From fine to fine and record settlement to record settlement, a persistent question has hung over the biggest U.S. banks as they continue to digest the consequences of their pre-crisis dealings in the subprime property market: When will the pain end? This week saw Citigroup strike a $7 billion agreement with the Department of Justice to settle all outstanding crisis-era subprime grievances; J.P. Morgan reached a similar $13 billion settlement in November last year; and Bank of America has faced multiple rounds of mortgage fines over the last few years, with its cumulative punishment for crisis-era activities now rising to over $47 billion. While much of the focus for analysts is on trying to figure out how much further the crisis-era reparations process has to run, for some investors, there is opportunity in the pain.
Josh Birnbaum, co-founder and CIO of Tilden Park Capital Management, reckons that settlements out of the mortgage crisis could eventually top $50 billion. “Thirty billion of that is still up for grabs and has yet to be priced into mortgage markets,” he said, addressing the crowd at today’s best investment ideas panel at Delivering Alpha. Just 2 percent of existing defective subprime mortgage deals have been “put back,” the process according to which loan originators are compelled, as a result of proven defects or fraud, to repurchase the loan from its current holder, according to Birnbaum. But this figure could rise to over 40 percent in the remaining tranche of settlements to come.
Birnbaum, a former co-head of the structured products group at Goldman Sachs, co-founded Tilden Park Capital in 2008; the firm now has $2.3 billion under management. “If you boil it down to its most simplistic level, what we’ve been effective at doing is identifying cheap options,” Birnbaum told Institutional Investor earlier this month.
Mortgage putbacks, in Birnbaum’s view, represent one such option. Tilden Park Capital has purchased secondary tranches of deals built on top of defective subprime loans, often for steep discounts to par; with the appropriate legal compulsions in place, the banks that originated the loans will be forced to repurchase those deals at par. Birnbaum projects that holding a portfolio of putback-constrained subprime securities, purchased at something like 49 cents to par and repurchased by the originator banks at par, could result in a hold to maturity yield of 32 percent and an annualized rate of return of 60 percent. The trade, said Birnbaum, is “uncorrelated to macro — whatever happens in Ukraine is not going to affect your payout,” although he conceded there is some interest rate risk.
So why aren’t more investors interested in putbacks? The answer might be that it’s simply a difficult task to manage, especially from a legal perspective: It’s a painstaking task to source the right type of deals that meet the right profile to qualify for a putback. There’s also, according to Birnbaum, an intense data gathering and technical analysis effort involved. “You have investors who check some of those boxes, but few who check all,” he said.
Listen to the earnings calls and most big banks seem resigned to the continuation of the wave of subprime-related punishment, even as they somehow want to will it all to disappear. “The banks are trying to put this whole issue behind them and lowball this,” Birnbaum told the conference. But if more institutions follow Tilden Park Capital in investing in subprime-related securities subject to a putback, the pain for banks will be sure to deepen.
Follow Aaron Timms on Twitter at @aarontimms.
