Why the Fed's TALF Is Bad for America

The recent Term Asset-Backed Securities Loan Facility (TALF) announcements bring to mind Einstein’s definition of insanity – “doing the same things over and over again and expecting different results”. It is well documented that securitization of loans, use of leverage, and government intervention in the free markets helped inflate asset bubbles, fostered a culture of debt, and distorted the efficient allocation of limited resources in our economy. If you want a good real world example, Fannie Mae bonds guaranteed by the government, backed by a pool of subprime mortgages, and bought using borrowed money (leverage) touches most of the bases. In the past, we have outlined the problems associated with the government guarantees and distortions of the free market. Our government created Fannie and Freddie with the noble goal of helping more people become homeowners.

The following is a summary of a September 8, 2008 CCM article Welcome to the Mortgage Business, which highlights the law of unintended consequences:

Mortgages carry risk. If you place a guarantee behind a mortgage-backed security, like Fannie and Freddie bonds, there really is no risk to the investors who keep supplying capital to the mortgage market. As investors supply more capital to the system, more questionable mortgages can be written and builders can keep building more houses. Why is anyone guaranteeing mortgages? Placing a guarantee behind a risk asset creates moral hazards. Why? Because the loan originators do not care if the mortgage holder keeps making their payments since they can sell the mortgage to Fannie and Freddie, who in turn will place a guarantee behind the mortgage. The guarantee behind Freddie and Fannie bonds were and will continue to be a source of moral hazard. If you remove the guarantee and Fannie and Freddie from the entire system, banks and investors would treat mortgages as risk assets, which is what they are. Instead of propping up Fannie and Freddie with taxpayer funds and guarantees, both firms should be gradually removed from the system. The free market can supply mortgage capital to people who have the necessary debt-to-income ratios and credit history. Loans should be made to people who can pay them back. The current state of the mortgage and housing markets clearly illustrates the results of placing guarantees behind risk assets, which is what Fannie and Freddie do. Fannie and Freddie are part of the problem, not part of a solution. Selling a house to someone who is unable to make the payments is not helping anyone and is not part of the American Dream.

In March of 2009, the Federal Reserve’s TALF attempts to correct the problems of the day by encouraging more of the same. The highlights of the plan to “return the credit markets back to normal” include:

• The Fed offering cheap credit to large players in the private sector including hedge funds and private equity firms.
• Businesses are encouraged to loan money to small businesses and consumers to purchase more cars, trucks, heavy equipment, houses, commercial real estate, or anything using a credit card.
• Businesses that make loans can securitize them (sound familiar?) and sell them to the hedge funds and private equity firms who buy them using leverage as high as 12-to-1 (sound familiar?). The capital to leverage is provided by our government.
• Hedge funds and private equity firms will not have to post any collateral for their Fed loans, making it even easier to overextend themselves with credit.
• With the government providing a backstop, investors can, according to the Wall Street Journal (03/04/09), "walk away from a deal if they are unable to repay the Fed loan, losing only their initial investment." TARP (a.k.a. the taxpayers) will absorb the initial losses.

The Fed is no longer the lender of last resort, but has become the only lender. For those not keeping tabs at home, the Fed has doubled its balance sheet assets to an eye-popping $1.92 trillion in the past year via the creation of numerous emergency and “temporary” credit programs. Under TALF, the Fed is becoming a giant prime broker for hedge funds and private equity firms. Many of the real world prime brokers effectively ran themselves out of business with securitized loans and use of high leverage (e.g. Bear Stearns and Merrill Lynch). The Fed hopes hedge funds and private equity firms can be enticed to buy more asset-backed securities with favorable loan and repayment terms.

Just as a government backing of mortgages distorted the housing markets, resulting in overbuilding and "homeowners" who should have been renters, the TALF program will distort the free market by effectively subsidizing specific types of loans related to a limited number of industries. There is a reason the "shadow banking system" has dried up – supply and demand. Given the state of the economy and consumers’ impaired balance sheets, demand for loans has naturally decreased while the risk of making the loans has increased. Rather than accept the natural consequences of poor decisions, the government is hoping to get the whole cycle started again with TALF as a primary driver.

The supply of asset-backed securities (ABS) is already overwhelming a market with few interested buyers. Increasing the supply of securitized loans, which is what TALF will do, is not going to help stabilize prices in a market that is having trouble finding a bid. The use of leverage basically creates additional buying power and helps distort asset prices. Leveraged buying power has contributed to distorted prices in many markets including housing, stocks, commodities, and the ABS market. The recent crash in asset prices shows us what happens when the artificial demand of excessive leverage is removed from the system. TALF hopes to create more artificial demand via leverage in the ABS market.

The Wall Street Journal (03/04/09) confirms the Einstein theory:

The government, in essence, is trying to save the economy by turning to the very financial engineering that spun out of control during the credit boom.

Government backing of programs, subsidies, and guarantees to limit losses, lead to distortions in the way capital is allocated in our economy. Evidence of this is already surfacing. In a Washington Post article, Stephen Schwartzman, head of the Blackstone Group, said his firm has decided to look into buying up the assets offered in TALF, though the firm has never bought the securities before. The government’s program will pull capital away from more productive free market projects as favorable terms change the behavior of market participants. Look no further than the glut of unsold homes to see the effects of inefficient allocation of capital due to government "incentives".

The TALF program and basic concepts were originally announced in November of 2008. Due to the complexities of the program, the first TALF loans to hedge funds and private equity firms will be made available on March 17, 2009. The stock market has not been encouraged by the basic concept of TALF. We will have to see how asset prices react once the program is up and running. The early returns reinforce the need for a disciplined risk management and stop loss discipline. The S&P 500 recently broke through long–term support, an event that should not be taken lightly by investors. The longer the S&P 500 stays below 741, the less likely that TALF will be the rabbit the markets are hoping policymakers can pull out of their bailout hat.

Rather than letting nature take its course and see consumers begin to pay down excessive levels of debt, the TALF program encourages the accumulation of more debt. Recessions purge bad debt from the system and punish poor decision makers and managers. The United States needs to check itself into credit rehab rather than go on another credit bender that will only create more bubbles.

Comments

[MARTYPAUL1943:]

GECC should either be broken in two different companie, spun off to stockholders, and stop buying leases from third party lessors that have no recourse. If GECC in some form is spun off, the monies that they can raise would have negated borrowing money at a high rate from the past great envestor. People still consider Buffet a great investor. Do you think that his stock is down $70,000.00 per share makes his stock holders happy. Sorry I lost track. Immelt and the entire board of directors must be replaced. This morning on CNBC the CFO was almost as good as immelt at spinning the truth. His answere was IF THIS< IF THAT< IF THE QUEEN HAD ____> He gave nothing of substance

Mar 05 11:30 AM

[tivoboy:]

Is this some future prediction?

"The following is a summary of a September 8, 2009 CCM article Welcome to the Mortgage Business, which highlights the law of unintended consequences:"

Mar 05 11:46 AM

[athena:]

Bravo, you summed it up.

Mar 05 12:12 PM

[pacman1947:]

Chris,
The government is anything but consistent in these matters. Maybe the NYSE can delist the companies accepting bailout money and whose stocks have fallen below $1 a share -- usually the break point for delisting. These would include Citi and AIG, and soon many more -- GM, Ford, etc.

Maybe Geithner and Co. can issue stock in their efforts to nationalize. In my view, many of the actions by the Fed and Treasury since this fiasco began are utterly unconstitutional. We can write articles on that subject too. King Henry smiles upon his kingdom!

This is not a Republican or Democratic calamity -- It is America being victimized by fools who do not know what they're doing. Einstein had it right.

I hope that someone puts an end to these tragedies and soon!

Mar 05 12:22 PM

[Jason Rines...:]

The American people will default on all obligations that are not assigned to there own personal behavior. Those investors ga ga about debt market are in for a very rude surprise, including sovereign debt holders. I am not advocating such a citizenship response just projecting on outcome. That outcome is the stuff of civil war or global war.

Mar 05 12:56 PM

[NahP:]

Hey COOK

Why are you talking about GECC when this article is on TALF?

Mar 05 01:20 PM

[User 370440:]

Perhaps we should just complete the shift and take the private market out of the mortgage business. That would remove moral risk altogether and the temptation for the financial industry. This was also a problem in the run-up to the Great Depression, if I remember my history correctly. However, I believe the problem lies more in the concept of the market as rational and using that as an indication of the general health of a company or using statistics and mathematical modeling to predict the health/growth of a company. Results of correlations between behaviors and attributes in a group cannot predict individual outcomes or conditions, only the general behavior of the group. This basic misunderstanding gave false confidence to the habitually positive and undermined the few analysts who spoke up about systemic problems. The fault lies in a failure to understand the ramification of a system in which short term profits always win over long term stability, which is what fund managers demand, and reinforces self-destructive but spectacular policies. I am a firm believer in free enterprise, but we simply have to rethink our "debt is good" mentality or the problems will be perpetuated.

Mar 05 02:17 PM

[vaughn:]

Irrational market induced by fear requires extraordinary measures to counter the fear. The Talf will work so long as the buyers of AAA rated assets have reasonable belief they will make money out of this and it is highly likely the FED will charge the interest far below the yield of those assets will bring. If Talf works, that means all originators will have a new source to create credit.
Bottom line: The market will be flooded with newly created credit by the shadow banking system which will then put some sense back into the nonsense market which will bring up the artificial deflated price back into fair price. (Note: mark to market price is not fair price for economic sense. Mark to market price is fair price only from the view point of bean counters)
The credit market has already responded to the TALF program,just look at the buying spree of the super senior CDO.

Mar 05 04:13 PM

[Howard_T:]

TALF is like trying to prop up a weakened structure by using the same building techniques that caused the structure to weaken in the first place. What ought to be done is to let the thing fall down. After the dust has settled, go in and find out exactly what went wrong (already obvious), salvage whatever good pieces remain, then start building all over again, but without making the same mistakes. Sure, there'll be pain, but it will be over a lot sooner than frantically trying to prop up something that's doomed to fail eventually.

Mar 06 10:12 AM

[MarkitWacha:]

I agree with the premise of the article--government intervention in markets will skew them and cause different allocations of capital. I can see what they're trying to do: they're trying to reduce the volatility involved in price discovery in a pariah's market. This will reduce the brunt of the problem the government created in the first place, but will also result in artificially high prices again (back to the bubble future). To any government official that's reading this: the road to hell is paved with good intentions.

The government should concentrate on what it's good at: controlled, orderly failures of bankrupt institutions. Regulation. Acting as the lender of last resort. Pulling the strings on interest rates.

One other point: All these 'facilities' from the Treasury are driving Bernanke crazy, so much so that he wants to have the authority to buy assets now. So, on the one hand, Bernanke is buying bonds, and, at the same time, the Treasury is issuing new bonds. Can anyone explain how that's rational behavior? Maybe someone in a high government position should read Einstein.

Mar 06 12:32 PM

[john1:]

Just more unpatriotic negativity from liberals who hate America, Ronald Reagan, the great business leaders of America, and the troops.

Mar 06 06:28 PM