Will TALF Soar? Or Fall Flat?

The Fed's ability to attract bidders for its loan plan is crucial to unfreezing credit markets

By David Bogoslaw

Spring is almost here, but hopes are riding on the Federal Reserve, not Mother Nature, to jump-start a much-needed thaw in the credit markets. After multiple delays and adjustments, the Fed's Term Asset-Backed Securities Loan Facility, or TALF, has arrived. However, the TALF is off to a slow start with investors requesting only $4.7 billion in the first round, the Federal Reserve Bank of New York said on Mar. 19. The funds will be disbursed on Mar. 25.

The first installment is composed of $1.9 billion that investors will use to buy securities backed by auto loans, and $2.8 billion for the purchase of securities backed by credit card loans. Applications for the next round of loans will be accepted starting April 7 and those funds will be disbursed on April 14.

The central bank has said it expects to create up to $200 billion in liquidity for credit markets under the TALF program.

The U.S. government's ability to attract private capital from hedge funds and other investors through the TALF program is even more crucial now that public sentiment has turned so virulently against bank bailouts. Public anger about the $165 million in bonuses paid to American International Group (AIG) execs may have soured prospects for additional financial-sector bailouts and could threaten to scuttle further government liquidity measures.

Attracting Private Investors

"The Treasury and the Fed realize they've got to get private money involved. They don't have enough money left in the TARP program to do it on their own," says Scott Valentin, an analyst who covers consumer finance for Friedman, Billings, Ramsey (FBR) in Arlington, Va.

The Fed has had to make adjustments to TALF after hearing from private investors who objected to having to open their books and records to broker-dealers who would be applying for the loans on behalf of investors. There was also opposition to the idea of turning nonrecourse loans into recourse loans—to the jeopardy of investors—if the assets pledged as collateral are determined to be ineligible after the fact by the Fed. Questions have also been raised about whether the program would restrict participating companies from replacing fired U.S. employees with foreign workers, since TALF comes under the stimulus package.

Not content to wait to see how TALF takes hold, the Fed on Mar. 18 announced plans to buy an additional $750 billion of government-guaranteed mortgage-backed securities (MBS), in addition to the $500 billion of MBS it is already in the process of buying. The Fed also said it would purchase up to $300 billion of longer-term Treasury bonds over the next six months in an effort to lower longer-term interest rates on a variety of loans.

Mortgage Stumbling Block

Some economists and analysts believe that resuscitating the market for securitized consumer loans won't be enough by itself to repair the all-but-disabled financial system, since mortgage-backed securities constitute the bulk of the debt clogging banks' balance sheets. That's why the success of TALF is critical. Early signs of strong investor participation would encourage the Fed to expand the program at some later date to include residential and commercial MBS.

The TALF program is essentially a way for investors to use eligible, triple-A, asset-backed securities—such as pools of prime auto loans, credit-card receivables, student loans, and small business loans—as collateral against loans from the Federal Reserve Bank of New York, which can then be used to buy additional asset-backed securities, or ABS. Only securities created since Jan. 1, 2009, are eligible for these loans.

The key feature is something called the collateral haircut, or the minimum capital an investor has to put up to obtain the loan, expressed as a percentage of the loan's value. Generally, the longer the maturity of the ABS, the higher the haircut—to account for the greater risk the Fed is taking. The higher the haircut, the less leverage available to the investor.