The greatest bait and switch of this generation in all its visual splendor. As a result of the TALF's non-recourse/non-margin nature, a hedge fund X can buy Bank X's MBS Portfolio which is marked on the bank's books at 80 cents on the dollar (but has a market price of 20 cents) for the marked price with a 3% equity check and TALF filling the balance. A day later, Bank X repurchases the portfolio from hedge fund X at the 20 cent market price, and pays HF X a $5 million fee for the "trouble." The way this would be effectuated is that at t+1, the Hedge Fund decides to run a loss model via TREPP of what have you, and, lo and behold, realizes the loan will default in 1 day (assumptions and outcomes can be easily fudged) and threatens to default on the entire TALF portion. The key word here is non-recourse: the HF would not be liable for anything over its first-loss equity component. In the case of a declared portfolio default, the TALF portion would have to be marked at pure market value, and taxpayers would get stuck with as close to a donut as possible. So here is Bank X running back to the rescue, offering to buy back the original portfolio at market price (even a 1 cent premium would make it politically palatable), in this case 20 cents. For the sinister minded, it become immediately evident, why hedge funds, once loaded up on these investments, would have an incentive to push down the value of the entire portfolio complex, especially if they, wink wink, bought protection via CMBX or other derivatives. The recent spike in CMBX spreads (massive buying pressure) may be one indication of just how hedge funds might be positioning themselves.
Once purchased the bank waits for the portfolio to appreciate to 50 cents on the dollar by 2014 (although the appreciation is not necessary and is a best case example of how the bank would fare if the market does pick up). Hedge fund X takes a 75% loss on its nominal equity stake but more than makes up in transaction fees. The TALF portion takes a 75% loss with no recourse and no margin to fall back on.
As a result Bank X takes no writedown now, and in 5 years may book an equity profit of as much as $25 million (net of transaction fees paid to the Hedge Fund X), while Hedge Fund X books a profit of $3.2 million for one day's work...
Lastly the U.S. taxpayer loses $54.3 million on a $77.6 million TALF Investment, or 70% (net of 5 years of interest income).
Note: the maximum TALF size is $1 trillion. Will U.S. taxpayers suffer $700 billion in losses from the TALF? Ask your congressman.
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