May 11, 2014 6:33 pm

Hedge fund titans are testing the quality of US democracy

If branches of government bow to big business, public policy will be decided by the highest bidder
Kenyon illustration©Matt Kenyon

John Paulson made his fortune by taking a massive short position against the US housing bubble. Today the hedge fund billionaire is betting that the US political system will fail. This time he has company. Other billionaires have launched a lawsuit to force the US Treasury to pay shareholders vast sums from the government-sponsored housing enterprises that it bailed out in 2008. Betting on Washington’s largesse has become a routine investment strategy. Whether this one works, aspiring billionaires should take note: if you want to strike it lucky, try shorting American democracy. The risk is small and the rewards are spectacular.

In 2008, the US government did “whatever it takes” to save the world economy from a rerun of the 1930s. Bailing out the people who had caused the crisis was an ugly spectacle that helped embitter politics in the US and elsewhere. But it was a necessary evil. The alternative was too dire to contemplate.

As it usually does, the US system got its act together in an emergency. The real problem is how it functions in normal times. Two of the largest beneficiaries of Washington’s firefighting were Fannie Mae and Freddie Mac, the mortgage underwriters, which took $187.5bn in taxpayers’ money to keep them alive. Without that infusion, the entire US housing finance system would have seized up – and with it the global economy. And Fannie and Freddie would have ceased to exist.

Six years later, some of the richest people on the planet are petitioning the courts to reward Fannie and Freddie’s shareholders for having been rescued by the US taxpayer. Last week, the two enterprises, which are in government “conservatorship” – a step short of nationalisation – said they would bring their total dividend payments to the US Treasury to $213bn since 2009, which is above the original bailout.

Although both enterprises were delisted, investors bought their common and preferred shares on the grey market and now want their speculation redeemed. The US Treasury rightly argues that the dividends do not qualify as a repayment of the bailout. Moreover, it is the government that will pick up the bill if the housing market goes into reverse. The losses will continue to be socialised even if the gains are temporarily flowing to the taxpayer.

Bill Ackman, the activist investor, last week predicted that the case would go all the way to the US Supreme Court. Given its recent record, that should be little comfort to American taxpayers. But the hedge funds’ real game is to stop Congress from passing legislation that would wind down the two behemoths and share part of their vast mortgage risk with the private market. As long as Fannie and Freddie stay alive, there is hope for the speculators.

Last week the hedge funds notched up a big success: the Fannie/Freddie reform bill ground to halt in the US Senate and is now highly unlikely to pass in 2014. The fact that they lobbied Congress heavily is one reason why the bill is stalling. There is nothing to stop them spending more. The return on lobbying in Washington is astronomic. If they win, the speculators will get $33bn in taxpayers’ money. If they lose, their outlay was a drop in the bucket. Last year, overall lobbyist spending in Washington was just $3.2bn – a minute sum given the returns available.

The stakes for the future of the US housing market are high enough. During their golden years before the meltdown, Fannie and Freddie profited hugely from being considered by investors as too big to fail. That enabled them to borrow cheaply at near sovereign rates, and produce monopolistic profits for their shareholders. Fannie and Freddie did as much as any Wall Street firm to underwrite the US subprime mortgage bubble, even if they did not invent it. Winding them down is arguably the largest piece of unfinished business from 2008.

But the quality of US democracy is also at stake. If the hedge fund titans can bend two out of three branches of the US government to their will, it will set a toxic precedent. With enough money, you can pull off anything. Public policy can be auctioned off to the highest bidder. Paying off vulture funds will get seniority to the taxpayer. Some argue that it has always been like this. Look at the way US agribusinesses manage to capture the bulk of subsidies intended for small farmers. Or the ability of large oil companies to write off their investment costs. Likewise, private equity funds have for years staved off efforts to treat their “carried interest” profits as normal income. As Warren Buffett likes to point out, he is still taxed at a lower rate than his secretary.

But the Fannie and Freddie dispute offers the spectre of a dangerous tightening in the oligarchic grip on US democracy. In the past few years, the share of US income going to the wealthiest 0.1 per cent has skyrocketed. At the same time, the US Supreme Court has scrapped most remaining limits on political spending by companies and wealthy individuals. Billionaires come in all shades. Democrats like to target the Koch brothers, who bankroll much of the Tea Party movement. But liberals happily take private equity money to block reform of carried interest tax treatment.

As in life, so in politics – watch what lawmakers do, not what they say. Fannie and Freddie must be reformed, says the bipartisan refrain. Let us see in practice if that is what they really mean.

edward.luce@ft.com

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Letters in response to this column:

The US housing finance system works just fine / From Mr Chris Lafakis

Basic fairness is not complicated / From Mr Ike Brannon

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