TARP, Capital Purchase Program…Making It Up As They Go Along?

November 14, 2008

There was an eruption across news networks and websites earlier this week as Henry Paulson announced that the Federal bailout package, dubbed the TARP (Troubled Asset Relief Program) would no longer function as a program to purchase troubled assets. Sparing no time to allow the irony of this to sink in, Paulson proceeded to outline what many of us have been suspecting all along. The first portion of the bailout money, approximately $260 billion, has been set aside to purchase stock in banks.This has been fittingly dubbed the Capital Purchase Program (CPP).

There are a few different ways to look at this, but it would seem that the Treasury believes that their primary goal is to ensure that survival of the American banking system, and that the best way to do this is to provide them with excess capital and allow banks to meet the demand for loans. It also would seem that the Treasury is making it up as they go along, but that’s another discussion for another day.

So what to do with all those bad, ugly subprime loans that they were going to purchase? Is there some way to make them, well, not so bad? Ah, yes, by rewriting them! The Federal Housing Finance Agency, in an almost simultaneous announcement, outlined a plan to restructure delinquent and troubled mortgages held by Fannie Mae and Freddie Mac. Homeowners would have the terms of their loan adjusted as follows: payments could not exceed 38% of their household income, the maturity date of the loan could be extended to 40, rather than 30 years, and a portion of the loan principle could be deferred.

I won’t bother to elaborate on the philosophical quandaries presented by this proposal, but rather I will focus on the issues of practicality. First, the fact is that only 20% of the subprime mortgages in America are owned by Fannie and Freddie. Second, of that 20%, only a fraction are actually the whole loans. Since loans have been chopped up, bundled, and sold in fractional shares to investors, any one of those investors could stop the loan modification from going through.

But then why would those investors want to block the restructuring? After all, doesn’t that help them retain the value of their investment? Well, yes and no. Most of those investors are not individual retail investors, but rather are institutional investors, such as banks, investment banks, trusts, hedge funds, etc. That means that in addition to holding the mortgage backed security, they also own the collateralized debt obligation (CDO) tied to that security, and more likely than not have also probably issued a CDO or two (or several) on that security. So whereas with a traditional investment in a security, you have a winning bet and a losing bet, with mortgages and mortgage-backed securities, you could have one winning bet, but multiple losing bets. Michael Lewis, the celebrated author of the Wall Street classic “Liar’s Poker,” describes the situation succinctly in this article.

Let’s not forget that additionally, from the perspectives of homeowners, it would exacerbate the plunge in home values across the country, and could potentially encourage non-delinquent homeowners to stop paying their mortgage in hopes of a loan modification.

Is it any wonder that we’re in this mess?

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