Undoing Moral Hazard in Governance of Fannie and Freddie for Liberty

Sankarshan Acharya
Founder, Pro-Prosperity.Com

To:       Honorable President Barack Obama

Cc:       Mr. Eric Holder, Attorney General
Mr. Preetinder Singh Bharara, Attorney for the Southern District of New York
Mr. Mel Watt, Director, FHFA

Sub:     Undoing Moral Hazard in Governance of Fannie and Freddie for Liberty

Date:   April 6, 2014

The government is now arguing through several new Fannie-Freddie wind-down bills that replacing the two highly profitable mortgage financing firms with a (to be created) Federal Mortgage Insurance Corporation is absolutely necessary to save the economy and to protect the taxpayers.  The government has indicated that it would abide by the court’s decision on the value of Fannie-Freddie stocks so that it does not hurt private investments. 

The focus of this memo is not protection of private stockholders that the court will decide and the government will accept.  This memo is exclusively about the noble government objective of enhancing the economy and reducing the risk to taxpayers.  The government objective of minimizing the cost to taxpayers is the basis of formal academic research which has shaped the bank foreclosure law (FDICIA-1991).[1] The memo shows that all the new Fannie-Freddie wind-down bills are driven by moral hazard in governance which squarely jeopardizes the noble government objective.  It also offers a practically feasible method to avert moral hazard for liberty of the government and people.

I. Giveaway to Private Banks

  • The proposed bills will giveaway Fannie and Freddie loan pools at heavy upfront discount and freely transfer profits earned on these loan pools to private banks. 
  • This give away will run to trillions of dollars in present value terms. 
  • Private banks will then have a complete control over the mortgage interest rates to extract more from the borrowers. 
  • Private banks will also receive guarantee of taxpayers for 90% of mortgages via FMIC. 
  • These points make every Fannie-Freddie wind-down bill financially suicidal for the economy and taxpayers, as argued earlier.[2]   

II. Giveaway ordained by Moral Hazard

So, the true intention of the government is not to accomplish the noble objective.  It is to somehow eliminate the current Fannie-Freddie stocks, by disregarding even the calamity that would befall on the economy and taxpayers and by breaking existing laws that guarantee residual claims of stockholders and establish necessary investor confidence in USA.

The government guarantee for safety is necessary for an individual to earn incomes.  Does it mean that the government will take away all the individual residual incomes through taxes? If the government does so, it would no longer be a constitutional government of We the People of USA.        

The government has argued that only its lending and debt guarantee made possible for Fannie-Freddie to generate their profits to repay the Treasury loans and to have any residual profit for stockholders.  But this is how the private banks too have generated massive compensation and dividends for their executives and stockholders.  This is how GM, AIG and host of other companies survived through government bailout.  In fact, the government took over Fannie and Freddie and transferred taxpayers’ money to buy worthless private bank assets at par.  This transferred Fannie-Freddie shareholders’ and taxpayers’ wealth to the private banks.  If rescue of private banks was really vital for the economy, the government should have given the money openly to these banks, instead of hiding the truth and penalizing Fannie and Freddie shareholders.  Again, this is not the focus of this memo.

Again, why does the government want to apply opposite norms to Fannie and Freddie in zeroing out their stocks?  This seems befuddling because Fannie and Freddie really averted a complete collapse of private banking.  Fannie and Freddie are chartered as private-shareholder-owned financial entities under FDICIA-1991 like the private banks are.  On whose behest did government even pronounce an assurance to wind down Fannie and Freddie just to wipe out their stocks, even though doing so is financially suicidal for the economy and taxpayers?  The answers to these questions are crucial to save the US economy, reduce risk to taxpayers and gain liberty from moral hazard in governance.  My answers are based on rational inference from a critical fact that government is still adamantly wants to wipe out Fannie and Freddie stocks through new bills in Congress and by pleading in court to dismiss the shareholder lawsuits. 

The government can win its case in favor of private banks to wipe out Fannie-Freddie stocks by convincing the judge privately that the entire banking system would otherwise collapse because most money center banks (members of Clearing House LLC under the domain of protection by the Federal Reserve Board) have hedged their assets by building very large short positions in Fannie-Freddie stocks.  The money center banks did so with explicit assurance of the government that Fannie and Freddie would be wound down.  The government has to keep its commitment to private banks.  Or else, the entire banking system, life blood of the economy, would perish.  This would adversely affect even the courts.  The judge will, thus, be forced to accept the government argument to dismiss Fannie-Freddie shareholder suit.  

The private banks will thus win handsomely due to moral hazard or blackmailing of the government and judges of a mighty county like USA even at the cost of severely ruining the economy and risking the taxpayers.  The private banks will then advise the government and Federal Reserve to print oodles of dollars to revive the economy.  By then any residual confidence of investors in USA will have perished and the productive majority will have lost its willingness or incentive to work for the sharks and the edifice of an empire based on printed dollars will have perished.

III. Averting Moral Hazard

Just to avert such blackmailing, I have shunned significant calls, emails and invites from private financial institutions to invest through them for my retirement.  I would rather cultivate fruits and vegetables in my village farmhouse than succumb to blackmailing. 

Here is a method of resolving moral hazard in governance of Fannie and Freddie that seems to have frightened a mighty nation:

  • Find out how many systemically important money center banks have huge short positions in their institutional accounts.  The only way they could credibly blackmail the government and court is by presenting huge institutional short interests.  If their institutional short interests are not much, they cannot credibly claim that the banking system will go down if Fannie and Freddie stocks are not zeroed out. 
  • The official net short interest data required to be reported by any institution could still be zero even if the institution’s own accounts have huge short interests if their private hedge funds have matching long positions.  The institutions are required to report short interests after netting out long positions of their account holders who have contractually agreed to lend their shares for selling short.  This is how I see these ‘systemically important” institutions have lately obfuscated unconstitutional short-selling by their market making subsidiaries as a hedge against long positions in their clients’ accounts.[3]
  • Trace the dates (since 2007) when the privileged private hedge funds, managed by the systemically important money center banks, built their short positions, covered their shorts and went long.  I saw about 130% institutional ownership of Fannie Mae common stock sometime in 2008 when the breakdown of the markets was shaping.  This means at least 30% of Fannie stock was shorted then. 
  • If the privileged private hedge funds covered their shorts by buying Fannie and Freddie stocks from systemically important financial institutions, it is very likely that the latter went short and have built huge institutional short interests.  Otherwise, Fannie and Freddie stock prices would have skyrocketed when such huge positions were bought in the open market to cover the short interest at privileged private hedge funds. 
  • If the institutions went short to let their privileged private hedge funds cover, the owners of these funds have essentially robbed everyone else-unprivileged private hedge funds, pension plans, mutual funds and household investments in Fannie and Freddie stocks-while transferring huge risk to taxpayers and economy through enormous institutional short interests, which is the only basis of blackmailing of the government and court.
  • If the private trading books of the systemically important institutions and their privileged hedge funds prove point 5, there should be a claw back of all the privileged private hedge funds’ assets, which will really cover only a small part of the enormous loss caused to everyone else including taxpayers and economy.

IV. Conclusion

Unless the system of moral hazard is undone, a recurrence of the Great Depression will grip a mighty economy with irreparable losses to everyone including taxpayers.

With profound regards,

SankarshanAcharya     
Founder, Citizens for Development and Pro-Prosperity.Com

[1] http://pro-prosperity.com/Research/Bank-foreclosure-rule-paper-Acharya-Dreyfus-Journal-of-Finance-1989.pdf
[2] http://pro-prosperity.com/Research/Coalition%20of%20Borrowers.pdf
[3]http://pro-prosperity.com/Research/Sub-Optimality%20of%20Short%20Selling.pdf