Fed Watch: Will TALF Do the Job?

The Administration is putting high hopes on TALF, especially now that the program will reach as high as $1 trillion (remember when $1 trillion was a lot of money?). It has always seemed to me that TALF would fall short of the mark. The key constraint

Eligible collateral includes U.S. dollar-denominated cash ABS that are backed by auto loans, credit card loans, student loans, or small business loans that are fully guaranteed by the SBA, and that have a credit rating in the highest investment-grade rating category from two or more nationally recognized statistical rating agencies and do not have a credit rating below the highest investment grade rating category from a major rating agency.

The expansion of TALF to CMBS also requires AAA-ratings. I suspected that limiting the program to investment grade securities would severely curtail the effectiveness of the program for one simple reason - that, relative to expectations of officials, investment grade borrowers are relatively few, and they have maintained that status by not accumulating excessive debt, so already they are not inclined to borrow. The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt. Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction.

Two recent stories tend to support this point. First, from the Wall Street Journal:

The government's $200 billion program to revive the market for securities backed by consumer loans may end up providing little help to the very industry that needs it most: U.S. auto makers.

As the Federal Reserve hashes out final terms of its Term Asset-Backed Securities Loan Facility, or TALF, it is becoming clear that securities that help finance auto dealers mightn't meet some criteria. That would block a form of funding that auto companies had hoped would provide immediate relief as they fight for survival.

The problem came to a head because of credit ratings. The Fed has insisted that any deal it helps finance be given a triple-A rating from Moody's Investors Service, Standard & Poor's or Fitch Ratings. Bankers said this kicks out deals backed by loans to auto dealers because S&P and Moody's, in particular, have cut the ratings on such securities over the past several weeks as the industry grapples with potential bankruptcy filings and weaker demand for U.S. cars.

The second is from Bloomberg:

The Fed, through the TALF, could reduce the cost of financing commercial real estate by taking as collateral CMBS already traded in the secondary market rather just new bonds, said RBS analyst Lisa Pendergast in Greenwich, Connecticut.

Accepting bonds from the secondary market would be a “big deal” for reviving credit, said Jan Sternin, a senior vice president at the Mortgage Bankers Association in Washington.

The central bank also should make loans with at least a five-year term against CMBS, Pendergast said. The TALF is now geared to make loans of no more than three years against collateral, a misalignment with the typical five- or 10-year term of commercial mortgages.

“Nobody would buy a 10-year asset with a three-year loan,” she said.

The Fed initially proposed a one-year term for TALF loans it will make before revising to a three-year period in December.

Without TALF support, borrowers would have a tougher time refinancing maturing debt and avoiding delinquency or foreclosure, said Chip Rodgers, senior vice president at the Real Estate Roundtable, a trade group in Washington.

The Fed has said it will only accept newly issued AAA-rated CMBS collateral. Presumably, newly issued CMBS could be used to refinance maturing debt, assuming the refinanced debt could be rated AAA. And, I suspect, therein lies the heart of the industry's conundrum. Given the deterioration in credit quality, we can presume that much of the maturing debt is rated at something less than AAA. Much less. Consequently, the TALF would do little to help refinance maturing commercial mortgage debt, at least directly (I would not count on the indirect effect of building confidence in dodgy assets via liquidity programs). They know it - the article contains a telling quote:

Atlanta Fed President Dennis Lockhart said today that commercial real estate is “the one domestic factor that keeps me up at night.”

“Many banks are pretty heavily exposed to commercial real estate,” he said in Orlando, Florida.

Lockhart must sleep well compared to me; I have a laundry list of economic issues that keeps me up at night.

If the maturing debt cannot be refinanced at reasonable interest rates, then rising defaults and additional asset markdowns will wreak further havoc on the banking industry. The Fed cannot fix this if they limit their loan programs to AAA-rated ABS, as the problem debt by definition has a lower rating. This appears to be the signal the industry is sending, so holders of CMBS want the next best thing - the Fed to absorb the risk of the existing AAA-ABS:

Top-rated commercial mortgage bonds are currently trading at about 10.82 percentage points more than benchmark interest rates, compared with 2.32 percentage points a year ago, Bank of America Corp. data show. In January 2007, the debt traded at 0.22 percentage point.

Seems those "top-rated" bonds are riskier than expected. Better to sell them off to the Fed (and eat the haircut) while they are still AAA rated. Of course, it may already be too late; ratings are dropping fast:

Moody's Investors Services downgraded an additional $23.89 billion of commercial mortgage-backed securities amid concerns that losses would grow from increased leverage, reduced reserves to pay debt and loan losses.

The move follows the ratings firm's announcement last week that it would review the ratings of some $300 billion of bonds backed by commercial-real-estate loans. More than a quarter of those securities are vulnerable to multiple-notch credit downgrades.

Last Thursday, Moody's said it will apply new assumptions about falling property cash flows and stressed capitalization rates, which are the ratio of net income to its value, when considering the rating of the bonds. The review is slated to be completed within 60 days.

Including the latest round of downgrades, $62.09 billion of CMBS has been downgraded by Moody's in the past week.

The commercial real-estate market had held up better than the residential real-estate market, but it began to deteriorate quickly at the end of 2008 as the recession deepened.

The ratings firm had expected cumulative losses of 2% on commercial bonds issued between 2006 and 2008, but it has increased that to 5%.

Moody's, which on Tuesday downgraded 124 classes and affirmed 69, expects a significant decline in future property cash flows on higher tenant defaults, bankruptcies and a sharp decline in lease-renewal rates. Those cut include 47 tranches valued at $6.6 billion from Wachovia Corp., which was acquired by Wells Fargo Co. (WFC) five weeks ago, 11 classes valued at $3.8 billion at JPMorgan Chase & Co. (JPM) and 10 classes valued at $2.8 billion at UBS AG (UBS).

Existing CMBS might not be rated AAA for long.

Bottom Line: TALF limitations provide protection for the taxpayer, but curtail the program's effectiveness. This is not meant to imply that efforts should not be made to support the normal functioning of credit markets; it's simply to keep expectations about effectiveness in check.

Comments

[kelm:]

This is a good article - thank you. I have not seen any detailed analysis of TALF until now.

Feb 26 09:45 AM

[Green Eyes:]

I appreciated your bottom line. The rest of it was difficult to get through but this isn't your typical subject matter.

Feb 26 10:35 AM

[phdinsuntan...:]

give me 20% a year insured by the Fed and
I am willing to join TALF and hold this paper in my name
for 3 years! Not less than thatm what about you? Accept 19%? 15%? 10%? 10%? 5%? 1%? swap it for USTB?

Feb 26 04:26 PM

[J. D. Swampfox:]

"The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt. Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction." I think you are right on here! It's even worse when we take into account that the number of high grade entities who want to actually borrow and the amounts they would consider borrowing in the middle of all this uncertainty is very small. That's why they are high grade entities - they're not so dumb as that.

"Lockhart must sleep well compared to me; I have a laundry list of economic issues that keeps me up at night." Wonder why he is losing so much sleep about it? It may be that the collapse of CMBS's on some banks' balance sheets could cause those banks' capital to be insufficient with respect to the terms of the off-balance sheet CDS's. Then one bank's bad CMBS makes another bank have to recognize a bad CDS and place it on their balance sheet... result: snowball and heck to pay.

Feb 26 04:44 PM

[dlaw:]

Awesome. Author calls it.

Folks can pretend that low-grade debt is high-grade for only so long. If that's true of government debt, it's doubly (or triply, or quadruply?) true of MBS.

Feb 26 06:03 PM

[User 365198:]

But I think a lot of people are missing the point of the TALF. You do not have to be a high grade entity to use the TALF. In fact, a CCC entity like GMAC could use the TALF. That is the idea behind securitization. You put the receivables into a bankruptcy remote entity (SPV) so that the securities that are issued can have a higher rating than the issuer. The deal is then structured to have sufficient credit support so that a certain percentage (Probably 80-85%) of the deal will be AAA rated. The problem is that most entities can not use securitization to make new loans because the AAA securities are trading at a significant discount to par. That is where this vehicle comes in. An entity like GMAC can create a pool of newly originated conservatively underwritten auto loans and use the TALF to finance the AAA at par. They would retain the subordinate bonds and a residual interest in the auto loans to ensure the quality of the receivables. The reason why you cannot finance old receivables is because the idea is to promote new lending. There is a hard date in the terms that the recievables must have been originated on or after. These will be high grade securities because the rating agencies have become significantly more conservative in setting subordination levels because their expected losses on the collateral are now significantly higher. Other programs, such as the CAP will inject new capital using convertible preferred equity to bolster bank capital to buffer losses on previously originated receivables.

Feb 26 07:21 PM

[JohnL:]

--“Nobody would buy a 10-year asset with a three-year loan,” she said.--

What is she talking about? The financial industry has been borrowing short and lending long for years. That is part of our problem -- failure to align assets and liabilities, causing liquidity problems and forced selling. Hmm...I wonder why they couldn't get people to loan them that quantity of money for the long-term?

Feb 26 07:57 PM

[Robert Nabloid:]

What a waste of money. Ah well, it's only US Dollars... not like they're worth much anyways (at this rate). Too bad people decided to throw it all away. I personally can't wait for change from all this political BS. Ron Paul was real change. Too bad America was so infatuated with physical appearance, rhetoric and 'propaganda inspired emotions' instead of intellectual substance from a real PhD (not a deceiving lawyer who never says anything of substance!).

Eight more years of this crazy fiscal irresponsibility is scaring more people than its helping. We already had a bad eight year run - and now we are almost guaranteed to turn it into a bad 16 year run. I don't know if the US can take another bad eight years of social spending and big government - Look at what a toll the first eight did! The saying used to be "Uncle Sam Needs You!" Now? "Uncle Sam Owns You! (and your house, car, land, 401k's, children, pets, dollars, gun, job, etc)"

We are a broke nation who's main economic driving force will quickly be retiring (or they would be retiring if they could afford it!) and requiring medical services in a unprecedented scale. It's about time we realize demographics plays a huge role in all of this. You can't spend your way to economic prosperity with debt dollars or every third world nation would be prosperous beyond belief by now. Trust me on this, it didn't work for anyone else. I've never seen a single country or business use this model and succeed. America is following the typical and easy route that most drug users take - When it starts to feel bad, do more until it feels good again - but eventually you OD.

It helps that America has the world currency and can print it out of thin air (something the rest can only dream of) - but the world won't continue to buy them dollars forever if this continues. The dollar is not stable.

America is lost and headed down a dangerous path which leads to death. We must find our way back to fiscal responsibility, regardless of which party is in power. It's not a political thing - it's an economic and money thing. Besides, I think most of us can agree, Washington has centralized far too much power in its hands and it hasn't done a whole lot of good. Our rights are being infringed upon and a nanny state is emerging from which we all beg for crumbs. I'd be in favour of bringing more power back to the individual states and the individual citizen. This patient will be terminal if this continues for too long - and the scary part is we don't know how long is too long. Maybe it's already too late?

Feb 26 09:39 PM

[JohnL:]

"Ron Paul was real change."

Amen. If we had listened to the man over the last 30 years, we wouldn't be up this creek.

Feb 26 09:47 PM

[MichaelZChi...:]

You are mixing apples and oranges. Loans placed on individual assets are maturing, and these loans are not rated. Refinancing the assets with new CMBS debt is currently not a viable option because of lack of market demand, and wide spreads are a symptom. Government participation as buyers, lenders or guarantors of new AAA bonds will help restore investor confidence and restart the market for new CMBS issuances.

Feb 26 11:09 PM

[billy32:]

banks are in a whole heap of a mess, and there could be more woes to come, see here crashmarketstocks.com

Feb 26 11:42 PM

[ArkansasAngie:]

And thus you have the straw that breaks the camel's back. It takes two to make a transaction. These legal construcks should be disolved. They never happened. Return the premiums. Heck! with interest.

On Feb 26 04:44 PM J. D. Swampfox wrote:

> "The spending bubble was not driven by high grade debt; it was driven
> by low grade debt disguised as high grade debt. Focusing on high
> grade debt as the solution will thus prove insufficient to give the
> economy much traction." I think you are right on here! It's even
> worse when we take into account that the number of high grade entities
> who want to actually borrow and the amounts they would consider borrowing
> in the middle of all this uncertainty is very small. That's why they
> are high grade entities - they're not so dumb as that.
>
> "Lockhart must sleep well compared to me; I have a laundry list of
> economic issues that keeps me up at night." Wonder why he is losing
> so much sleep about it? It may be that the collapse of CMBS's on
> some banks' balance sheets could cause those banks' capital to be
> insufficient with respect to the terms of the off-balance sheet CDS's.
> Then one bank's bad CMBS makes another bank have to recognize a bad
> CDS and place it on their balance sheet... result: snowball and heck
> to pay.

Feb 27 08:04 PM

[vaughn:]

So long as the yield on the AAA assets is higher than the cost of fed loan under TALF, hedge funds, etc., will do this given the non-recourse loan and lower hair cut. (the hair cut portions sounds like the equity, the loan from the TALF sounds like leverage)

I guess the yield on the aaa assets must be greater than LIBOR plus 100 bps. Anyone in the business knows that can be done? I don't know, but I shall not be surprised if the FED lowers the lending rate to libor flat.

Mar 03 01:54 PM