By Dr. Jonathan Tiemann, January 20, 2017

With a new Administration comes a new Cabinet, so the US Senate spent most of its time this week in hearings with Cabinet nominees on whom the Constitution requires them to provide their advice and consent. On January 19, the Senate Finance Committee interviewed the new Treasury Secretary-designate, Steven Mnuchin. The hearing was among the longest of the current round of Senate Committee confirmation hearings. It also provided a bit of a window onto the legislative sausage-making process. On two issues in particular — the profit Mr. Mnuchin made as a key investor in OneWest, a bank he reorganized from the husk of the failed mortgage lender IndyMac, and his directorship of an offshore entity in connection with his time as a hedge fund manager — both the Senators and Mr. Mnuchin offered statements that were narrowly true, but obscured important points that were not central to the message they wished to convey to the American people. Mr. Mnuchin deflected the main thrust of the Senators’ critique on those two matters, but failed to resolve questions about his commitment to public service.

Mr. Mnuchin arrived at the hearing prepared to discuss the OneWest matter. Critics of his nomination have described OneWest as a foreclosure mill, arguing that Mr. Mnuchin profited as OneWest foreclosed on mortgage borrowers, some of whom had made only the tiniest technical errors in keeping up on their payments. The fact that with a handlebar moustache, a dark cloak, and a stovepipe hat Mr. Mnuchin would look like Snidely Whiplash doesn’t help his case. Neither does his tenure as an executive at Goldman Sachs. In his opening statement at the hearing, Mr. Mnuchin offered his version of the OneWest story. He, along with a group of investors, had bought the failing IndyMac in 2008, renamed it OneWest, and reorganized it as a bank. IndyMac had failed in part because it had been so aggressive in writing mortgages to sub-prime borrowers in the run-up to the financial crisis of the last decade. Mr. Mnuchin’s strategy was most likely to buy IndyMac’s loan book for cents on the dollar, intending to liquidate it as quickly as possible. As he explained in his testimony, his group “voluntarily” chose to participate in the Obama Administration’s Home Affordability Refinance Program (HARP), offering loan modifications to a large number of borrowers. According to Mr. Mnuchin, it was the Department of Housing and Urban Development, which administered the program, that imposed the rules “forcing” OneWest to foreclose in many cases.

Nothing in Mr. Mnuchin’s account of the matter changes the essence of the criticism that he profited by trading in the obligations of distressed borrowers. In evaluating the opportunity IndyMac presented, he would surely have planned to push the bad loans as quickly as possible to either modification (making the loans saleable) or foreclosure (allowing OneWest to sell the underlying property). But his claim that HUD rules pushed him to foreclose in many cases blunted the attack coming from some Senators on the committee. To sustain the attack, they would have had to dive into the foreclosure rules under HARP, and argue that Mr. Mnuchin used those rules to make a modify-or-foreclose calculation in each case, indifferent to the fate of the individual borrower. That was too much ground to cover in a Senate hearing.

The second interesting issue concerned Mr. Mnuchin’s directorship of an offshore entity in connection with a hedge fund he managed. The critique arose in part because he had failed to disclose the directorship in his initial response to the Committee’s request for personal and financial information. Senator Robert Menendez (D-NJ) also questioned whether a person that would set up such an entity, whose purpose, he said, could only be for the reduction or avoidance of taxes, would really be committed to serving the American people as a whole. This critique also turned out to involve technical details too peculiar to explore in a confirmation hearing.

Mr. Mnuchin asserted that he set up the offshore entity not to avoid taxes for himself, but for the benefit of some of his investors. This is probably true. The issue is that the tax rules restrict the activities of tax-exempt entities, including pension funds and foundations. If those entities engage in profit-making activities, they generate Unrelated Business Taxable Income (UBTI), and become subject to tax on that income. Pensions and foundations may generally invest their funds for gain without creating UBTI, but only if they do so without leverage. Once they borrow in the course of their investing activities, they may run afoul of the UBTI rules.

Most hedge fund strategies make use of some kind of leverage, and as a consequence, pension and foundation trustees must worry about UBTI if they wish to invest in hedge funds. The most common solution, believe it or not, is for the pension or foundation to invest in the hedge fund through an offshore entity the fund creates for that purpose. So while Senator Menendez was correct in pointing out that the purpose of an offshore entity is to avoid taxation, in a hedge fund its purpose is to avoid taxation of what is ordinarily already a tax-exempt entity. But explaining that in the course of Mr. Mnuchin’s confirmation hearing would have drawn attention away from the nominee, and toward the practice by pension funds of investing in hedge funds through offshore entities. I’m sure that no Senator looking for ongoing support either from pensioners or from hedge fund managers wanted to go there.

In the end, Mr. Mnuchin’s hearing was sort of a standoff. He succeeded in persuading the Senators that he would stop short of tying delinquent borrowers to railroad tracks. He also succeeded in deflecting a couple of important criticisms into a swamp of inaccessible detail. But he fell short in two important respects. When asked about deficiencies in his initial disclosures, he offered the complexity of the forms as an excuse. Both his OneWest dealings and his setting up of an offshore entity for his hedge fund suggest, however, that Mr. Mnuchin is quite comfortable with complexity; in fact, he has shown an aptitude for exploiting complexity to his advantage. More telling though, is that even if his activities have all been entirely within the law, the activities the Committee explored were all about creating advantage for Mr. Mnuchin. What we do not know is the extent of his commitment to public service.