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TALF: A bailout if one reads the fine print

The Federal Reserve established the TALF (Term Asset-Backed Loan Facility Programme) to help provide liquidity to the asset-backed  securities market — you know, the market with all those toxic CDOs, MBSs, and the like. This facility goes into effect this month.  So, it would be nice to take a look at what it will achieve and how it operates.

The following page is now up on the New York Fed’s site regarding the TALF. Pay attention to my highlighting.  I sum it up at the bottom:

GENERAL

Why is the Federal Reserve establishing the TALF?
The asset-backed securities (ABS) market has been under strain for some months. This strain accelerated in the third quarter of 2008 and the market came to a near-complete halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS rose to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and U.S. Small Business Administration (SBA)-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads.

How will the TALF work?
Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral. On a fixed day each month, borrowers will be able to request up to two three-year TALF loans. Loan proceeds will be disbursed to the borrower, contingent on receipt by the New York Fed’s custodian bank (custodian) of the eligible collateral, an administrative fee, and margin, if applicable. As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets. The New York Fed will publish a Master Loan and Security Agreement (MLSA) which will provide further details on the terms that will apply to borrowings under the TALF. The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

ELIGIBLE BORROWERS

Who may borrow under the TALF?
Any U.S. company that owns eligible collateral may borrow from the TALF provided the company maintains an account relationship with a primary dealer. An entity is a U.S. company if it is (i) a business entity or institution that is organized under the laws of the United States or a political subdivision or territory thereof
(U.S.-organized) and conducts significant operations or activities in the United States (regardless of whether any such an entity has a parent company that is not U.S.-organized), including any
U.S.-organized subsidiary of such an entity; (ii) a U.S. branch or agency of a foreign bank (other than a foreign central bank) that maintains reserves with a Federal Reserve Bank; or (iii) an investment fund that is U.S.-organized and managed by an investment manager that has its principal place of business in the United States. Notwithstanding the foregoing, a U.S. company excludes any entity that is controlled by a foreign government or is managed by an investment manager controlled by a foreign government.

May a U.S. subsidiary of a foreign entity borrow from the TALF?
A U.S.-organized operating subsidiary of a foreign entity may borrow from the TALF so long as (i) the U.S. subsidiary conducts significant operations or activities in the United States and (ii) the U.S. subsidiary is not directly or indirectly controlled by a foreign government. A U.S.-organized investment fund subsidiary of a foreign entity may borrow from the TALF so long as (i) the U.S. subsidiary is managed by an investment manager that has its principal place of business in the United States; (ii) the U.S. subsidiary is not directly or indirectly controlled by a foreign government; and (iii) the investment manager of the U.S. subsidiary is not directly or indirectly controlled by a foreign government.

What is an “investment fund” for purposes of the TALF eligible borrower definition?
An investment fund is any type of pooled investment vehicle, including a hedge fund, a private equity fund, and a mutual fund, or any vehicle that primarily invests in eligible collateral and borrows from the TALF.

What types of investment funds are eligible borrowers?
Investment funds that are organized in the United States and managed by an investment manager that has its principal place of business located in the United States are eligible borrowers for purposes of the TALF. However, any investment fund that is controlled by a foreign government or is managed by an investment manager controlled by a foreign government is not an eligible borrower for purposes of the TALF.

Example
InvestcoBermuda is a “master” investment fund organized in Bermuda that makes joint investments on behalf of InvestcoUS, a U.S.-organized investment fund, and InvestcoCayman, a Cayman Islands-organized investment fund. InvestcoBermuda, InvestcoUS, and InvestcoCayman are all managed by an investment manager with its principal place of business in the United States. Only InvestcoUS is an eligible borrower because it is the only investment fund that is U.S.-organized. If, however, InvestcoBermuda establishes Newco, a subsidiary investment fund, in the United States and hires its U.S.-based investment manager to manage Newco, Newco would be an eligible borrower for purposes of the TALF.

What is the definition of “controlled” for purposes of the eligible borrower definition?
For purposes of the eligible borrower definition, a foreign government controls a company if, among other things, the foreign government owns, controls, or holds with power to vote 25 percent or more of a class of voting securities of the company.

Can a newly formed investment fund borrow from the TALF?
Yes, so long as it satisfies all the eligible borrower requirements set forth above.

ELIGIBLE COLLATERAL

What types of ABS are eligible collateral under the TALF?
Eligible collateral (eligible ABS) will include U.S. dollar-denominated cash (that is, not synthetic) ABS that have a credit rating in the highest long-term or short-term investment-grade rating category from two or more major nationally recognized statistical rating organizations (NRSROs) and do not have a credit rating below the highest investment-grade rating category from a major NRSRO. Eligible small business ABS also will include U.S. dollar-denominated cash ABS that are, or for which all of the underlying credit exposures are, fully guaranteed as to principal and interest by the full faith and credit of the U.S. government.

All or substantially all of the credit exposures underlying eligible ABS must be exposures to U.S.-domiciled obligors. The underlying credit exposures of eligible ABS must be auto loans, student loans, credit card loans, or small business loans fully guaranteed as to principal and interest by the SBA. The set of permissible underlying credit exposures of eligible ABS may be expanded over time. The underlying credit exposures must not include exposures that are themselves cash or synthetic ABS. The expected life for credit card or auto loan ABS cannot be greater than five years.

Eligible ABS must be cleared through the Depository Trust Company and, except for SBA Pool Certificates or Development Company Participation Certificates, must be issued on or after January 1, 2009. All or substantially all of the credit exposures underlying eligible auto loan ABS (except auto dealer floorplan ABS) must have been originated on or after October 1, 2007. All or substantially all of the credit exposures underlying eligible student loan ABS must have had a first disbursement date on or after May 1, 2007. SBA Pool Certificates and Development Company Participation Certificates must have been issued on or after January 1, 2008, regardless of the dates of the underlying loans or debentures. The SBA-guaranteed credit exposures underlying all other eligible small business ABS must have been originated on or after January 1, 2008. Eligible credit card and auto dealer floorplan ABS must be issued to refinance existing credit card and auto dealer floorplan ABS, respectively, maturing in 2009 and must be issued in amounts no greater than the amount of the maturing ABS.

Key points:

  1. The TALF is meant to provide liquidity in the Asset-backed securities market to any company – hedge fund, foreign-owned U.S. subsidiary, mutual fund, private equity fund, whatever — except Sovereign Wealth Funds (SWFs).  SWFs get the stick.
  2. The TALF covers AAA assets with a maturity under 5 years for credit card and auto loans.
  3. The TALF is non-recourse, meaning the government can seize the toxic assets if the borrower doesn’t repay, but the government has no other claim on the assets of the debtor. That means you can get a loan from the government in return for toxic assets, but if you do not pay the loan back, no penalty is exacted except seizure of the assets.  This is very much like a mortgage agreement.
  4. Seized toxic assets will be put into a Special Purpose Vehicle controlled by the U.S.  government.  Translation:  please dump your toxic assets with us. We will take them off your hands and have no recourse to any other assets you own.

In short, the TALF is a way for any and all comers, domestic and foreign, with toxic U.S. asset-backed securities, to dump those assets on to the U.S. government at taxpayers’ expense.  This is happening right now right under your noses and it smacks of crony capitalism.  At least the Fed has the transparency to spell it out.  But has anyone noticed?

Sources
Term Asset-Backed Securities Loan Facility: Frequently Asked Questions –  NY Federal Reserve
Nonrecourse debt – Wikipedia

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

13 Comments

  1. HN says:

    Hmm.. smells like a sale masquerading as a loan. Anyone know what haircut the Fed will apply? Surely Uncle Sam aint lending par, is he ?

    • @HN, those are my thoughts exactly. Basically, you have two possible outcomes.

      1. Irrational Despondency: The investment company’s asses are depressed due to overly bearish sentiment and poor liquidity. As the government steps in with liquidity, all of this changes and the assets rise to their true value. The company sells the asset and/or repays the loan. All is well.

      2. Continued Deleveraging: asset price depreciation reflects actual distress. The asset values remain low and the investment company is unable to repay the loan. The Fed seizes the asset and puts it into an SPV owned by the government. The Fed takes a loss on the investment. But, this doesn’t matter since it can print money at will.

      As to the haircut Uncle Sam takes? Bernanke seemed to address this last month in this video:

      http://www.creditwritedowns.com/2009/01/bernanke-speech-at-the-lse.html

  2. Haircuts are listed here: http://www.newyorkfed.org/markets/talf_terms.html

    I’m a structured finance lawyer, and I’m not wild about the TALF either. The government is essentially making a huge bet on the rating agencies, since a triple-A seal is all that’s required to access the TALF. Trust me, the rating process for ABS is more of a negotiation than an independent analysis — and the Street ALWAYS wins those negotiations. The Street will try to ram a crappy ABS through first (sub-30% subordination), and if they can get a triple-A for the crappy ABS, they’ll rev up the Great Securitization Machine again. I’ve seen that movie before, and it doesn’t have a happy ending.

    The Fed is also going to expand the TALF to include CMBS, and probably non-agency RMBS too.

    I don’t think people realize that the TALF is the real bailout program, especially now that the Fed has pushed back the cut-off dates for when the underlying credit exposure was originated (from 2009 to around late 2007). All the ABS that the banks weren’t able to sell off before the securitization market collapsed — which the banks are refusing to mark to market — will suddenly be monetized by the Fed, at higher-than-market prices.

    The press seems content to focus on trivial aspects of the bailout like the “stress test” and the public-private bad bank, quoting academic economists with very little knowledge of capital markets on whether the trivial programs will “work.” Meanwhile, the Fed is negotiating with the banks over the details of the real bailout. That’s fine with me, actually — I haven’t seen a pundit offer an informed opinion on the financial markets in months.

  3. Kid Dynamite says:

    isn’t the TALF just the good bank / bad bank plan in disguise, with the Fed eating all the bad assets?

    as for the ratings – oh man – it’s UNREAL that they’re using existing ratings.

  4. Hello, I followed across from naked capitalism. Does anyone know in more detail what happens on default? I find it hard to believe that there is really no cost of default other than loss of assets? For example, a mortgage defaulter would struggle to get another mortgage for a while. Maybe if a firm walks away from one under-water asset, they can no longer use the facility for other assets? That would provide some disincentive to default.

  5. Russ says:

    The investment company’s asses are depressed due to overly bearish sentiment and poor liquidity.

    Enjoyed the Freudian typo!

  6. jan says:

    What’s even worse is that Geithner’s “Public Private Investment Fund”, is going to work the same way — with non-recourse loans. That will ensure that the government overpays for the worst of the worst toxic assets.

  7. Brian says:

    1) “Eligible ABS must be issued on or after January 1, 2009.” – Big difference from the ‘toxic waste’ most people seem overly concerned is going to end up in this program and given that very little ABS issuance, of any type, was actually going on pre-TALF 2009 most issuance will be post-February.

    2) My reading suggests that CDOs are not eligible collateral given that the direct collateral of a CDO is other debt obligations not a car, house, etc…

    3) Haircuts range from 5% to 16%, so every investor/borrower is going to need to bring some capital to play. Higher credit quality and shorter average lives mean lower haircuts. A 3-year loan collateralized by the ‘AAA’ tranche of a subprime securitization with a 5-year average life will cost a borrower 10% of their own money. It is unlikely they are going to earn a spread (ABS interest – TALF interest) sufficient to cover the loss of that 10% in a three year period so repayment had best be the exit strategy of a borrower at origination. Any principal payments received must be proportionately remitted to the New York Fed.

    • robinmarc says:

      I’m puzzled by the suggestion that TALF will have the government buying toxic assets.

      If the government was offering to lend against or buy loans originated in 2007 and rated AAA in 2007, I could see the concern. But as I read this, the underlying collateral must be NEWLY originated AND AAA rated. Are folks here suggesting that NEWLY originated loans in a structure rated AAA (presumably not a legacy AAA) are “toxic?”

  8. CapVandal says:

    I agree with Brian’s comment and have written a blog post about Harley Davidson, who needs to securitize loans and is currently jammed up.
    HOG is a decent company and their ABS’s should be appropriate.
    Since the treasury is the buyer, they could have as much input into the details of the security as they want.
    In addition, the credit rating agencies seem to have gotten religion in some cases and have been pretty quick on the trigger.
    It is really a question of how many assets like the Harley dealer loans are clogging up balance sheets.

  9. CapVandal says:

    It is at least theoretically possible that the investment banks don’t have to fix their balance sheets to do these deals. That is, the loans could get originated, securitized, and sold without any change or bailout to the legacy investment banks.
    The so called “toxic assets”, if limited to structured securities, aren’t on the balance sheet of commercial banks — just investment banks. There seems to be a big effort to blur the distinction, but the commercial banks in the top 20 without significant investment banking operations simply don’t have ABS’s in quantity — just whole loans. Some of those portfolios may be awful (Pick a Pay), but as whole loans aren’t the same sort of problem. You can look at the balance sheets of companies like WFC and USB and won’t find much. Wells has some auto loans, but they don’t seem to be a problem.