Friday, November 28, 2008

We need? What about you need?

The Fed's new Term ABS Loan Facility (TALF) announced this week could be a significant step in improving credit availability. While many of the details of the program are not yet known, there is already several take aways.

First, this looks and smells a lot like a back-door way of reviving some of the TARP's original concept. Consider what we already know about the program. Eligible collateral for the TALF will basically include AAA-rated bonds within the major non-housing ABS sectors: auto loans, student loans, credit cards, and SBA loans. TALF loans will have a one-year term and will be non-recourse to the borrower. The facility appears to be oriented toward banks and insurance companies, but may actually be available to anyone. TALF loans "will no be subject to mark-to-market or re-margining" which is a critical part of the program.

Now put these criteria together and consider the effect. A bank may originate loans of the above types, then get funding from the Fed at an attractive rate. There is no need to worry about the funding being taken away suddenly because of changing haircuts, nor is there any worry about interim marks impacting economic results. The originator does have an incentive to make a good loan, since the Fed is going to require some haircut. But as long as the originator can make good loans, the eventual profit will be the differential between the lending rate and the Fed borrowing rate.
Let's look at a real life example. COMET 2008-A6 A6 is a credit card ABS issued in May. The original deal spread was +110bps over 1-month LIBOR with a 2.4 year average life. Currently bonds of this type are trading with a spread of around 600bps, which makes the dollar price of this bond around $89.
Analyzing asset-backed bonds gets complicated because bond holders get monthly principal and interest payments. But in simple terms, the bond is yielding LIBOR +600bps. If the Fed is willing to lend at LIBOR +50 or 100bps, banks will quickly gobble up high quality ABS paper. As a result, the yield spread on this kind of ABS will contract until its closer to the Fed's lending rate. If the COMET bond were to go from LIBOR +600 to LIBOR +300, the bond's price would appreciate by 5.5 points.
There would be two important knock-on effects. First, it would create a price floor for similar ABS which isn't pledged into a Fed facility, alleviating mark-to-market problems banks are currently facing. Second, it will allow for new origination in ABS, which will help rejuvenate consumer credit.
The primary beneficiary will be the ABS securities itself. Next would probably be the bigger holders of ABS paper, which include banks and P&C insurers. Companies involved in securitization will also benefit: credit card issuers like Capital One and student lenders like Sallie Mae. There is already talk that this program could be extended to Commercial MBS, which would benefit REITs tremendously.
Disclosure: Long certain ABS as well as Sallie Mae


  1. This may give the banks the opportunity to profit from that line of business, but they will still have the truly bad assets, right? Isn't it those assets that are really causing the capital constraints?

    It actually kind of reminds me of the plan DOE came up with to help FFELP lenders earlier this year. Not mechanically similar, but the concept is the same.

  2. I thought credit card ABS have bullet payment of principal. Perhaps HDMOTs (Harley Davidson auto loans) are a better example?

  3. No-recourse? Cool... so they can load up all their most toxic assets and lose at most the haircut + the no-recourse fee.

    The way this is structured, it looks a lot like the government selling a put option (especially since the haircut is based on volatility).

    From reading the document, it looks like losses get absorbed by treasury via TARP in a somewhat convoluted path.

    It's not quite clear to me what happens when they hit > $20 billion in losses. At that point the fed starts lending money to the SPV that holds the troubled assests, so it looks the fed is going to leverage TALF until... what?

  4. Re - selling a put option - that is exactly what I was getting at w/r/t to the Dept of Education and FFELP loans. After ARS blew up, there were no investors for FFELP student loans. So the DOE announced a program where the lenders could put the loans to the agency and use the proceeds to make new loans, recycling the funds over and over again. There are some differences, but this proposal could almost have been modeled on that one.

    My understanding is that we are talking about investments that still have AAA ratings, for whatever that is worth anymore.

  5. As currently written, this program only allows for newly underwritten deals, and no residential loans. And it has to be currently rated AAA. We can debate the veracity of AAA ratings anymore, but at least this means the deal needed significant subordination at the outset. So the truly toxic stuff won't qualify here.

    Now I'm not here to claim that credit cards and auto loans aren't having plenty of problems. But these aren't all going to zero! The concept of credit enhancement through subordination still works. As I said a few days ago, we didn't really get into trouble until we started resecuritizing stuff.

    And the DOE's plan is working to some extent. I mean, SLM and others are still making loans. Not what it used to be, but still, not shut down.

  6. On second thought, it's actually not a bad way to drive down rates, especially for stuff that the government would be on the hook for anyway.

    An interesting contrast to what is happening in the UK where the government is trying to force banks to lend at gunpoint. That idea doesn't seem to be working that well.

  7. Sure, from the Fed's standpoint, the losses on being stuck with AAA ABS, if it works out that way, should be smaller than if they were buying the toxic stuff. But from the investors' standpoint, if they have to continue to hold the toxic stuff, whatever they achieve through this program might be cannibalized by having to set aside ever more capital for the toxic stuff.

    The income from the loans does not have to go to zero for the program to consume more than the money set aside from the TARP.

  8. Coming late to this debate - but am curious what people make of this in the Terms and Conditions for TALF
    "Eligible collateral for a particular borrower must not be backed by loans originated by
    the borrower or by an affiliate of the borrower."

    That would seem to turn TALF into a more investor-oriented facility than a bank-oriented one (or am I just misreading that graph?)

  9. Mad: I hadn't read that particular provision... have to look into it.

    BT: I think the risk of running out of money is a question of how big the program becomes. Right now its only $200 billion. It'd have to get a lot larger for there to be any material risk of actually running out of money.

  10. I'm not a trader, but it seems to me that a big remaining question is how severe the haircuts would be and I haven't seen any guidance on that yet. Did I miss it?

    Madeleine, if the debt is non-recourse, my suspicious mind tells me that two banks could still swap bad assets to achieve the same end result.

    Also, someone can correct me if I'm wrong, but wouldn't any non-recourse lending program be geared more to banks and hedge funds than buy side investors like pension funds and insurance companies (where I spend my time), who are more often cash investors?

    Its an interesting program though.

  11. I agree that the program is clearly aimed at leveraged buyers. Banks, insurance companies, and possibly hedge funds.

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