TALF: Anoat system?

This is the second time I've made an Anoat allusion in a week. That has to be a record of some kind.

Anyway, how worried should we be about the lack-lustre start to the TALF? The thing that really worries me long-term is that we fall into a deflationary spiral, which really would result in Great Depression: Episode II. As you can see in this graph...


... bank reserves have sky-rocketed. Meaning that while the Fed has been busy "crediting bank reserves (i.e. printing money) to pay for their programs, banks have been shoving that money under the proverbial mattress.

The so-called shadow banking system is even worse. The ABS market has completely collapsed (at least until the TALF, more on that coming). Thus all spigots to consumer credit have slowed to a trickle. That has serious implications for the de facto money supply, which by my estimation is sharply negative.

TALF aims to reverse that. We might not be able to force banks to lend, and maybe we really want them to rebuild capital anyway. And we do want consumers to save and rebuild their own balance sheets. But we also don't want them to over-save. That's how we become Japan. But if we get a decent new issue ABS market doing, then at least consumers who can afford credit can access credit.

The TALF was supposed to work by basically giving a tax-payer subsidized free lunch. A nearly guaranteed arbitrage. But in fact, no one is showing up at the Fed to take out TALF loans.

Its worrisome, but we shouldn't panic yet. First, we don't really care how much the Fed lends under the TALF program. We actually only care that the ABS market gets back on its feet. So far, we've only had very high quality ABS deals get done since the TALF: a couple auto loan deals, a couple credit card deals, and a student loan deal back by the Department of Education.

ABS traders I've talked to say there is plenty of demand for those deals, but for whatever reason it isn't TALF demand. Its possible that buyers have other funding options away from the TALF. Amidst worries about Congressional interference in compensation and other BS, I'd sure as hell take some other funding option even if it were at a higher cost. The ability to bring back my girlfriend from the dead just isn't worth making a deal with Darth Pelosi.

There is also supposedly strong secondary demand for ABS, which is stuff that wouldn't be TALF eligible anyway. Its almost like a market that's properly functioning! People are looking for good bonds at decent spreads!

Anyway, its possible that the TALF actually revives the market without being used heavily. This is basically what happened with the Fed's commercial paper program. It revived that market at least to the point where the top issuers can access the market.

So the thing to watch is not TALF loans, which I'm sure is what the media will focus on. Watch ABS issuance.

TALF: Quicker, easier, more seductive

The Fed has expanded the Term Asset-Backed Loan Facility (TALF), which AI first discussed here. Here is the quick recap of the facility.

1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.

3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.

4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.

So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.

Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.

Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.

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

Asset-backed securities and the future of consumer lending

So... no buying of mortgages from banks in the TARP. What are they doing?

On the same day they pulled the rug from under our banking system, Treasury announced they would be "exploring" programs to improve liquidity in the AAA-rated asset-backed security (ABS) market. Although securitization has in many ways been a big part of the problem, revival of the ABS market would make a big difference.

Remember the covered bond idea? Its a structure used extensively in Europe where a bank pledges a pool of mortgage loans to "cover" a piece of debt. In theory, the bank enjoys a lower interest rate on such debt because it is both a general obligation of the bank as well as "covered" by the mortgage loans.

In July, the Treasury proposed covered bonds as an alternative to the traditional securitization markets. It never really got going in large part because the corporate bond market continued to deteriorate, and thus was not receptive to new products. But the idea was sensible enough. Covered bonds better align the bank's incentives with the investor, because the bank remains on the hook for the debt no matter what. This is in contrast to a straight securitization, the bank off loads all the risk to investors.

From a macro-economic perspective, a vibrant covered bond market would have allowed banks to lend knowing there was a ready source of cash. Banks will not lend until they are confident in their sources of cash. If the covered bond idea is dead, for now anyway, perhaps the ABS market can pick up the slack.

Historically, ABS have typically been backed by consumer loans, including credit cards, auto loans, home equity, and student loans. ABS were typically structured with a senior/subordinate credit enhancement, meaning that certain tranches of the deal would take losses first and only once those tranches were wiped out would other tranches take a hit.

Of course, there have been numerous problems with the ratings agencies allowing too little in subordination in certain deals. But there is nothing inherently wrong with the senior/sub concept. In fact, if its kept as a simple sequential loss structure, analyzing the credit of an ABS deal becomes relatively straight forward: its just losses versus available subordination. Sounds a hell of a lot more transparent than trying to decode a bank's balance sheet!

So what if the ABS market could be revived? Lenders who could not access the unsecured debt markets could access the ABS markets, raising loanable funds. If the lender also kept a sizeable residual on the deal, the result would be similar to the covered bond idea.

Many companies would benefit directly from an improved ABS market. Credit card issuers, such as American Express, Citigroup, and Capital One. Student lenders such as Sallie Mae. Even the autos would benefit, although obviously the GM and Ford situation is much deeper, Toyota and Honda would also benefit.

It wouldn't solve all our problems. I still wish they were buying mortgage assets. But this is better than nothing.

Student Loan ABS: Do or do not!

The world of asset-backed bonds (ABS) is in disarray. While home-equity securities have grabbed the headlines, other types of ABS have suffered as well. Student loan ABS are one example of the baby being thrown out with the bath water.

There are two basic types of student loan ABS. Some are constructed with private student loans, and these carry risk of those borrowers failing to make payments. Others are made up of Federal Family Education Loan Program (FFELP) loans. FFELP loans are at least 97% guaranteed by the Department of Education (loans made before July 2006 have a greater guaranty).

Despite the guaranty, the yield spread on FFELP student loan bonds has widened substantially, creating an opportunity for investors looking for income securities which are not significantly exposed to credit risk.

A typical FFELP student loan securitization will include approximate 5 tranches. The first four will usually be labeled something like A1, A2, A3, and A4. These are all senior securities. The last tranch is a junior security, commonly called the B tranche. In the most recent Sallie Mae student loan securitization, the B tranche represented 3% of the entire deal structure, exactly the amount uninsured by the Federal government. This effectively eliminates credit risk for the senior securities.

The four senior tranches pays floating interest quarterly based on a spread to 3-month LIBOR. The spread is set at issuance. In the secondary market, the bonds will trade at a premium or a discount to par based on the relative attractiveness of the original issue spread. Principal on these issues is paid sequentially, with all principal flowing to the A1 tranche until that tranche is completely repaid. Then all principal flows to A2 and so on. As a result, the tranches have very different average lives. Usually the A1 tranche has an average life of around 1 year. The average lives of the other tranches varies from deal to deal, but typically there is a 3-year and 5-year tranche as well.

According to Merrill Lynch, 1-year FFELP student loan ABS currently yields 65bps over 3-month LIBOR. 3-year paper has a spread of 100bps, and 5-year 125bps. These spreads had been relatively constant in the 0-15bps area for several years before widening rapidly last fall. So far in 2008, student loan ABS spreads have moved higher or lower with the tide of liquidity. Spreads peaked in March, tightened in April and May, and have recently widened to near March levels again.

In a fixed income market where many securities are offering historically wide spreads, student loan ABS offer some unique advantages over other short-term alternatives. The structure is most similar to a corporate floating rate note (FRN), but of course the student loan paper has no substantial credit risk. Consider that John Deere Capital (rated A2) just sold $350 million of a new 2-year FRN at LIBOR+50bps. Investors could buy a 1-year average life student loan bond and get more yield with less credit risk. Other alternatives, like agency discount notes, collateralized mortgage obligations (CMOs), or other ABS, either yield less or exhibit more credit risk.

Of course, student loan ABS has widened for a reason. General market liquidity is the primary reason. In consort with the lack of liquidity is the fact that funding of leveraged positions has become more difficult. So buyers who might have arbitraged away the wide spreads in student loans are just not able to do so. Indeed, there is no obvious catalyst for student loan ABS to tighten from current levels.

But these securities allow investors a place to hide from credit risk while still earning attractive interest rates. Eventually the fundamental value of these bonds will bring in buyers weary of losses in other sectors.