The Federal Reserve Board will launch the first phase of the Term Asset Backed Securities Loan Facility “TALF” program next week. The approved amount is a meager $200 Billion. The Obama administration has said it expects to expand the TALF to as much as $1 Trillion. These trillion dollar numbers keep coming up and one would think that such enormous sums of money will surely lead to a reversal in the endless contraction of available credit. Unfortunately that is not likely.
The objective of TALF is to revive the moribund asset-backed security "ABS” market. Those that work in this space know that a shot in the arm of this once critically important segment of the credit market is necessary.
The ABS market is the off balance sheet side of the regulated financial institutions. The history books will point to the extraordinary growth of the ABS market over the twenty years prior to 2007 as the single biggest contributor to the financial meltdown of 2008. The Shadow Banking System that evolved had all the ingredients for a problem. It was unregulated. There was no recourse or accountability of the assets that were created by the regulated institutions. There was little or no equity in the vast majority of the deals that were securitized. Investment grade ratings were applied to the securities that had been issued. The rating agencies used seniority ranking to justify these ratings. The layer cake approach to the corporate balance sheet was embraced. With all those subordinated tranches ‘beneath’ the Senior paper those AAA rating seemed justified. As it turned out this was one of those assumptions that just proved to be totally false.
Timothy Geithner then head of the NY FED described the Shadow Banking System in 2007. He provided these insights:
- $2.2 Trillion was funded by the commercial paper market.
- $2.5 Trillion was funded overnight in the repo market.
- $4.0 Trillion was funded short term by the large brokerage houses
- $1.8 Trillion was funded short term by large hedge funds.
A total of $10.5 Trillion of medium to longer term assets were being funded by short term IOU’s before this credit bubble blew up. No wonder we are in trouble today.
Mr. Geithner commented on the sheer size of the Shadow Banking System, “By comparison the traditional banking system as a whole held about $10 Trillion.” Possibly some bells should have gone off with this revelation.
There are very few players still standing that held this $10.5 Trillion two years ago. Those that are left do not want to be there any longer. Therefore in order to restore the true functioning of the ABS market something in excess of $5 Trillion has to be poured into it. The $200 Billion of TALF money that has been committed represents 2% of the outstanding ABS market. If the Obama Administration can sell Congress on an expansion of the program they might get the funds to extended the TALF to a total of $1 Trillion. That will still be less than 10% of the level outstanding at the end of 2007. The proverbial drop in the bucket.
As of this writing it has not yet been established whether the TALF program will accept only “new’ financial assets or permit banks to re-securitize their old book of IOUs. The banks want the opportunity to rearrange the deck chairs on their Titanic. The FED/Treasury are trying to create a ‘home’ for newly created assets. The most likely result will be a clarifying announcement next week that permits both old and new assets to be eligible collateral for TALF participation.
The FED will require that the collateral provided to TALF have a long-term credit rating in the highest investment-grade rating category. They require that these ratings be from “two or more major nationally recognized rating organizations”. In other words the FED will be relying on S&P, Moody’s and Fitch to determine what is “acceptable”. Talk about repeating the mistakes of the past.
The definition of Eligible Collateral for participation by a bank at the Discount Window of the FED today is much broader than the definition for eligibility under TALF. Therefore any bank can finance all of the collateral it has available without needing TALF. The banks want TALF because it gets the assets off of their balance sheet and into the unregulated Shadow Banking System. This is old school thinking. Balance sheet size and earnings per share were the metrics that drove the creation of the ABS market. EPS is a dead concept for banks in 2009.
At an initial size of only $200 Billion, TALF is irrelevant. That it will be increased to near $1 Trillion seems inevitable. President Obama, his economic team and Mr. Bernanke have all spoken volumes in recent months on the need for greater regulation and control of the credit formation process in America. It is interesting to note that the TALF program will provide a Trillion Dollar package in support of the unregulated Shadow Banking System.
Surely Mr. Bernanke, Mr. Geithner and President Obama are aware of this glaringly inconsistent policy. What concerns this writer is that in the rush to “do something” the Administration and the FED has overlooked this conflict and will stumble on it in the coming months. Either way TALF is DOA.