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  • Home>Research & Insights>Gray Matters>Uncle Sam Can Be Your Worst Enemy

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    Uncle Sam Can Be Your Worst Enemy

    Government regulation is a risk to companies.

    Ralph Wanger, CFA, 12/21/2016

    The views expressed here are those of the author and do not necessarily reflect the views of Morningstar.

    If your golf buddy gives you a stock tip and you decide to take a look at the company, one of the things that should be on your checklist is government regulation. There are lots of laws governing corporate activity. There are now government agencies regulating every company, and a lot of the regulations issued by a specific agency are only loosely related to some federal law.

    For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed after the 2008 mortgage crisis. The law did not contain specific rules, but authorized the SEC and the U.S. Department of Treasury to write rules on their own. The new banking rules were tough: Before Dodd-Frank, every year 100 or more banks were started up. Since Dodd-Frank, almost none have opened. If no one wants to open up a bank, then the rules are too tough.

    Each regulation was designed to reward good conduct and deter fraud and waste, but sometimes the aggregate effect is negative.

    The Patient Protection and Affordable Care Act was set up so that private health insurance companies would administer the payment system. The Affordable Care Act, however, ended conventional underwriting standards, such as not covering pre-existing illness, and established massive cross-subsidies, such as charging young people three times the true value of their insurance to offset the cost of insuring seniors. The consequence of these untested innovations has been creating unbearable losses for the insurance carriers, who are dropping out of the market.1This has left millions of consumers scrambling to find a new carrier and has whacked the shareholders of the insurance companies. One could imagine fixing this problem by enforcing the stipulated penalties for not buying a policy (called a fine by the U.S. Congress and a tax by the U.S. Supreme Court), but if there are 10 million voters who don’t like a particular law, the politicians will not have much enthusiasm for enforcing it (see: marijuana laws). I don’t want you to tell me how screwed up your health insurance policy is. I just want to make the point that a badly designed law has done major harm to companies such as UnitedHealth Group UNH. These regulations have not only infuriated the customers but also have hurt the stockholders of the company.

    Fannie Mae Debacle
    A classic example of the government ripping off shareholders is the case of Fannie Mae. Fannie Mae was set up on a peculiar basis, a shareholder-owned company but with an unstated guarantee of their mortgages by the Treasury Department. This worked pretty well from its founding during the New Deal until 2003, when FNMA managers were found cooking the books in order to increase their annual bonuses.2That was only a temporary distraction, and the company returned to its business of financing a large percentage of the U.S. mortgage market.

    One bank regulation, the Community Reinvestment Act of 1977 was to mandate increased lending to “red-lined” inner-city neighborhoods. It was a popular law, and banks wrote more mortgages in these neighborhoods. By March 2008, CRA loans were in obvious distress. “The financial soundness of CRA-covered institutions decreases the better they conform to the CRA.”3

    The heads of the banking committees were U.S. Sen. Chris Dodd and Rep. Barney Frank, so it is amusing that after the crash, the authors of the act who had to rescue the system from the collapse of the subprime mortgages were the same two gentlemen who helped create the disaster in the first place. In 2008, millions of subprime mortgages were recognized as worthless. The Treasury had to pay up on its unstated backstop to the mortgage system but rescuing FNMA cost $190 billion. FNMA was placed under the care of a conservator, the Federal Housing Finance Agency. For about three years, the company was in terrible shape, but eventually recovered, and today is making several hundred billion dollars a year. With this happy development, you might expect that I will recount how steadfast management led the company through the crisis, paid off the bailout money that they had borrowed from the government, and that FNMA shareholders today own a profitable and valuable company. That ain’t what happened. In 2010, the Treasury decided unilaterally to take all of the company’s profits forever. Because lots of investors had bought FNMA stock, hoping to profit by the dramatic turnaround in the mortgage market, they were irritated to discover that the government had permanently seized all the future profits of the company without telling anybody. Numerous lawsuits have been filed concerning this matter.

    CFA, is a trustee of Columbia Acorn Trust.