"Soros Put" Hits Record As Billionaire's Downside Hedge Rises By 154% in Q4 To $1.3 Billion

A curious finding emerged in the latest 13F by Soros Fund Management, the family office investment vehicle managing the personal wealth of George Soros.

Actually, two curious findings: the first was that the disclosed Assets Under Management as of December 31, 2013 rose to a record $11.8 billion (this excludes netting and margin, and whatever one-time positions Soros may have gotten an SEC exemption to not disclose: for a recent instance of this, see Greenlight Capital’s Micron fiasco, and the subsequent lawsuit of Seeking Alpha which led to the breach of David Einhorn’s holdings confidentiality).

The second one is that the “Soros put”, a legacy hedge position that the 83-year old has been rolling over every quarter since 2010, just rose to a record $1.3 billion or the notional equivalent of some 7.09 million SPY-equivalent shares. Since this was an increase of 154% Q/Q this has some people concerned that the author of ‘reflexivity’ and the founder of “open societies” may be anticipating some major market downside.

Then again, as the chart below shows, as a percentage of total AUM, the put position rose to 11.1% of his notional holdings. By way of reference, as of June 30 2013, his SPY put may have had a smaller notional value, but it represented both more shares (7.8 million), and was far greater as a % of AUM, at 13.5%.

Finally, remember that what was disclosed on Friday is a snapshot of Soros’ holdings as of 45 days ago. What he may or may not have done with his hedge since then is largely unknown, and since there are no investor letters, there is no way of knowing even on a leaked basis how the billionaire has since positioned for the market.

That said, while the SPY puts are most likely simply a hedge to his overall bullish exposure, perhaps more notable was the $25 million call position that Soros put on the gold miners ETF which has been beaten into oblivion over the past year, in the fourth quarter. Does Soros think that it is finally the miners’ turn to shine?


    



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“Soros Put” Hits Record As Billionaire’s Downside Hedge Rises By 154% in Q4 To $1.3 Billion

A curious finding emerged in the latest 13F by Soros Fund Management, the family office investment vehicle managing the personal wealth of George Soros.

Actually, two curious findings: the first was that the disclosed Assets Under Management as of December 31, 2013 rose to a record $11.8 billion (this excludes netting and margin, and whatever one-time positions Soros may have gotten an SEC exemption to not disclose: for a recent instance of this, see Greenlight Capital’s Micron fiasco, and the subsequent lawsuit of Seeking Alpha which led to the breach of David Einhorn’s holdings confidentiality).

The second one is that the “Soros put”, a legacy hedge position that the 83-year old has been rolling over every quarter since 2010, just rose to a record $1.3 billion or the notional equivalent of some 7.09 million SPY-equivalent shares. Since this was an increase of 154% Q/Q this has some people concerned that the author of ‘reflexivity’ and the founder of “open societies” may be anticipating some major market downside.

Then again, as the chart below shows, as a percentage of total AUM, the put position rose to 11.1% of his notional holdings. By way of reference, as of June 30 2013, his SPY put may have had a smaller notional value, but it represented both more shares (7.8 million), and was far greater as a % of AUM, at 13.5%.

Finally, remember that what was disclosed on Friday is a snapshot of Soros’ holdings as of 45 days ago. What he may or may not have done with his hedge since then is largely unknown, and since there are no investor letters, there is no way of knowing even on a leaked basis how the billionaire has since positioned for the market.

That said, while the SPY puts are most likely simply a hedge to his overall bullish exposure, perhaps more notable was the $25 million call position that Soros put on the gold miners ETF which has been beaten into oblivion over the past year, in the fourth quarter. Does Soros think that it is finally the miners’ turn to shine?


    



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Judge Napolitano on Lincoln, Wilson, and Roosevelt; Amity Shlaes on Coolidge and FDR

On
Friday’s special President’s Day episode
of
The Independents
, Fox News
Senior Judicial Analyst
and Reason.com
columnist
Andrew Napolitano celebrated the holiday by sharply
criticizing the revered president Abraham Lincoln:

For more on Napolitano’s Civil War-related commentary, consult
his
Dred Scott’s Revenge: A Legal History of Race and Freedom in
America
. The judge’s latest book,
Theodore and Woodrow: How Two American Presidents Destroyed
Constitutional Freedom
, was subject of another
Independents segment:

Also comparing presidents was Amity Shlaes, author most recently
of
Coolidge
, and also
The Forgotten Man: A New History of the Great Depression
:

Reminder: All these videos and many score more are available on
The Independents’ playlist
page
.

Nick Gillespie interviewed Shlaes for Reason in
2007
, and Napolitano for Reason.tv in
2011
. The judge also got cross-examined by
Brian Doherty
in 2007, and Damon Root in 2010.

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A. Barton Hinkle on When Eminent Domain Is Just Theft

Eminent domainWhen the government seizes
private property, it has to meet two conditions spelled out in the
Fifth Amendment: The property must be taken for public use, and the
government must reimburse the owner with just compensation.
Starting around the middle of the last century, “public use” became
“public purpose.” Then came the 2005 Kelo case,
in which the town of New London, Conn., took private property to
give it to other private interests it hoped would use the land
better, and the Supreme Court said that was OK. Reaction to
Kelo was ferocious, and sparked reform. But,
points out A. Barton Hinkle, government bodies often will take
private property for genuinely public uses, such as a road—and then
try to stiff the owners, especially if they don’t take the first
offer that’s put in front of them.

View this article.

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It ripped me up inside to see this kid in jail

February 17, 2014
En route from Buenos Aires, Argentina

On the tail end of my Army career over a decade ago when I was still living in the Land of the Free, I used to be a volunteer for the Big Brothers / Big Sisters program.

If you’ve never heard of it, BBBS is a non-profit that temporarily matches up at-risk youth with responsible mentors in an effort to provide kids with positive role models.

When I first enrolled, the administrators linked me up with a kid from the inner city just hitting his ‘tween’ years. I’ll call him “DJ”.

DJ was great. Despite living in one of the most violent, crime-infested areas of Dallas, he had managed to keep a positive attitude on life. He was always smiling, and polite.

And unlike a lot of kids from his area who aspired to be either drug dealers or professional basketball players, DJ wanted to be in real estate sales.

(I used to encourage this by driving him around on the weekends looking at open houses and property listings, trying to teach him the valuation methods that I had picked up over the years.)

Eventually, life got in the way. My business interests and personal philosophy had always been pulling me overseas. And my father (the primary reason I had been living there to begin with) had passed away after a terrible bout with cancer.

DJ and I saw less and less of each other. And in our periodic phone calls, it became clear that he was changing. For the worse.

By the end of high school, DJ had hooked up with the wrong crowd. The constant influence of other youth had a powerful effect on him. And with a father in prison and his mother barely at home, he quickly got pulled into a darker world.

His entire personality was changing. It was as if he had become a completely different person. Gone was the happy kid with solid, realistic aspirations and a drive to succeed. DJ had become a thug, respecting only violence, ignorance, and wanton cruelty to other human beings.

Right after his 18th birthday he was arrested for a whole slew of felonies– and was just old enough to be tried, convicted, and sentenced as an adult.

The last time I saw him I barely recognized him. It was sad… really ripped me up inside.

This story is far too common; I’m sure many of our readers have been in similar situations, watching people they once cared about descend into a chaotic downward spiral.

I’ve been thinking about this over the past few days during my time in Argentina. Because nations, like people, can enter a downward spiral from which they become completely unrecognizeable.

The Economist recently did a great spread on Argentina, explaining how this country– this city– used to be one of the greatest in the world.

In its heydey, Buenos Aires was considered among the wealthiest, most opulent places in the western hemisphere.

A century ago in 1914, GDP per capita in Argentina was higher than in most of Europe, and its economic growth outpacing even the flourishing United States.

And while the rest of the world blew itself to smithereens in the Great War, Argentina very smartly remained neutral.

By 1918, Argentina was one of the only prosperous, debt-free nations left. And the consequent surge in exports to support all the reconstruction in Europe resulted in a heady economic boom.

But that was then. Today is a different story.

Decades of utterly destructive corruption, debt, and absurd economic centralization have taken an irreversible toll on the country and its economy.

Despite its massive potential, abundant resources, huge population, and culturally-ingrained business prowess, Argentina has become a pitiful shell that continually vaccilates into the the 3rd world.

And people here have had their liberties and livelihoods ravaged by a government that has imposed price controls, capital controls, media controls, and people controls.

They have nationalized private pensions, confiscated private assets, jailed opposition, spawned a currency crisis, and corrupted public institutions.

All of this has devastated a once rich culture. Theft, deceit, and coercion are all now unfortunately pervasive. Crime and malfeasance have become the means of survival for a substantial portion of the population.

Like DJ, this place is hardly recognizable when compared to its former greatness– the result of a long, steady decline punctuated by a sudden collapse.

Regrettably there are a number of ‘rich’ Western nations in this cycle as well. And a great many people are waking up each day with this realization thinking “This is NOT the country that I grew up in…”

But this IS what happens after decades of poor choices: Too much debt. Too much war. Too much money printing. Too much regulation.

Just as people in decline enter a vicious cycle where the consequences of their actions begin to feed on each other, nations too reach a point of no return– a bifurcation point where the decay becomes exponential.

And once they reach this point, the trend becomes a one-way decline where they must first hit rock bottom before being able to climb out.

If you’re not willing to be pulled into that spiral, I’d encourage you to consider your own situation.

If you live, work, bank, invest, own real estate, structure a business, etc. all in the same country… and that country is on an obvious decline that you can feel in your gut, then you are taking serious, serious risks with your livelihood.

The oppressive controls employed by the Argentine government provide the perfect case study of what happens to people who ignore their instincts and trust their politicians.

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How Healthy Is The Real Estate Market?

Submitted by Ramsey Su via The Acting-Man blog,

The strength of the real estate market should not be measured by price appreciation, or the number of new and existing home sales. It should be measured by the support of underlying fundamentals and whether they can help to withstand economic cycles without policy makers having to go hog wild just to avoid a total collapse.

How healthy is the real estate market today?

 

The Subprime Majority.   Recently, I came across a report by the Corporation for Enterprise Development (CFED) titled Assets and Opportunity Scorecard.  Some of their findings are quite interesting.  According to the CFED Scorecard, 56% of all consumers have sub-prime credit.  Sub-prime is "earned". A consumer has to miss a few payments, or default on a loan or two to earn that status.  These 56% cannot, or should not, be taking on more debt, especially a large debt like a mortgage.  They may also be struggling with a mortgage that they should not have taken out in the first place.  

Liquid Asset Poor.  CFED found that 44% of households in America are Liquid Asset Poor, defined as having saved less than three months of expenses.  As one would expect, 78% of the lowest income households are asset poor, but 25% of middle class ($56k to $91k) households also have less than three months of expenses saved.  Pertaining to real estate, the report suggests that there are little savings to buy and a small cushion for changes, such as job loss.

Income Inequality.  The Center for Household Financial Stability of the St. Louis Fed recently released a study titled Inequality, the Great Recession, and Slow Recovery.  Skip the 43 pages of academic mumbo jumbo and you will find half a dozen of very simple and informative charts, such as the two below.   I will leave the inequality debate to others.  With regard to a real estate stress test, it appears that households are not exactly well prepared to weather even minor economic setbacks. 

 

 


 

debt-income ratios

Debt-income ratios by income groups – click to enlarge.

 


 

Net-worth-to-disposable income

Net worth to disposable income by net worth groups – click to enlarge.

 


The Federal Reserve is Spent.  QE1, 2 and 3 all involved the purchase of agency MBS.  In January 2014, the FOMC announced that it will decrease debt purchases by another $10 billion, from the original $85 billion to $65 billion per month, $30 billion of which is supposed to be for agency MBS.  That appears to be all talk.  For the first 6 weeks of 2014, the Fed has already purchased $74.7 billion, or $54 billion per month.  They are not only continuing the QE3 purchases, they are still replenishing the prepaid holdings from QE1 and QE2.  Mortgage rates are not responding anymore.  Though somewhat stabilized, the current rate (30yr) is still a full percent above the low recorded before QE3 (see the table below from Mortgage News Daily).  

 


 

latest rates



Mortgage rates from MND's daily survey – click to enlarge.

 


 

Furthermore, Fed members are only kidding themselves if they think they can ever tighten monetary policy.  The national debt is at $17.3 trillion and growing at about $700 billion this year.  The cost of financing this debt, per the Treasury, was $415.7 billion in 2013, crudely estimated at an average rate of about 2.5%.  At the moment, the 3 months bill is at less than 0.2% interest, while the 10 year note is only at 2.75%.  If the cost of financing this debt were to increase by just 1%, it would cost the Treasury $173 billion more a year.  There is no way that the dovish Fed chair Yellen would even dream of doing that.

Therefore, the risk of monetary policy is not whether the Fed will tighten, but rather what it can do to repeat a 2008 style bailout. In other words, the Fed as a safety net is full of holes that re big enough for an elephant to pass through.

Exhausted Government Intervention.  The FHFA just announced that HARP has reached the three million mark.  We are no closer to reforming Freddie and Fannie than when they were put under conservatorship over five years ago.  Numerous State and Local Governments have deployed their own foreclosure prevention laws and ordinances.  The Consumer Finance Protection Bureau has created a mountain of bureaucratic red tape, adding compliance costs to the mortgage industry while providing questionable benefits to the consumer.  The  FHA is now pushing for lending to borrowers with credit scores as low as 580  only one year after major financial catastrophes such as foreclosure.

In conclusion, the reason I remain bearish on real estate is that when the noise is filtered out, the market has only survived by means of an unprecedented amount of intervention.  This dependency is not only unhealthy, its stimulating effect is now fading.  If real estate prices cease to appreciate, the market will suffer, same as it did when the sub-prime bubble burst in 2006/2007.  The Fed has already gone all in and there is little left it can do.  Washington can always create a new set of laws to further erode private property rights as we knew them.  Ironically, price appreciation is also not the answer, as it will just widen the income equality gap, turning would-be home owners into rent slaves of Wall Street's fat cats.  It may be best for the market to freeze for an extended period and let consumers catch their breath.


    



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Don't Cry for the Shareholders of Fannie Mae and Freddie Mac

Yesterday in The New York Times, columnist Gretchen Morgenson confirmed that the US Treasury has no intention of returning the mounting profits of the federally chartered housing agencies, Fannie Mae and Freddie Mac, to shareholders. In her fine comment, “The Untouchable Profits of Fannie Mae and Freddie Mac,” she reveals that Treasury Secretary Tim Geithner approved a policy that ensures that the “existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.”

http://t.co/C6g5Xo5pIz

A number of people have expressed shock and outrage at this shabby treatment of the common shareholders of Fannie and Freddie.  In a post on Twitter in response to a tweet from your humble blogger, former FDIC Chairman Sheila Bair noted: “No sympathy for GSE shareholders here, but this is punitive compared to how AIG, Citi shareholders were treated.”

And of course Chairman Bair is right.  The common shareholders of AIG and Citigroup were not wiped out when these organizations received government bailouts under the doctrine of “too big to fail.” 

Our friend Nom de Plumber, who formerly worked at the Fed of New York and now makes a living in the risk management world, is similarly outraged:  

“If Treasury was so uncertain of GSE future, as it just stated, why did it need to seize surreptitiously such unforeseeable earnings, especially with zero public policy governance and disclosure?  Either liquidate under receivership, or conserve for debt and equity claimants under conservatorship. Treasury did half and half, skimming the earnings but keeping the liabilities off the US balance sheet. It was a revenue grab, violating the Constitution…  The core issue is following the asset conservation and shareholder disclosure rules which you set for others to meet.   Because the GSE are public shareholder companies, their governance is not exempt from federal investor-protection laws.”

Morgenson notes that the public disclosure from Fannie does not mention the Treasury’s intention to retain the earnings of the GSEs for the benefit of the US taxpayer indefinitely.  Freddie, on the other hand, does disclose that Treasury “has indicated that it remains committed to protecting taxpayers and ensuring that our future positive earnings are returned to taxpayers as compensation for their investment.”

There are now a raft of lawsuits pending against the US Treasury, both by common shareholders and investors in the preferred securities of Fannie and Freddie.  All follow the logic of Nom de Plumber and Morgenson, who see the actions of the Treasury as somehow unfair.  The lawsuits seek restoration of earnings and damages.  But while you may be able to justly criticize the Treasury for hypocrisy and inconsistency when it comes to federal securities laws applicable to private corporations, I am not sure that such arguments can be successfully made against agencies of the federal government. 

First let’s consider why Secretary Geithner chose to support a policy of confiscation of the earnings of the GSEs.  First and foremost, Geithner wanted to cripple Fannie and Freddie financially in order to prevent them from being restored to their former status in Washington.  For those who have not read Morgenson’s 2011 book which she co-authored with my friend Josh Rosner, Reckless Endangerment, the GSEs were the tail that wagged the dog of official policy on housing in Washington for years.  

By putting in place the tough agreement whereby the US Treasury injected preferred capital into the GSEs and in return has the right to confiscate all earnings of Fannie and Freddie indefinitely, Geithner sought to cripple these institutions as a political matter.  I rather agree with his judgment, but wish that he had put the two GSEs into receivership during the crisis.  With the higher fees put in place under the conservatorship, Fannie and Freddie look really profitable, at least in a nominal sense.  But if those profits are adjusted for the risk the GSEs take on housing, there are no profits.

Geithner told Congress in 2011: “The Administration is committed to a system in which the private market – subject to strong oversight and strong consumer and investor protections – is the primary source of mortgage credit.”  But the reality is that the U.S. government is the only entity that is willing and able to truly underwrite the risk of the multi-trillion dollar housing market.  

As we saw during the housing boom of the 2000s, when for a brief couple of years private investors did support a large chunk of the mortgage finance market, as soon as the true risks were revealed the private capital ran for the door.  Even commercial banks are unwilling to support more than a tiny fraction of the housing sector’s overall risk with their own capital.

In his book The Death of Liberalism, R. Emmett Tyrrell notes that during the chaos following the 2008 subprime market collapse; “Some institutions went down in flames, and the government backed institutions, Fannie and Freddie, went hat in hand to the taxpayer.”  Chairman Bair is right when she notes that the shareholders of AIG and Citigroup were treated better than are the shareholders of Fannie and Freddie, at least insofar as their ability to benefit from the financial recovery of these firms. But the key point to take away from that comparison is that the GSEs are not private corporations chartered under state law.  

In the United States, the roots of the subprime crisis of 2008 and the political reaction thereto stretch back to the founding of the republic.  In a legal sense, the power of the federal government to regulate finance begins with the 1819 Supreme Court decision establishing supremacy of federal law over conflicting state law.  In McCulloch v. Maryland, the Supreme Court settled a dispute that arose when Maryland sought to tax The Second Bank of the United States, which that was seen as endangering Maryland’s state banks during the depression of 1818.  The landmark Supreme Court decision confirmed that the Government of the Union, though limited in its powers, is supreme within its sphere of action.  The Court said that federal laws, when made in pursuance of the Constitution, form the supreme law of the land.  

As a practical matter, the power of the US Treasury and ultimately Congress over the GSEs is absolute.  The terms imposed by Treasury in return for the bailout are harsh and perhaps even unfair in a narrow sense, but it is far from clear that private shareholders have any power to object or seek redress.  If, for example, Congress passed legislation tomorrow extinguishing the GSEs without any compensation to the private “shareholders” whatsoever, it is clear that there would be no legal basis for objecting to this action.  Likewise, if Treasury were to put the GSEs into receivership, the private stakes could be wiped out and Fannie and Freddie would emerge as they e
xisted when first chartered by Congress.  In a moral sense this would be wrong, but in a legal sense there seems little basis for private citizens to object.

The second issue that is equally powerful is the question of risk.  The whole operational basis for the GSEs was their implicit guarantee from the U.S. government.  Neither of these entities ever had sufficient private capital to achieve the “AAA” credit standing that Fannie and Freddie commanded in the past and still command today.  At best, the private shareholders of the GSEs were free riding on the backs of the U.S. tax payer, collecting supranormal returns for taking little or no risk – or at least we thought.  

For years the common and preferred shareholders of Fannie and Freddie benefited from the pretense that these corporations were, in fact, private for profit entities.  But in the background, federal officials regularly assured their counterparts around the world that the debt issued by Fannie and Freddie had the full faith and credit of the United States.  When push came to shove during the subprime crisis, the implicit guarantee became explicit and the private shareholders of both GSEs paid a terrible price.  But they should not have been surprised.  Morgenson includes an important quote in her piece:

“People disagree about what should happen to the G.S.E.’s,” said Matthew D. McGill, a lawyer at Gibson, Dunn & Crutcher in Washington who represents Perry Capital. “But if the plan is to wind them down, Congress provided a means to do that in the 2008 law — it’s called receivership, and it provides a host of procedural protections to claimants. What the Treasury cannot do is abuse its conservatorship powers to nationalize the companies and then, when it deems convenient, wind them down without the protections enacted by Congress.”

Well, maybe.  The trouble here is that the Treasury is only accountable to Congress, not to the private shareholders seeking redress in the courts.  The GSEs are creatures of the federal government, not the states.  They were “privatized” in name only under the Administration of Lyndon Johnson, more as an effort at fiscal window dressing than as a serious attempt to separate them from the federal government in a financial, operational or risk perspective.  

While private investors in the GSEs may not like the way that they have been treated since the 2008 bailout, there seems little that they can do except waste money on a lot of litigation that seems unlikely to bring relief.  Federal judges do not like second guessing Congress or the Executive Branch when it comes to the exercise of basic Constitutional powers.  For decades, private investors benefitted from the pseudo privatization of the GSEs and reaped enormous returns for essentially doing nothing.  Now those shareholders who were too dumb to head for the door when the music stopped want to be made whole for their losses.  

When considering what is fair to private investors in this situation, the treatment of the investors in the Madoff fraud comes to mind.  The investors are given back their original investments, but none of the pretended gains because the money was never really invested in the first place.  Perhaps such a scheme would be appropriate here.  But the only thing you can really say to investors in a GSE is “caveat emptor.”  When you as a private individual undertake to do business with a sovereign entity governed by politicians, you have only yourself to blame when the U.S. government decides to break its own rules on disclosure and securities fraud.  

This is just another Washington fable which reminds us all of the words of Mark Twain: “History has tried hard to teach us that we can’t have good government under politicians. Now, to go and stick one at the very head of the government couldn’t be wise.”


    



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Don’t Cry for the Shareholders of Fannie Mae and Freddie Mac

Yesterday in The New York Times, columnist Gretchen Morgenson confirmed that the US Treasury has no intention of returning the mounting profits of the federally chartered housing agencies, Fannie Mae and Freddie Mac, to shareholders. In her fine comment, “The Untouchable Profits of Fannie Mae and Freddie Mac,” she reveals that Treasury Secretary Tim Geithner approved a policy that ensures that the “existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.”

http://t.co/C6g5Xo5pIz

A number of people have expressed shock and outrage at this shabby treatment of the common shareholders of Fannie and Freddie.  In a post on Twitter in response to a tweet from your humble blogger, former FDIC Chairman Sheila Bair noted: “No sympathy for GSE shareholders here, but this is punitive compared to how AIG, Citi shareholders were treated.”

And of course Chairman Bair is right.  The common shareholders of AIG and Citigroup were not wiped out when these organizations received government bailouts under the doctrine of “too big to fail.” 

Our friend Nom de Plumber, who formerly worked at the Fed of New York and now makes a living in the risk management world, is similarly outraged:  

“If Treasury was so uncertain of GSE future, as it just stated, why did it need to seize surreptitiously such unforeseeable earnings, especially with zero public policy governance and disclosure?  Either liquidate under receivership, or conserve for debt and equity claimants under conservatorship. Treasury did half and half, skimming the earnings but keeping the liabilities off the US balance sheet. It was a revenue grab, violating the Constitution…  The core issue is following the asset conservation and shareholder disclosure rules which you set for others to meet.   Because the GSE are public shareholder companies, their governance is not exempt from federal investor-protection laws.”

Morgenson notes that the public disclosure from Fannie does not mention the Treasury’s intention to retain the earnings of the GSEs for the benefit of the US taxpayer indefinitely.  Freddie, on the other hand, does disclose that Treasury “has indicated that it remains committed to protecting taxpayers and ensuring that our future positive earnings are returned to taxpayers as compensation for their investment.”

There are now a raft of lawsuits pending against the US Treasury, both by common shareholders and investors in the preferred securities of Fannie and Freddie.  All follow the logic of Nom de Plumber and Morgenson, who see the actions of the Treasury as somehow unfair.  The lawsuits seek restoration of earnings and damages.  But while you may be able to justly criticize the Treasury for hypocrisy and inconsistency when it comes to federal securities laws applicable to private corporations, I am not sure that such arguments can be successfully made against agencies of the federal government. 

First let’s consider why Secretary Geithner chose to support a policy of confiscation of the earnings of the GSEs.  First and foremost, Geithner wanted to cripple Fannie and Freddie financially in order to prevent them from being restored to their former status in Washington.  For those who have not read Morgenson’s 2011 book which she co-authored with my friend Josh Rosner, Reckless Endangerment, the GSEs were the tail that wagged the dog of official policy on housing in Washington for years.  

By putting in place the tough agreement whereby the US Treasury injected preferred capital into the GSEs and in return has the right to confiscate all earnings of Fannie and Freddie indefinitely, Geithner sought to cripple these institutions as a political matter.  I rather agree with his judgment, but wish that he had put the two GSEs into receivership during the crisis.  With the higher fees put in place under the conservatorship, Fannie and Freddie look really profitable, at least in a nominal sense.  But if those profits are adjusted for the risk the GSEs take on housing, there are no profits.

Geithner told Congress in 2011: “The Administration is committed to a system in which the private market – subject to strong oversight and strong consumer and investor protections – is the primary source of mortgage credit.”  But the reality is that the U.S. government is the only entity that is willing and able to truly underwrite the risk of the multi-trillion dollar housing market.  

As we saw during the housing boom of the 2000s, when for a brief couple of years private investors did support a large chunk of the mortgage finance market, as soon as the true risks were revealed the private capital ran for the door.  Even commercial banks are unwilling to support more than a tiny fraction of the housing sector’s overall risk with their own capital.

In his book The Death of Liberalism, R. Emmett Tyrrell notes that during the chaos following the 2008 subprime market collapse; “Some institutions went down in flames, and the government backed institutions, Fannie and Freddie, went hat in hand to the taxpayer.”  Chairman Bair is right when she notes that the shareholders of AIG and Citigroup were treated better than are the shareholders of Fannie and Freddie, at least insofar as their ability to benefit from the financial recovery of these firms. But the key point to take away from that comparison is that the GSEs are not private corporations chartered under state law.  

In the United States, the roots of the subprime crisis of 2008 and the political reaction thereto stretch back to the founding of the republic.  In a legal sense, the power of the federal government to regulate finance begins with the 1819 Supreme Court decision establishing supremacy of federal law over conflicting state law.  In McCulloch v. Maryland, the Supreme Court settled a dispute that arose when Maryland sought to tax The Second Bank of the United States, which that was seen as endangering Maryland’s state banks during the depression of 1818.  The landmark Supreme Court decision confirmed that the Government of the Union, though limited in its powers, is supreme within its sphere of action.  The Court said that federal laws, when made in pursuance of the Constitution, form the supreme law of the land.  

As a practical matter, the power of the US Treasury and ultimately Congress over the GSEs is absolute.  The terms imposed by Treasury in return for the bailout are harsh and perhaps even unfair in a narrow sense, but it is far from clear that private shareholders have any power to object or seek redress.  If, for example, Congress passed legislation tomorrow extinguishing the GSEs without any compensation to the private “shareholders” whatsoever, it is clear that there would be no legal basis for objecting to this action.  Likewise, if Treasury were to put the GSEs into receivership, the private stakes could be wiped out and Fannie and Freddie would emerge as they existed when first chartered by Congress.  In a moral sense this would be wrong, but in a legal sense there seems little basis for private citizens to object.

The second issue that is equally powerful is the question of risk.  The whole operational basis for the GSEs was their implicit guarantee from the U.S. government.  Neither of these entities ever had sufficient private capital to achieve the “AAA” credit standing that Fannie and Freddie commanded in the past and still command today.  At best, the private shareholders of the GSEs were free riding on the backs of the U.S. tax payer, collecting supranormal returns for taking little or no risk – or at least we thought.  

For years the common and preferred shareholders of Fannie and Freddie benefited from the pretense that these corporations were, in fact, private for profit entities.  But in the background, federal officials regularly assured their counterparts around the world that the debt issued by Fannie and Freddie had the full faith and credit of the United States.  When push came to shove during the subprime crisis, the implicit guarantee became explicit and the private shareholders of both GSEs paid a terrible price.  But they should not have been surprised.  Morgenson includes an important quote in her piece:

“People disagree about what should happen to the G.S.E.’s,” said Matthew D. McGill, a lawyer at Gibson, Dunn & Crutcher in Washington who represents Perry Capital. “But if the plan is to wind them down, Congress provided a means to do that in the 2008 law — it’s called receivership, and it provides a host of procedural protections to claimants. What the Treasury cannot do is abuse its conservatorship powers to nationalize the companies and then, when it deems convenient, wind them down without the protections enacted by Congress.”

Well, maybe.  The trouble here is that the Treasury is only accountable to Congress, not to the private shareholders seeking redress in the courts.  The GSEs are creatures of the federal government, not the states.  They were “privatized” in name only under the Administration of Lyndon Johnson, more as an effort at fiscal window dressing than as a serious attempt to separate them from the federal government in a financial, operational or risk perspective.  

While private investors in the GSEs may not like the way that they have been treated since the 2008 bailout, there seems little that they can do except waste money on a lot of litigation that seems unlikely to bring relief.  Federal judges do not like second guessing Congress or the Executive Branch when it comes to the exercise of basic Constitutional powers.  For decades, private investors benefitted from the pseudo privatization of the GSEs and reaped enormous returns for essentially doing nothing.  Now those shareholders who were too dumb to head for the door when the music stopped want to be made whole for their losses.  

When considering what is fair to private investors in this situation, the treatment of the investors in the Madoff fraud comes to mind.  The investors are given back their original investments, but none of the pretended gains because the money was never really invested in the first place.  Perhaps such a scheme would be appropriate here.  But the only thing you can really say to investors in a GSE is “caveat emptor.”  When you as a private individual undertake to do business with a sovereign entity governed by politicians, you have only yourself to blame when the U.S. government decides to break its own rules on disclosure and securities fraud.  

This is just another Washington fable which reminds us all of the words of Mark Twain: “History has tried hard to teach us that we can’t have good government under politicians. Now, to go and stick one at the very head of the government couldn’t be wise.”


    



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The Feds' Scary Reassurances to Banks That Deal With State-Licensed Marijuana Businesses

On Friday, as J.D. Tuccille

noted
, the Treasury Department and the Justice Department
issued guidelines for banks that do business with state-licensed
marijuana suppliers. According to Attorney General Eric Holder, the

aim
of the memos is to reassure financial institutions that are
leery of accepting cannabusinesses as customers because they worry
it will attract unwanted attention from federal regulators and
prosecutors. But as with the
August 29 memo
in which Deputy Attorey General James Cole said
that prosecuting properly regulated marijuana growers and sellers
would not be a high priority, there are
no guarantees
, and that fact is likely to
deter
traditionally cautious banks more than plucky cannabis
entrepreneurs.

The
Treasury memo
, issued by the department’s Financial Crimes
Enforcement Network (FinCEN), says the Bank Secrecy Act (BSA)
requires financial institutions to file “suspicious activity
reports” (SARs) for all marijuana businesses. But FinCEN draws a
distinction between marijuana businesses that violate state law or
implicate one of the Justice Department’s “enforcement priorities”
and marijuana businesses that do neither. The former merit
“marijuana priority” reports, while the latter fall into a newly
invented “marijuana limited” category. According to the memo, this
distinction “aligns the information provided by financial
institutions in BSA reports with federal and state law enforcement
priorities.”

What are those priorities? Cole’s August 29 memo lists eight: 1)
“preventing the distribution of marijuana to minors,” 2)
“preventing the diversion of marijuana from states where it is
legal under state law in some form to other states,” 3) “preventing
drugged driving and the exacerbation of other adverse public health
consequences associated with marijuana use,” 4) “preventing the
growing of marijuana on public lands,” 5) “preventing marijuana
possession or use on federal property,” 6) “preventing revenue from
the sale of marijuana from going to criminal enterprises,” 7)
“preventing violence and the use of firearms in the cultivation and
distribution of marijuana,” and 8) “preventing state-authorized
marijuana activity from being used as a cover or pretext for the
trafficking of other illegal drugs.” At the end of the memo, Cole
adds that the feds might also intervene for other, unspecified
reasons. 

The FinCEN memo lists “red flags” that suggest a marijuana
business deserves special scrutiny, including “international or
interstate activity,” an inability to “demonstrate the legitimate
source of significant outside investments,” signs that the
business is “using a state-licensed marijuana-related business as a
front or pretext to launder money derived from other criminal
activity,” and “negative information, such as a criminal record,
involvement in the illegal purchase or sale of drugs, violence, or
other potential connections to illicit activity.” Such red flags
are supposed to inform banks’ decisions about which customers to
reject or drop as well as which sort of SAR to file. FinCEN warns
that the red flags it mentions “do not constitute an exhaustive
list.” Although FinCEN says its advice “should enhance the
availability of financial services for, and the financial
transparency of, marijuana-related businesses,” it never actually
says banks that follow the guidelines need not worry about getting
into trouble with regulators.

The
Justice Department memo
 that Cole released on Friday,
which like his August 29 memo is addressed to U.S. attorneys, has a
similar limitation. He notes that the earlier memo “did not
specifically address what, if any, impact it would have on certain
financial crimes for which marijuana-related conduct is a
predicate,” such as money laundering or failure to file SARs. The
new memo clarifies that prosecution decisions related to those
crimes “should be subject to the same consideration and
prioritization” as prosecution decisions related to marijuana
trafficking. Again, the feds are not making any promises. Here is
the closest Cole comes: “If a financial institution or individual
offers services to a marijuana-related business whose activities do
not implicate any of the eight priority factors, prosecution for
these offenses may not be appropriate.” Then again, it may! Like
Cole’s August 29 memo, this one closes with a caveat that is not
exactly reassuring: “Nothing herein precludes investigation or
prosecution, even in the absence of any one of the factors listed
above, in particular circumstances where investigation and
prosecution otherwise serves an important federal
interest.” 

This weak tea may be pretty much the best that the Obama
administration can do under current law, which is why bankers are

calling for congressional action
to address the tax,
regulatory, and public safety issues raised by forcing marijuana
suppliers to deal exclusively in cash. In a press
release
issued on Friday, Don Childears, president of the
Colorado Bankers Association (CBA), does not sound grateful for the
new guidance:

After a series of red lights, we expected this guidance to be a
yellow one. This isn’t close to that. At best, this amounts to
“serve these customers at your own risk,” and it emphasizes all of
the risks. This light is red.

The CBA complains that the guidance from FinCEN and the Justice
Department “reiterates reasons for prosecution and is simply a
modified reporting system for banks to use,” a system that “imposes
a heavy burden on them to know and control their customers’
activities, and those of their [customers’] customers.” The CBA
says “no bank can comply” with those expectations. Childears
concludes that “an act of Congress is the only way to solve this
problem.” The Marijuana
Businesses Access to Banking Act
, introduced last summer by
Reps. Ed Perlmutter (D-Colo.) and Denny Heck (D-Wash.), would
protect banks that deal with state-legal marijuana businesses from
criminal investigation or prosecution and from regulatory
repercussions, including loss of federal deposit insurance.

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