Money Stuff: Fannie and Freddie Get a Guarantee

I’m sorry but this is a very funny way to do financial regulation:

President Donald Trump said that the US government would retain guarantees and an oversight role over Fannie Mae and Freddie Mac even as he pursues a public offering for the mortgage giants.

“I am working on TAKING THESE AMAZING COMPANIES PUBLIC, but I want to be clear, the US Government will keep its implicit GUARANTEES, and I will stay strong in my position on overseeing them as President,” Trump wrote Tuesday night in a post on his Truth Social platform.

The companies, which play a crucial role in the market for mortgage-backed securities, have been under government conservatorship since the 2008 financial crisis. Fannie and Freddie have both returned to steady profitability, with earnings being retained. Shares of both surged last week when Trump said he was considering a public offering. …

The president’s post appeared to reduce the risk that the government, as part of privatizing Fannie and Freddie, would leave the two GSEs without a financial backstop. Had it done so investors who participate in the $9 trillion MBS market for agency mortgage bonds might have demanded higher yields to own the securities, ultimately pushing mortgage rates higher. Mortgage rates could still increase in other privatization scenarios but potentially by smaller amounts.

For many years, Fannie and Freddie had what everyone referred to as “implicit guarantees” from the US government. Everyone, that is, except Fannie, Freddie, and the government. Because … I just … because if you say it’s a guarantee it’s not implicit? Like that’s what “implicit” means? And so every Fannie and Freddie mortgage-backed security offering said, right on the cover, that the securities were “not guaranteed by the United States and do not constitute a debt or obligation of the United States or any agency or instrumentality thereof.” 

And then they collapsed in 2008 and the government did in fact step in to guarantee their liabilities. That’s what an implicit guarantee is: You say there’s no guarantee, but there is. 

We talked in January about the renewed interest in re-privatizing Fannie and Freddie, and I went through the tortured history and the possibilities for returning them to private hands. I won’t go through that all again here, though I have a feeling that I will soon enough; the amount of social media posting about this has ticked up, and maybe something will happen. For now, though, the point is that, if they leave government control, then one of three things has to happen:

1. They won’t have a government guarantee: They’ll guarantee mortgages themselves, with their own balance sheet, like ordinary (but giant) insurance companies; they’ll need to have fortress balance sheets and AAA ratings to make that guarantee credible. That will require a lot of capital, and might also lead to higher mortgage rates if the market doesn’t trust their guarantees entirely as much as it trusts the government. [1]
2. They will have a government guarantee: They will take a first-loss risk with their capital, [2]  but it will be made explicit that, in the worst case, the government will back the mortgages that they guarantee. US conforming mortgages will continue to be credit-risk-free. There is an economic problem with this: The government will be guaranteeing the debts of regular shareholder-owned companies, so one could worry about moral hazard and about favoritism; the government would presumably charge a fee for that guarantee, but there would be debate about the fair level of the fee. There is also a possible accounting problem: The reason that the government historically avoided (explicitly) guaranteeing Fannie and Freddie’s debts was that doing so would make them government debt, adding trillions of dollars to the US national debt and running into problems with the debt ceiling. 
3. They will go back to what they were like in 2007: not explicitly guaranteed by the government (so not adding to government debt) but, you know, wink wink. An implicit guarantee.

The third option seems bad and untidy, but also perhaps the most practical outcome. No government backstop of the multitrillion-dollar mortgage market seems, at this point, a little optimistic: the re-privatized Fannie and Freddie will be the definition of “too big to fail,” and it would be hard to set up a structure to absolutely prevent future bailouts. [3] The explicit government guarantee is optically difficult due to the accounting and moral-hazard problems. But “there’s no government guarantee, Fannie and Freddie will be very well capitalized and carefully regulated to make sure that they don’t fail, but wink wink” might get most of the benefits of a pure private-capital solution, but with the financial stability and low mortgage rates of a government backstop.

How do you communicate “wink wink,” though? At this point, after Fannie and Freddie have failed and been bailed out once and are now perhaps being returned to profit-seeking private hands, when any sort of further backstop will be controversial? It’s possible that a random Truth Social post from Trump is a pretty effective approach. Then you go re-privatize Fannie and Freddie, they raise a lot of capital, they’re carefully regulated, etc., and the prospectuses all say “not guaranteed by the United States.” But everyone has read the Truth Social post and thinks “ehh Trump doesn’t mean that.” And then they come roaring back and become too-big-to-fail and the guarantee — expressed only in this one post — becomes an entrenched expectation and every future president knows that doing anything to walk it back would cause the mortgage market to seize up.

And then in 2075, if Fannie and Freddie collapse again, the future treasury secretary will say “well obviously the market has spent the last half-century assuming that Fannie and Freddie’s debt was government-guaranteed, so it is treated as super-safe and used as collateral everywhere, and if we don’t bail it out the entire financial system will collapse.” And the future president will say “why did the market assume that if the debt says on the front page that it is not guaranteed by the United States”? And the treasury secretary will say “well Donald Trump posted that it was implicitly guaranteed.”

Meanwhile if Fannie and Freddie collapse in, like, 2027, and the government doesn’t bail them out, could a creditor sue the government on the basis of this Truth Social post? Is it … is it … is it securities fraud? If Fannie and Freddie issue debt that says “not guaranteed by the United States,” but Donald Trump has posted on Truth Social that the debt is “implicitly guaranteed by the United States,” can’t investors reasonably rely on that? You sue and go to court and the government says “well the securities say on the front page that they’re not guaranteed, I don’t see how you could have been confused,” and you say “but they were implicitly guaranteed, and I know because President Trump said so explicitly.” 

The basic situation is that a corporation has revenue, and then it pays its expenses (salaries, etc.), and what’s left over is net income. And, in the US, the corporation pays 21% of its net income to the federal government as income tax; the rest belongs to its shareholders.

Meanwhile the situation for a big US university is that it has an endowment, and the endowment generates investment income, and if the university is big and rich enough it pays 1.4% of that income to the federal government as an excise tax. And that might change to 21% under the new tax bill. The Wall Street Journal has a story about the potential effects:

If the bill passes, it would lift the tax on investment income for some of the biggest endowments from 1.4% to 21%, in line with what U.S. corporations pay. Other schools would see their taxes jump by significant amounts as well.

Under the new tax plan, universities might pull back from strategies that regularly generate short-term gains and shift money into other investments such as private equity, which generally don’t realize gains for years.

The Wall Street Journal spoke to officials at eight private universities and colleges about their thinking on investment strategies in light of the bill. They largely said they would begin using a new lens of tax-efficiency as they think about how to direct—and redirect—their billions. …

Several endowment chiefs said they might consider moving part of their portfolio to indexes, where they could easily pull money from if their schools need cash, and away from active-trading strategies that could generate tax liabilities. Several said certain hedge-fund strategies could be less attractive going forward because they could generate tax liabilities if they frequently realize gains.

For endowments able to shift more of their dollars into longer-term investments, directly investing in private companies or co-investing with private-equity firms could be attractive, some investors said. Those structures have the benefit of not requiring endowments to fund capital calls for years.

It is a big shift. Much of the world of asset management is organized around the facts that (1) some investors are taxable and some are not taxable, (2) you do different stuff if you are trying to maximize pre-tax or after-tax returns, and (3) some of the most adventurous non-taxable investors are, like, Yale and Harvard. If they became taxable, the range of viable adventurous investing strategies will change.

Notice, though, the discrepancy in my first two paragraphs. Corporations pay a tax of 21% on the difference between their revenue and their expenses. Universities would pay a tax of 21% on their investment income, with, as far as I can tell, no ability to deduct regular operating expenses. [4]  A corporate executive’s salary is tax deductible, but a university professor’s salary isn’t. “The 21% rate matches the corporate tax rate, but the effective tax rate on some schools could in some cases be higher than what for-profit corporations pay, as nonprofits can’t claim certain deductions the way corporations can,” the Journal notes.

That does suggest the germ of a trade, doesn’t it? At big universities, endowment income largely pays for salaries for professors, administrators, football coaches, etc. Those salaries presumably would not be deductible against an endowment excise tax.

It is not that uncommon for professors at big research universities to work on topics — biopharmaceuticals, artificial intelligence, whatever — that have commercial potential. Sometimes there are arrangements: Work that a professor produces in her lab at the university, using the university’s resources and her graduate students’ work, can be commercialized, with some deal in which the professor and the university and a for-profit company all share in the value. And then if it becomes hugely valuable the university gets a big capital gain, in its endowment, somewhere down the line.

In the current framework, a big capital gain is good, for the university. In a 21% excise tax framework, it is less good. (It’s 21% less good.) In the excise-tax framework, $100 of endowment income would pay for $79 of professors’ salaries. But if a for-profit corporation were to pay $100 of professors’ salaries, that payment would be tax-deductible (for the corporation). And so the trade is something like:

1. The for-profit Chemistry Corporation hires all of Harvard’s chemistry professors, sets them up with labs, buys their equipment and pays their graduate students. Let’s say the operating budget of the chemistry department is $8 million, a number I just made up. The Chemistry Corporation takes over the responsibility for that budget.
2. Harvard invests $100 million in the Chemistry Corporation and gets 95% of the stock; the professors get the rest.
3. The Chemistry Corporation re-invests that cash with whoever currently manages Harvard’s endowment, targeting an 8% annual return.
4. The Chemistry Corporation makes $8 million a year on its investments, and pays $8 million a year in operating expenses, for a net income of $0.
5. It pays no taxes, because it has no net income.
6. Harvard doesn’t pay any excise tax on the return on its $100 million Chemistry Corporation investment, because that return is zero.
7. Harvard also rents office space to the Chemistry Corporation (not taxable, because not investment income?) and pays, you know, $1 a year for the Chemistry Corporation to provide teachers for undergraduate chemistry classes.
8. I guess if they discover a valuable new chemical that’s gravy.

There is a precisely analogous approach for the Harvard Professional Football Team Inc., though it could also earn revenue from ticket sales. Or for the Classics Corporation, which probably couldn’t.

This is extremely not tax advice, but you get the idea, right? On the current model, Harvard earns an endowment income, which it uses to pay its expenses. In a world of 21% excise tax, there would be a 21% slippage between the endowment income and the paying of expenses. But Harvard’s endowment income is generally less than its expenses. If you could pay the expenses before income becomes endowment income, you would avoid the slippage: $1 of expenses would reduce endowment income by $1. The big university endowments are already adventurous long-term investors, and “directly investing in private companies ... could be attractive” for them. Perhaps for the tax deductions.

I have been writing for months now about the fact that the US stock market will pay $2 for $1 worth of crypto. Any company that announces “we’re doing a crypto treasury strategy where we will spend $100 million to buy Bitcoin” will see its market capitalization shoot up by at least $200 million. We talked yesterday about a company, SharpLink Gaming Inc., that added $2.5 billion of market cap by announcing it would buy $425 million of Ethereum. I wrote:

This keeps working? ... The stock market just consistently loves brand-new crypto treasury companies. I have no explanation for this. “It looks a little bit like crypto keeps playing a prank on the stock market, and the stock market keeps falling for it,” I wrote, a month ago, and it looks a lot more like that now.

Well we finally found the limit! We finally found a company that announced it would buy Bitcoin and saw its stock go down. You will never guess what it is. I mean, you probably will. It’s Trump Media & Technology Group:

Trump Media & Technology Group Corp., the company behind Truth Social, agreed to sell around $1.5 billion in stock and $1 billion in convertible bonds to buy Bitcoin for its treasury.

The company’s shares fell as much as 9.8% on Tuesday after rallying premarket following a Financial Times report on its plans to raise capital to spend on cryptocurrencies.

Trump Media is the latest company connected to President Donald Trump to invest in crypto. PSQ Holdings, which his son Donald Trump Jr. sits on the board of, also announced plans on Tuesday to explore a digital asset treasury strategy. They join numerous other companies in following the model that Michael Saylor created at Strategy, by using equity and debt offerings to fund Bitcoin purchases.

Trump Media will add Bitcoin to its balance sheet along with its current cash, cash equivalents and investments, which were worth $759 million at the end of the first quarter, according to a filing Tuesday.

Here are the filing and the press release, which says that “Yorkville Securities, LLC and Clear Street LLC acted as Co-lead placement agents,” which may or may not mean they were the lead investors. (Yorkville Advisors previously did an equity line of credit for Trump Media.) The investors agreed to buy stock at $25.72 per share, equal to Friday’s closing price; the stock closed yesterday at $23.05. Loosely speaking, $1.5 billion of Bitcoin at Trump Media is worth $1.34 billion to the stock market. 

What happened? I think — I hope — that I am partially joking when I say “the stock market will pay $2 for $1 worth of crypto.” I do not mean that giant institutional equity managers want to buy crypto, but can’t buy it directly or in the form of exchange-traded funds or futures, so they have to buy it in the form of shares of crypto treasury companies, which pushes up the price of those shares. I think there’s probably a little of that — MicroStrategy Inc. has some institutional holders — but that’s not why SharpLink added $2.5 billion of market cap yesterday. Instead, the obvious appeal of the crypto treasury strategy for most small US public companies is probably along the lines of “nobody is paying attention to our tiny company, but if we announce we’re buying a big pot of crypto, retail traders will get excited and overpay for our stock.”

And then that doesn’t work for Trump Media because, you know, retail traders already got excited and overpaid for its stock. There is only so much attention that anyone can pay to Trump Media, and just doing more stuff — even otherwise pretty reliable stuff like announcing a Bitcoin treasury strategy — is not really additive. The pool of retail investors who could get excited about Trump Media stock, but were not already excited about Trump Media stock, is small, and the Bitcoin treasury pivot doesn’t seem to have found any more of them.

Various other theories are possible. One reason that you might ascribe a premium to a Bitcoin in the hands of MicroStrategy is that you might think that MicroStrategy will do some cool stuff with the Bitcoin. I don’t really know what that is, but the big crypto treasury companies tend to talk about a holistic financial strategy, investor education, and otherwise doing stuff with crypto. We talked last month about Twenty One, another big Bitcoin treasury company, which “intends to develop a corporate architecture capable of supporting financial products built with and on Bitcoin.” Similarly Trump Media has … some sort of plan:

Trump Media’s CEO and Chairman Devin Nunes said, “We view Bitcoin as an apex instrument of financial freedom, and now Trump Media will hold cryptocurrency as a crucial part of our assets. Our first acquisition of a crown jewel asset, this investment will help defend our Company against harassment and discrimination by financial institutions, which plague many Americans and U.S. firms, and will create synergies for subscription payments, a utility token, and other planned transactions across Truth Social and Truth+. It’s a big step forward in the Company’s plans to evolve into a holding company by acquiring additional profit-generating, crown jewel assets consistent with America First principles.”

It’s possible that you could think “a Bitcoin in the hands of MicroStrategy is worth two Bitcoins, because Michael Saylor’s plans are good, but a Bitcoin in the hands of Trump  Media is worth 0.9 Bitcoins, because Devin Nune’s plans are so-so.”

Ha okay we found another one:

GameStop fell as much as 8.6% after it announced it bought 4,710 Bitcoin tokens. This is the video-game seller’s first Bitcoin purchase after it announced in March that it plans to add the cryptocurrency as a treasury reserve asset, following the model set out by Michael Saylor’s Strategy.

At current prices, GameStop’s Bitcoin holdings are worth over $507 million.

Right, again, GameStop Corp. got all the attention already; throwing in some Bitcoin doesn’t move the needle.

I don’t know, if you are kidnapped and held in an eight-bedroom NoLIta townhouse that rents for “at least $30,000 a month,” and then tortured for three weeks “in a scheme to get [your] Bitcoin password,” one thought that might cross your mind is: “How many other people did this guy torture into giving up their Bitcoin passwords in order to be able to afford this sweet house?” I mean, what:

A 37-year-old cryptocurrency investor was charged on Saturday with kidnapping a man and beating, shocking and torturing him for weeks inside a luxury townhouse in downtown Manhattan, all in a scheme to get the man’s Bitcoin password, the authorities said.

The crypto investor, John Woeltz, was taken into custody on Friday after the man managed to escape the townhouse and notify the police. …

The abuse continued for about three weeks until Friday morning, when the man managed to escape and alert the traffic agent. ...

Two butlers who worked at the home were also present and agreed on Friday to be interviewed by the police, the official said.

I have not found a ton of information about Woeltz online, and he does not yet seem to have his own crypto treasury company, so I’m not entirely sure what makes him a “cryptocurrency investor.” (Though the New York Post reports that he and an alleged accomplice were “known for dropping $100,000 in a single night partying it up at an exclusive erotic nightclub.”) But I would naively have assumed that if you are renting a NoLIta townhouse you are probably rich enough that you do not need to kidnap and torture people for their Bitcoins. But “behind every great fortune is a crime,” I guess, and one way to become a crypto investor is to torture some passwords out of other crypto investors.

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