed would default. The cost of protection from the government was that all of the cash flow from these entities would go to the treasury, forever. The shareholders lost everything. The government found cash flows that could finance programs that congress would not appropriate funds for. At the same time, the backbone of the U.S. housing market and the global mortgage backed security market were unable to build up any capital buffer.
The accounting of these assets proved to be extremely conservative. As the dust settled, it was found that bankruptcy rates during the period after the crisis were well within the assumptions modeled by the firms. Fannie Mae and Freddie Mac were not in a death spiral as suggested by many in the government. Shareholders who saw their rights violated sued.
Source: Financial Services Committee
On July 19, 2017, Judge Margaret Sweeney unsealed court documents produced in discovery for the lawsuit brought by Fairholme Funds in the U.S. Federal Claims Court. This lawsuit brought into question the government narrative that the companies were in a “death spiral”. The Treasury and the Federal Housing Financial Agency (“FHFA”) were fully aware that Fannie and Freddie were about to experience a surge in profitability well before the net worth sweep was announced. In addition, a study done by BlackRock suggests that “long-term solvency does not appear endangered, [and that BlackRock does not] expect Freddie Mac to breach capital levels even in a stress case”. Treasury Secretary Paulson forced the company into a conservatorship, a time out, while not satisfying any of the 12 requisites for that action as set out in the housing and economic recovery act, meaning the companies should not have been put into conservatorship. Through the use of write downs of deferred tax assets, it was made to appear that the companies were in a death spiral, but after two years and the accounting procedure was about to be reversed, the Obama Administration changed the rules of the game, now collecting all the net worth of the companies forever. By coincidence, this was at the same time that the Affordable Care Act and Obamacare desperately needed money. The once conspiracy theory now has documentation to support its thesis. Will the plaintiff win in court? If we live in a world where the rule of law is the basis for our society, then yes. However, we could be living in a world where we are evolving into a “Banana Republic”.
Treasury Secretary Steven Mnuchin has stated that there is a goal to privatize Fannie Mae and Freddie Mac, however, privatization would require private capital to be successful. Our simple thesis is that no new private capital will invest in these entities until the existing shareholders are compensated for the past 10 years. If President Trump is truly a “law and order” President, then the past wrong will be righted. Investment in the common shares of Fannie Mae and Freddie Mac offers a compelling risk reward opportunity.
In a report released by the RNC on September 14, 2017, it was stated that “the RNC recognizes the sanctity of property rights in America, and acknowledges the need to resolve the outstanding claims of Fannie Mae and Freddie Mac shareholders in a manner than honours and respects the rule of law governing the rights of corporate stock owners”.
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