Saturday, March 7, 2009

TALF 2.0: Here There Be Dragons

In a speech at the Council on Foreign Relations yesterday, the new President of the New York Fed, William Dudley, provided important insights on the likely future of the TALF. Dudley hinted that the terms of the TALF might eventually be relaxed to include below-AAA tranches of ABS, as well as legacy (as opposed to newly-issued) ABS. From the speech:

The TALF is being rolled out in two stages. In the first stage, which I’ll call TALF Version 1.0, the Federal Reserve will provide non-recourse loans to investors against AAA-rated consumer asset-backed securities collateral. ... The AAA-rated securities eligible as collateral for this non-recourse lending program are used to fund a wide variety of consumer and business loans, including student, credit card, auto and small business administration loans. The market for these securities had dried up because the traditional investors in these securities—SIVs, bank-related conduits and securities lenders—have either disappeared or are balance sheet constrained. This has reduced the availability of credit for consumers and led to higher borrowing costs. The first subscriptions for financing under TALF Version 1.0 will occur on March 17. The first batch of new securitizations will be funded on March 25. TALF Version 2.0 will follow. This will broaden the TALF into new asset classes such as Commercial Mortgage Backed Securities. Development of this phase is still in its early days. But it [is] anticipated that the size and scope of TALF will expand sharply in the months ahead. ... This is a very exciting program because it provides balance sheet capacity to risk capital that cannot currently get leverage. It goes beyond current programs. Just as important, once it is up and running it can be scaled up and out in many different dimensions. In principle, it could be applied to other distressed asset classes, it could move down the credit spectrum to lower-rated tranches, and it could be used to fund older vintage assets.
I think it's increasingly clear that the Fed will end up using the TALF to provide 3-year (or longer) non-recourse loans against the risky tranches of commercial and residential mortgage-backed securities that are currently stuck on banks' balance sheets. The TALF term sheet states that the program may be expanded later to include other asset classes, and specifically mentions CMBS and private-label RMBS. In addition, there are widespread rumors that the Fed is at least considering (and some say actively planning on) accepting below-AAA legacy CMBS. From there, it's not too difficult to make the jump to risky legacy tranches of private-label RMBS (i.e., Alt-A and subprime). In his speech, Dudley suggests that the Fed will mold the terms of TALF 2.0 to fit the market's needs—that the TALF will be aimed at "risk capital that cannot currently get leverage." There's no doubt that risky tranches of legacy CMBS and RMBS can't get leverage right now. Whether the Fed will expose taxpayers to the high level of risk involved in lending against these risky securities remains to be seen. I think the answer will probably end up being yes. (Treasury's white paper on the program mentions that CLOs and CDOs are also "under consideration" for inclusion in the TALF, but I don't foresee that ever happening.)


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