Ira Artman's  Instablog

After Roy Lichtenstein, TIME June 21, 1968.

I wish I could take full credit for my heist of Lichtenstein’s TIME ™ cover – but I can’t.

Credit belongs to Geetesh Bhardwaj and Rajdeep Sengupta, co-authors of two disturbing St. Louis Fed working papers:

• Where’s the Smoking Gun? A Study of Underwriting Standards for US Subprime Mortgages (WP 2008-36, Apr 2009); and

• Did Prepayments Sustain the Subprime Market? (WP 2008-39, May 2009).

Credit also has its place in a well-underwritten mortgage loan. But - as their recently revised works suggest - subprime loans replaced creditworthiness with transactions, riddling holes in the US economy.

I’ve previously observed (Banks, Home Prices, Home Sales Are 'Just Fine') that there is a tight relation between home price appreciation and transactions - IF you measure the former by price change in excess of financing cost, or carry; and the latter by the percentage of total homes sold, or turnover.

The following chart from that SeekingAlpha article depicts this relationship:

Figure 1: Scatterplot of Carry and Turnover, 1978 – 2008.

The two Fed working papers suggest how subprime lenders, borrowers, and regulators exploited this link between transactions and home price appreciation to create the appearance of a viable mortgage product, as long as home prices were increasing.

SUBPRIME UNDERWRITING STANDARDS

The first paper - Where’s The Smoking Gun? – tackles the shibboleth that:

• A dramatic weakening of subprime underwriting standards - beginning in late 2004, and extending into early 2007 - triggered the turmoil in financial markets.

Bhardwaj and Sengupta look at data from more than 9 million mortgages originated between 1998 and 2007, and ask two questions:

1. Was there a dramatic weakening of underwriting standards within the subprime mortgage market?; and
2. Did this weakening begin around late 2004?

Their detailed loan-by-loan analysis does NOT reveal any deterioration in underwriting standards for subprime originations, if underwriting is defined to include a variety of characteristics, such as LTV, FICO scores, and documentation.

Over the period, relaxed standards in one factor (such as documentation) were offset by tighter standards for other factors (such as LTV or FICO).

They conclude that if loans underwritten in 2005, 2006 or 2007 were originated in 2001 or 2002, then they would have performed significantly better on average than loans that were actually originated in 2001 or 2002.

So, if there was NO smoking gun, what hijacked the subprime market and caused it's crash?

SUBPRIME PREPAYMENTS

In the second paper - Did Prepayments Sustain the Subprime Market? - Bhardwaj and Sengupta reexamine their 9 million-loan dataset. They first observe that subprime loan features prevented borrowers from refinancing into a different mortgage for at least two years.

1. Over seventy percent of subprime originations for each origination year were refinances;
2. A significant majority of these originations were hybrid-ARMs designed to reset into a fully indexed rate after two or three years;
3. Contrary to conventional wisdom, teaser rates on hybrid ARMs were not low and not significantly different from those of fixed rate subprime loans; and
4. Most subprime originations included prepayment penalties with the prepayment term expiring on or after the ARMs’ reset date.

The economists conclude that that the viability of subprime loans depended upon continued home price appreciation:

1. The subprime mortgage design sought to benefit from short-term home price appreciation;
2. When home prices rise, borrowers can build up equity in their homes and become “less risky” on subsequent mortgages;
3. This allows borrowers to refinance at a lower interest rate (on their subsequent loan), reducing their likelihood of default;
4. Subprime loans functioned, to some extent, like a bridge loan, providing temporarily credit-impaired borrowers with access to short-term financing; and
5. The majority of all subprime loans were only viable as long as home prices continued to appreciate – once home prices slowed or declined, the borrowers no longer had a viable “exit option”, that they could trigger either by refinancing their mortgage or selling their home.

Once home prices failed to increase in 2006, subprime borrowers could not economically cover their debts by rolling over their old subprime loans.

It was the lack of a profitable “exit option,” rather than any late-stage underwriting failure, that shot a hole through the heart of the subprime mortgage market.

I have a modest proposal. I believe it will rein in the banks, and compel them to behave properly. Here it is.

• If any bank fails to comply in the future with federal capital or lending guidelines, then the US Treasury receives an option to acquire warrants in the common stock of that bank or its parent company.


• This option will be granted to the US Treasury for each reporting period (either year or quarter, to be determined) that the bank is NOT in compliance.


• The tenor, or term, of the warrants will be ten years. The warrants’ strike price will be the average stock price for any 20 consecutive trading days selected by the Treasury.

• The twenty-day period must fall within a two-year window that begins one year before the Treasury announces that the bank is not in compliance; and ends one year after the Treasury’s non-compliance announcement.

• The number of warrants will be set as a percentage of the average number of outstanding common shares of the non-compliant bank or parent company, for the 20 consecutive trading days used to establish the “strike.”

• The actual percentage will be a small but not insignificant positive percentage that is fixed for all companies, by statute. The specific percentage will be determined by a bill originating in the US House.

• The Treasury will have the ability to hold the warrants until their expiration. It does not have to exercise the warrants that it holds on behalf of US taxpayers.

• The Treasury may also elect to sell the warrants that it holds - in whole or in part, at any time - to private parties in a public competitive auction.

• The Federal Reserve and a private company will jointly administer the auction. The private company would presumably be BlackRock, unless BlackRock warrants are being offered, in which case Goldman Sachs would be the private auction co-administrator.

• The Secretary of the Treasury will report to the US House and Senate, twice a year, on the status of its warrant holdings. This report will include a full accounting of the warrants held, acquired, auctioned, or lapsed. The Secretary will report on the gains – or profit – if any, that the Treasury earns on the warrants.

If portions of the above sound familiar, that would be because the terms resemble those of warrants granted to the US Treasury under the 2008 TARP Capital Purchase Program [“CPP”], as I described in The Real Options Monster.

Since I penned that Monster piece, events have moved swiftly.

Even the US Congress realizes that they would have left a lot of money on the table – more than $4 billion – if they had botched the disposition of taxpayer CPP warrants for more than 300 banks. As reported by Bloomberg on 20 May 2009:

• [Treasury Secretary Timothy] Geithner … reiterated that the government can sell the [TARP CPP] warrants back to the bank or to a third party. 

• New legislation, passed by Congress late yesterday, removes previously imposed deadlines for extinguishing the warrants once a bank repays the government’s main equity stake, allowing the government more flexibility.

• The Treasury says banks can choose whether to negotiate over the warrants or not. If the bank refuses or can’t agree on a price, then the government will sell the warrants to a third party, as outlined in the original contracts [emphasis added].

Source: R. Christie, Bloomberg, Geithner Says Treasury May Move ‘Quickly’ to Sell TARP Warrants, 20 May 2009.

If Congress enacts the Bank Annual Optional Warrant Acquisition Operation (BAOWAO, pronounced “bow-wow”) program described above, it should restrain the Lords of finance and compel them to prudently manage their regulated financial quasi-utilities.

If not, the Lords (who had no problem rewarding themselves with well-timed stock options in the high times of what is now seen as low finance) will face the warranted wrath of their taxpayer vassals. 

Finally, since the program is conditional upon future financial sector missteps, it preserves the spirit, if not the substance, of our hallowed free-enterprise system.

Would someone please put the SEC out of its post-Madoff misery?   

It would save the more than $900 million that it costs to annually fund an agency that missed the self-confessed  (that’s English for “the SEC had no idea”) $50+ billion Ponzi scheme. 

It would also save us the bother of reading "ridiculous" stories such as these: 

May 18 (Bloomberg) -- Monster Worldwide Inc., the world’s largest online recruiting company, will pay $2.5 million to resolve SEC accusations that it misled the public about its stock options.  

… Settlement papers were filed today in federal [case in which a Monster executive was found] … guilty …of defrauding investors by improperly accounting for backdated stock options at the company.  

Source: D. Glovin, Bloomberg, Monster to Pay $2.5 Million, Settle SEC Option Case, 18 May 2009.

I say “ridiculous” because while the SEC is pursuing these penny-ante options fraud cases, the US government is quietly negotiating to give back warrants to TARP participants that are worth billions of dollars.  

You want improper accounting?  How about $4.72 billion worth? 

As described by the US Treasury in the TARP application (in a 12 point font that’s more than three times the size of the fine print used in bank credit card agreements): 

[The Treasury has obtained 10 year] … warrants [that are]… convertible into an amount of [the applicant’s] common stock … equivalent in value to 15% of the amount of the capital purchased by the Treasury from the applicant under the TARP Capital Purchase Program, based on the average of closing prices of the common stock on the 20 trading days … prior to the execution date of the [TARP CPP] Purchase Agreement.  

Source: FDIC, Application Guidelines for TARP Capital Purchase Program, Page 3, 2008.

Due to the long 10-year term of these warrants, they are quite valuable.  

Linus Wilson is a Professor of Finance at the University of Louisiana at Lafayette. His recent writings and thoughts hint at the size of the government’s contemplated give-away.   

Last week, Professor Wilson looked at the agreement that the government made when it sold back TARP warrants owned by US taxpayers to Old National Bank [ONB]. In his SeekingAlpha post he wrote that US taxpayers received “71% less than the median of my lowest and highest estimates” of their value.

What will it cost taxpayers if – for example – other TARP participants are able to negotiate deals as sweet as that struck by Old National Bank?  

The 19 May 2009 New York Times DealBook reports that Professor Wilson currently estimates the value of ALL of the US taxpayer TARP warrants at about $6.65 billion.  

Note:  I came up with the $6.65 billion figure by taking the midpoint of Professor Wilson’s high [$10.9 billion] and low [$2.4 billion] DealBook estimates for all TARP warrants.  This is similar to what Professor Wilson did in his Old National Bank analysis.    

If we apply this same 71% “Old National Bank” haircut to the entire US taxpayer TARP warrant position (what’s fair is fair, right?), this suggests that taxpayers would only receive $1.93 billion, or about $4.72 billion less than Professor Wilson’s estimate.  

So, the next time you see a story that says that “so-and-so will pay $2.5 million to resolve SEC stock options accusations ..." -  don’t even bother to read it!

Why should you?  You won’t even think about the $4.7 billion monster in the room.  Why fill your brain with a mere $2.5 million?