Wednesday, March 4, 2009

Could TALF Be The Biggest Disappointment Yet?

Many hopes and dreams reside with what so far has been the best accepted (at least by Wall Street's conventional wisdom) government program - the Term Asset-Backed Securities Loan Facility, aka TALF, aka Prime Broker Of The People, By The People, For The People. But as we have seen before (TARP 1, TARP 2, Tim Geithner) it is usually only a matter of time before those who read (instead of just repeating the talking heads) scratch the surface and sniff between the lines.

An implicit role for the TALF is to provide the role that securitizations used to provide in the good old days (and which also were one of the main factors that lead the global economy to be where it is now), as securitizations facilitate the reselling of leverage by allowing risk tranching (of which Iceland always somehow ended up buying the riskiest class) and further leveraging when it is finally offloaded to the end investor. The TALF launched yesterday in its non expanded version covers $200 billion of loans ($20 billion of TARP funds leveraged 10 times) supporting autos, credit cards, student loans and small business lending. Once the TALF is expanded into its fully unaccordioned state it will have access of up to $1 trillion and will support CMBS, RMBS and ABS corporate loans (through the soon the be downgraded CLOs). The three main benefits to a TALF investor are the following: the program will be non recourse (no risk aside from an initial haircut defined for any specific asset class it is used for), there will be no mark to market, and participants will not be subject to executive compensation limits. TALF has some significant limitations on the surface (and below it, as we will investigate further): the TALF only lets investors back into the AAA market (TALF is not geared at any asset classes below AAA), it does not benefit auto and credit card issuers that have become bank holding companies (due to the direct-from-Fed lower funding costs of on-balance sheet financings), and lastly, the cost of all these incremental loans will have to be funded by the Fed which is already seeking enhanced authority to issue debt and finding ways to create other monetary base expansion mechanisms.

How does the TALF work?

In summary, TALF leverages TARP funds, turning $20 billion of funds into $200 billion purchasing power (or $100 billion leveraged to $1 billion per the revised TALF definition), which as mentioned, is non-recourse and has no-remargining. This means the only risk for investors is the initial haircut, and even that should not be classified as a risk per se (more on this shortly).

The initial problem with the TALF appears its expanded size, which may have been just some more of the Fed's psychology of "picking a really big number." As Bank Of America says, the $1 trillion target size "appears outsized relative to the underlying issuance capacity of the targeted markets suggesting less impact from this program than advertised." Granted, when the TALF was first announced on December 19, it caused a dramatic tightening of AAA spreads in the auto loan, credit card and student loan space, and per the recent update, will also likely benefit the CMBS and CLO AAA spreads. One could argue, and the market would justify, that all benefits from the TALF have already been priced into AAA tranches.

The Treasury's justification for such a focus was the "$1.2 trillion decline in securitized lending" between 2006 and 2008. The figure below demonstrates the changes in level and composition of securitized lending that were being referred to:

Unfortunately for Geithner, who apparently did not read too deeply into the data, the bulk of the $1 trillion decline in securitizations came from home equity lending and non agency RMBS, which reflect the "non-conforming" mortgage market, i.e. the subprime, alt-A and jumbo origination, loans which are the cause for the credit crisis, and which are rated far below the relevant AAA level. The truly unmet market, which the Treasury is addressing is at best 20% of the revised total amount.

Thus, the focus of the TALF appears misplaced. While the original size of $200 billion is applicable to current market needs, pushing for a 5x higher total notional of securitization replacement, even after utter pandering to private participants, is nonsensical, and likely the administration had the unfortunate intent of merely shocking the market into believing that as the program now has a trillion handle, all securitization problems could be resolved. That is patently wrong.

What is in it for the investor?

The TALF will not be demand limited, as it will generate up to 20% virtually risk-free returns to investors, due to low funding levels (roughly 100 bps over LIBOR) and marginal haircuts. The simplest return calculation is taking the net spread on the assets times the leverage, the traditional formula used by all leveraged lenders. Using a prime credit card 3 year loan, this works out to 200 bps over LIBOR less funding costs (i.e. 100 bps) all times 20 (1/ asset specific haircut of 5% as seen in matrix below), resulting in the mentioned 20% return.

Based on that formula the returns would vary between roughly 7% and 20% with essentially no downside risk due to the non-recourse and non-margin nature of the TALF.


As noted above, there seems to be a gross misperception of the nature of the TALF as a product that has been created to address a "demand for credit" problem. This is wrong, as seen in the returns analysis above from a TALF investor's standpoint: the very attractive returns guarantee there will be no lack of desiring participants to use taxpayers' capital and backstopping to generate up to 20% returns. The problem is that in an overall environment of consumer and commercial deleveraging, using the 2006 peak market conditions as a guide to the program's success ignores that based on the inevitable decline in demand by potential securitizers, overall use of the program relative to peak securitization levels will decline. Therefore the $1 trillion maximum utilization target on the TALF is a pipe dream and merely one more round in the government's arsenal of shocking the market with soundbites and large numbers: its old incarnation of $200 billion would have been perfectly satisfactory, even more so as $80 billion less taxpayer capital (via TARP) would have been put at risk. The success of the program will hinge on merely avoiding more defaults and economic damage that would have been inevitable if credit availability had not been there. And lastly, the stupid shift in the administration's push to encourage demand, which will be there regardless, by removing compensation limits is, of course, another blatant demonstration of the government's misunderstanding of its own programs and the supply/demand market mechanics they create. Sphere: Related Content
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Arcturus said...

Thanks for the post. So in your opinion, how long before the Fed/Treasury comes out with TALF 2.0 to attempt to tackle the sub-AAA assets?

Anonymous said...

Is this your research or from a dealer? I would love to see the original.

CreditTrader said...

Tyler - this is one of the best breakdowns on the TALF that I have seen. I threw some stuff at it yesterday but you nail it here! The thing that worries me here (from a bear's perspective) is that it becomes yet another government intermediated market that they can point to and say - "look - everything is better now" - think Libor! What is they can never get away from these deals?

Anonymous said...

Can you buy recent securitizations with TALF money (ones that have already commenced trading in the secondary market)?

CreditTrader said...

yes, if they were issued post Jan 1 2009 right? but you can also do some smartypants financial engineering and take your legacy stuff, re-pack it (jobs for the old structurers), and create a AAA-rated security which you issue now and the market picks up as part of TALF! nice work if you can get it...

Michael Krause said...

Regardless of sizing issues, unused extra capacity isn't such a bad thing this day in age. There will be demand for this since it offers nice returns for participants, and should force interest rates down in the borrower's space. This should be very good for CMBS and thus stabilize the marks on banks' assets.

Am I seeing this wrong?

babar ganesh said...

The analysis of return is fine as far as it goes, but TALF will only provide leverage for the most senior tranches.

Someone (ie private capital) will still have to take the equity tranche. That will have the first loss. So the return to investors will be much less than 20%.

Anonymous said...

I don't think the $1 trillion number was meant purely as shock and awe or for newly issued securities alone. Eventually, outstanding credit, not just newly issued securities, will become eligible collateral. The reason this makes sense is that the presence of the put option embedded in the TALF program reduces the likelihood that the security will drop to the exercise price. (Think about how the risk/reward for an unlevered investor in AAA CMBS improves if the maximum loss on the security is reduced to the security's haircut rather than its full price.) Considering the amount of money the federal government would have to transfer into the banking and insurance sectors to replenish depleted capital if those strike prices were ever reached, it makes reasonable sense to try to prevent prices in the secondary market from falling to those strike prices.

Anonymous said...

From what I've read, wouldn't a major shortfall of the program be that structural support to create AAA tranches is increasing with the declining economic conditions, this means more of the structure will be rated below AAA than would have been the case prior to mid-2008. With TALF only covering AAA, this increases the amounts securitizers will be required to hold on balance or sell at yields/discounts that would wipe out the benefit of creating the securitization.

Anyone with experience in securitization have any thoughts on this?

babar ganesh said...

same question as anon above. so you can get someone to invest in the AAA tranche, fine. who are you going to get the lower tranches? esp now that nobody is going to let you lever against them?

it will be interesting to see if this goes anywhere; i bet it does not.

Anonymous said...

anonymous 6:01pm has it dead on.

the capacity problem in the ABS market isn't at the AAA level. you can find buyers of AAA securities at a price.

the problem is that the originators don't have the balance sheet capacity to hold the subordinates. the consensus in the market is that the subs will be at least 30% of the deal, which would make the required spread on the original loan prohibitively expensive.

the next problem with the TALF (and what makes it such a joke) is that the term is only 3 years. again - there isn't any problem with demand at the short end of the market. the problem is longer dated funding.

the final problem is that only new ABS are TALF eligible. um ... no new ABS (or CMBS) are being created. so at best the TALF can be used to clean up loans that were originated before the ABS market collapsed in sep 08. it only will support new lending if originators use the freed up balance sheet capacity to make new loans. that's very unlikely in the current environment.

so the TALF wins the trifecta of stupidity. it supports the AAA tranches of short-dated ABS that represent relatively recent originations. that's EXACTLY the part of the market that's functioning.

I attended ASF in LV in Feb and the major ABS issuers (AXP, ACF, SLM, COF, DFS, JPM, C, etc) made it crystal clear they had no intention of using the TALF. the only issuers who are even remotely interested are GMAC and FMCC. and even then they weren't sure it made sense.

the biggest joke is the idea that TALF may be used to support the CMBS market. yeah, right. you can't originate a commercial real estate loan right now because of the fact that the equity on every single property that was sold this decade has been wiped out by the massive rise in cap rates (if you listen to the CRE brokers, they will tell you that 'indicated' cap rates at 9%, but the "buyers on the sidelines" won't actually transact at that price because they are waiting for "compelling" returns. that's spin designed to obfuscate the real issue, which is that the bid on CRE right now is in the 15-20% range - not the 5-7% that was prevalent at the market peak).

unless the landlords inject equity or turn the properties over to the lenders, it is impossible to refinance any CRE property that traded in the 2000's. the idea that TALF will magically lead to a refinance wave that will take distressed commercial real estate off of bank and insurance company balance sheets is a pipe dream held by regulators who are even more terrified of what's going on in the CRE market than they are the SFR market.

i mean, how on earth do you finance a 10 year commercial real estate loan with a 3 year TALF ABS? it is idiotic.

the idea of having the government step in to revive the ABS market is not, in theory, a bad one. but the TALF is a joke. it is the by product of a school of thought which still seems to think that what is going on in the market is an irrational panic, and that once cooler heads prevail, ABS/CMBS prices will revert back to "normal" levels.

that's not happening. the sooner the regulators realize that the costs of the clean up will be massive (e.g., > $5T) and borne almost entirely by the public (due to the highly leveraged nature of our financial system) the better off we will all be.

by the way, if you want to hear the bear case on CRE (and it is truly terrifying) talk to the folks at goldman. not the REIT or CMBS analyst, but the top of the house.

the reason the insurance industry has imploded is that the market has figured out they are the biggest owners(via principal investors and CMBS) of US CRE.

and if you want to understand why GE capital is trading points up front, go take a look at their commercial real estate EQUITY exposure. the polish stuff is interesting, but small and *probably* covered by Genworth (even if it bankrupts GEMICO). GECC has no such patsy to absorb the first loss on the CRE deals they did this decade.