Will TALF Soar? Or Fall Flat?

Spring is almost here, but hopes are riding on the Federal Reserve, not Mother Nature, to jump-start a much-needed thaw in the credit markets. After multiple delays and adjustments, the Fed's Term Asset-Backed Securities Loan Facility, or TALF, has arrived. However, the TALF is off to a slow start with investors requesting only $4.7 billion in the first round, the Federal Reserve Bank of New York said on Mar. 19. The funds will be disbursed on Mar. 25.

The first installment is composed of $1.9 billion that investors will use to buy securities backed by auto loans, and $2.8 billion for the purchase of securities backed by credit card loans. Applications for the next round of loans will be accepted starting April 7 and those funds will be disbursed on April 14.

The central bank has said it expects to create up to $200 billion in liquidity for credit markets under the TALF program.

The U.S. government's ability to attract private capital from hedge funds and other investors through the TALF program is even more crucial now that public sentiment has turned so virulently against bank bailouts. Public anger about the $165 million in bonuses paid to American International Group (AIG) execs may have soured prospects for additional financial-sector bailouts and could threaten to scuttle further government liquidity measures.

Attracting Private Investors

"The Treasury and the Fed realize they've got to get private money involved. They don't have enough money left in the TARP program to do it on their own," says Scott Valentin, an analyst who covers consumer finance for Friedman, Billings, Ramsey (FBR) in Arlington, Va.

The Fed has had to make adjustments to TALF after hearing from private investors who objected to having to open their books and records to broker-dealers who would be applying for the loans on behalf of investors. There was also opposition to the idea of turning nonrecourse loans into recourse loans—to the jeopardy of investors—if the assets pledged as collateral are determined to be ineligible after the fact by the Fed. Questions have also been raised about whether the program would restrict participating companies from replacing fired U.S. employees with foreign workers, since TALF comes under the stimulus package.

Not content to wait to see how TALF takes hold, the Fed on Mar. 18 announced plans to buy an additional $750 billion of government-guaranteed mortgage-backed securities (MBS), in addition to the $500 billion of MBS it is already in the process of buying. The Fed also said it would purchase up to $300 billion of longer-term Treasury bonds over the next six months in an effort to lower longer-term interest rates on a variety of loans.

Mortgage Stumbling Block

Some economists and analysts believe that resuscitating the market for securitized consumer loans won't be enough by itself to repair the all-but-disabled financial system, since mortgage-backed securities constitute the bulk of the debt clogging banks' balance sheets. That's why the success of TALF is critical. Early signs of strong investor participation would encourage the Fed to expand the program at some later date to include residential and commercial MBS.

The TALF program is essentially a way for investors to use eligible, triple-A, asset-backed securities—such as pools of prime auto loans, credit-card receivables, student loans, and small business loans—as collateral against loans from the Federal Reserve Bank of New York, which can then be used to buy additional asset-backed securities, or ABS. Only securities created since Jan. 1, 2009, are eligible for these loans.

The key feature is something called the collateral haircut, or the minimum capital an investor has to put up to obtain the loan, expressed as a percentage of the loan's value. Generally, the longer the maturity of the ABS, the higher the haircut—to account for the greater risk the Fed is taking. The higher the haircut, the less leverage available to the investor.

How the Haircut Works

For example, a one-year $100 credit-card bond with a 5% haircut would permit an investor to pledge collateral worth $5, leaving the remaining $95 available to buy other securities. That equates to employing 20 times leverage. "Nowhere else in the marketplace can you get that kind of leverage," says Valentin at FBR. "Right now, no one can lever up, so there's a lack of demand for debt assets." (ABS are typically purchased on margin.)

The greater the leverage, the higher the return on invested capital an investor can earn—around 40% to 60% for 20 times leverage, vs. 10% to 15% for five times leverage, says Valentin.

If the TALF loans are offered at the one-month London Interbank Offered Rate (Libor) plus 1%, and the investor uses the loan to buy ABS with a spread of 5% above Libor, his profit is the difference of 4%. That could result in a huge profit for the investor given the amount of leverage he can use. As demand for ABS rises, prices should go up, causing the spreads to come down.

Consumers Would Ultimately Benefit

"The Fed is trying to spur investor demand for these bonds, to get issuance going again," says Valentin. "But also, if you can lower the funding cost [for companies issuing debt], that savings should be passed on to consumers," who would end up paying a lower interest rate on an auto loan or a credit card.

The expectation is that over time, as the ABS market improves, demand for the assets will rise—and that will lower the cost of issuing debt for such companies as automakers. They in turn could then lower the interest rates they charge their customers on auto financing, benefiting both consumers and the automaker.

Besides allowing for more leverage, TALF also limits investors' downside risk in case the ABS is downgraded or defaults, since TALF loans are nonrecourse to the investor. So the most an investor can lose is the collateral he has put up. And investors won't be required to post more collateral if the assets' value falls.

Where are the Hedge Funds?

A key question is how much demand for TALF loans will come from such private investors as hedge funds, many of which have suffered enormous cash outflows and may be risk-averse at the moment. Joe Davis, chief economist at the Vanguard Group outside Philadelphia, thinks the main reason more investors haven't expressed interest in TALF is questions about the requirements, which the Fed has been ironing out.

"The private sector is very worried about downside risk. The recession is deepening, and there are going to be more consumer defaults and investment defaults," says Richard Marston, a finance professor at the Wharton School. "If they weren't worried, [private investors] would be purchasing these assets at their current prices. They've got to break this logjam we're in."

Douglas Elliott, a fellow at the Brookings Institution, says he expects TALF will ultimately succeed in reviving the ABS market, since it's "well-designed" and provides guarantees via nonrecourse loans, which will encourage private investors without incurring that high a risk for the Fed.

Unlike securities issued last year, prices of the new securities are factoring in a severe recession and a really ugly scenario for consumer-loan defaults before the economy improves, says Elliott. The new securities have greater protections in place, so fewer consumers need to repay their loans for ABS investors to get repaid. The fact that credit spreads on the securities are much wider than a few years ago means investors will be better compensated for the higher risk they're taking. "That's where you want to buy," Elliott says.

No Student Loan Participants Yet

Among the prime auto-loan issuers that have announced plans to tap into TALF, Nissan Motor's (NSANY) finance arm sold $1.3 billion of triple-A bonds on Mar. 19, and Ford Motor (F) said it soon will issue $2.95 billion of TALF-eligible bonds. Huntington Auto has also mentioned a debt offering.

While private student-loan providers, such as Sallie Mae and First Marblehead, didn't apply for the first round of TALF, they are considering it for future rounds, according to Mark Kantrowitz, publisher of www.FinAid.org, a free Web site for advice and tools on student financial aid. Improved terms, such as lower interest rates, may make TALF loans attractive to private lenders, especially for consolidation loans, which many lenders have been unable to securitize because the margins are too thin, he says.

The main impediment to student-loan providers using TALF is the mismatch between the three-year term on TALF loans and the average 12-year life of private student loans, which can stretch out to 30 years.

"I'm not entirely certain this is going to lead to an improved liquidity situation," says Kantrowitz. It may serve as an incentive for lenders who have considered securitization but remain undecided. The three-year term, however, means lenders would need to find an alternate source of liquidity after the three years are up, he says.

Credit-Card Decline

Despite the request for $2.8 billion in loans to finance credit card securities in the first round, Valentin says it may be tough to attract a great number of credit-card issuers to the TALF. Currently, credit-card issuers are all bank holding companies, which are in no rush to securitize their receivables. That's partly because credit-card use is shrinking, not growing, and partly to consumers having other funding sources, including savings deposits and funds from the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program (TLGP), says Valentin.

"Credit-card issuers are waiting to see what the price [of loans] will be," he says. "If the cost is low enough, and it's cheaper to issue debt than go through the TLGP, they'll use [TALF]."

Elliott at Brookings thinks there will be interest among credit-card issuers. "If you're American Express (AXP) and you're not able to securitize your old [loans], the ability to fund new stuff with securitization through TALF is a godsend."

To expand TALF to include commercial mortgage-backed securities will require a somewhat different structure, says Davis. Either the program will have to provide funding for longer than the current three years, or the securities that qualify for loans will have to be expanded to include longer maturities. Keefe Bruyette & Woods, in a Mar. 19 research note, said CMBS would require funding for seven years, while funding for nonagency residential mortgage-backed securities would need to run five years.

For Davis, the real purpose of TALF is to break the pervasive negative psychology in the market, which has killed investor appetite for risk. Investor confidence often depends on leadership in policy. Contrary to 1931 and 1932, when little leadership was apparent and confidence evaporated as a result, the Fed has been very aggressive this time on the policy front.

"The stakes haven't been this high for policy in a long time," Davis says.

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