Viewpoint: The COP Ralfs on TALF
Elizabeth Warren, chair of the Congressional Oversight Panel (COP), appears to have a vendetta against the Federal Reserve’s Term Asset Backed Loan Facility (TALF). To my knowledge, she first mounted this hobby horse back in March based on a deeply misleading report appearing recently in the Wall Street Journal (“TALF Is Reworked After Investors Balk," March 14, 2009). The article asserted that several Wall Street dealers were creating CDO-like vehicles harking back to the financial engineering that helped crash the credit markets. The vehicles were designed to “allow investors in the program to circumvent many of the restrictions laid out by the Fed,” the story asserted. And on it goes, citing as its source the ever-convenient “people familiar with the matter.” I haven’t seen the Barclay’s presentation that the WSJ reporter, Liz Rappaport, claims to have seen, but I suspect this nefarious new vehicle was much more akin to a closed-end mutual fund or other pooled investment vehicle (both of which were explicitly and from the get-go eligible to participate in TALF). Nonetheless, Warren took the story at its word, telling a March 31 Senate Finance Committee hearing that TALF poses substantial downside for taxpayers while offering substantial rewards to a small number of private parties, and subsidizes the continuation of practices that were a primary cause of the crisis. She complained that the documents posted on Treasury’s website (actually it’s the New York Fed’s) contradict press reports! As if a WSJ scribbler were more credible! The upshot, she told the hearing, was that she had “opened an inquiry into” the TALF, demanding more information from the Treasury. That inquiry apparently contained 11 questions, answered on April 1 in a letter to Warren from Ben Bernanke (Fed chair) and William C. Dudley (New York Fed president). The letter was subsequently made public on the New York Fed website on April 7. I’ve already written about this flap at length in “Save TALF,” my Kitchen Sink column for the May 2009 issue of HousingWire Magazine. Read it if you can get your hands on it (and you can, right here). And be sure to check out the Fed’s “Responses to March 20 Inquiry," too. Meanwhile, I’ve no time to reprise my contempt for that March slime-slinging grandstanding episode. Warren has moved on -- and so must I. She’s taken her innuendo-decorated attacks on the TALF directly to the American people. You can catch the video on YouTube, where for seven minutes she summarizes the Executive Summary of the COP’s May 7 Oversight Report, “Reviving Lending to Small Businesses and Families and the Impact of the TALF.” The money shot in this video comes early, when she says TALF stands for Term Asset-Backed Securities Loan Facility. She says it all in one breath, smiles and pauses for effect: “Try saying that quickly three times.” Out there in the Heartland, they gotta think it’s nothing but a government tax-and-spend tongue twister! According to Warren, TALF is iffy and disappointing. The program, she says, raises two important questions: Is it well designed to help market participants meet the credit needs of households and businesses? And will it make a significant impact on access to credit for these sectors of the economy? Intelligent design? With regard to design, there are “some reasons why investors would not want to participate,” she claims. First of all, the report asserts, there are restrictions on a borrower’s ability to sell the securities, “so that investors are ‘locked in’ to their investment for a number of years.” I guess Warren and her compatriots did not check the TALF FAQs on the New York Fed’s website. Here, it clearly states (1) a TALF loan is prepayable (which would release the collateral) and (2) if the collateral is sold, the TALF loan can be transferred to an eligible borrower with prior consent of the Fed (until the program terminates, currently scheduled for the end of this year). Doesn’t sound very locked-in to me. Another feature that would discourage borrowers, saith the COP, is that interest rates on TALF loans may be higher than investors can get from other lenders. This is either an urban myth, or a lie. The TALF, like several other emergency liquidity programs conducted out of the New York Fed, was designed to substitute, temporarily, for customary private market financing mechanisms that have broken down and do not presently exist. Prior to the credit crunch, leveraged investors (like hedge funds, proprietary trading desks and so forth) typically financed their purchases of ABS in the repo (purchase-repurchase) market -- also with haircuts, secured, no recourse, etc. but with margin calls and much shorter term, so borrowers compensated by continuously rolling over their repos. This source of funding from private dealers vanished with the credit crisis. As a result, the hedge and opportunity fund investors who once used leverage to reach their target returns on equity (ROE) have lowered their bids (substantially) to achieve the same yields outright. Why, non-financial readers might be asking, should taxpayers subsidize leveraged investors? Everyone on the right and the left has figured out it’s a handout to the rich, after all. Answer: Because it’s expedient. These investors, who don’t use “real money” like bank and insurance company portfolios, pension or mutual funds, are the buyers on the margin, the buyers who buy, for instance, when securities cheapen because the other investors have fully allocated their real money. The buyer on the margin effectively establishes a floor on pricing. The existence of that floor means that returns are less volatile; lower volatility signals less risk to real money investors; and that fact is a substantial encouragement for real money investors to participate. By the way, much of the “fire sale” pricing that opponents of mark-to-market accounting rant about reflects the fact that leveraged buyers were forced to sell as the repo financing dried up in 2008. The new floor -- to achieve absolute yields of 15%, 20%, 25% on high quality paper -- sets the market values that in turn have consumed bank capital (hold that thought, we come back to TALF’s role in lifting market prices). Dealer repo financing for non-government securities is slowly returning, but it is not as attractively-priced or as readily available as TALF. Stop and think: if it were, no one would be borrowing at TALF, hedge funds would be growing again, and asset prices would have risen to reflect the leveraged bid. WE WOULDN’T BE TALKING ABOUT THIS. Great expectations, unmet? Warren’s summary concludes, “With these uncertainties, and the fact that so far there have been fewer issuances under the program than expected, it is not yet clear that the program has been well-designed to meet its purpose.” Who expected? What specific loan volume was expected? I haven’t seen that number in published Fed documents. (That doesn’t mean it’s not there. I am fallible.) I did see many headlines after the first March operation and several after the April operation, holding up small borrowings -- $4.7 billion and $1.7 billion, respectively -- as proof the program was floundering. I know the COP gets lots of its information from headlines, so that’s probably where they learned expectations weren’t being met. And I suppose demand might look a bit paltry when you've announced you’ll lend up to $1000 billion (ok, $1 trillion), you’re about a third of the way to the program’s sunset and only $17 billion (add $10.6 billion in May) have been taken down. But the fact is, the program is a success. Let me quote from an actual well-informed and experienced market analyst writing in Citigroup Securitized Products’ April 9 Monthly:
study and evaluation careless and biased self-dealing, the COP concluded that “it is not yet clear the program has been well-designed to meet its purpose.”
More credit for families and small businesses?
Back to the video (and its associated executive summary). The other question the COP poses is “whether any securitization program, no matter how well designed, is likely to help market participants meet the credit needs of small businesses and households.”
I apologize if this close reading of the text is tedious, but I believe words are weapons, and it’s rhetoric time again for the COP. Lawyer Warren, if you put it like that, how close is that to “asked and answered?” Saying "no matter how well designed" pretty much telegraphs the three-word answer: Not Very Likely.
Speaking of business credit, here’s how the COP reasons it:
The inaugural TALF sale was a success by any measure – more than $8 billion priced in a total of four ABS transactions. Roughly $8 billion in one week is a very satisfactory number – there is only so much ABS supply the market can absorb in one week because four deals within a few days taxes the market’s ability to perform sufficient credit analysis and diligence. Real money accounted for about 40% of purchases, which is a good sign that a good mix of investors are returning – the first step to restoring a true market. The meaningful presence of real money investors is great news because it demonstrates progress in restoring a genuine ABS market with a diverse investor base. But the true measure of the programs success for us remains the 300 to 300bp of spread tightening that the market underwent in the weeks ahead of the program implementation.The surge in issuance has continued -- by mid-May, Citigroup analysts noted over $30 billion had been priced across most major non-real estate ABS sectors since TALF launched. Some of these sectors -- credit cards and student loans for example -- had been virtually dry for 4-6 months, while others, like autos, had been running on one cylinder. Spreads continue to tighten -- almost too fast to track, notes one fixed income analyst I like to read. Another analyst spotted AAA ABS spreads over 500bp tighter since TALF was announced. And lower rated paper, the stuff TALF doesn’t finance, has begun tightening too, by hundreds of basis points as well. Adding CMBS to the list of TALF-able assets triggered tightening in AAA paper on the order of 400 to 900bp (depending on average life). There is a simple mechanical linkage between security yields and interest rates on the underlying loans: the lower the yield the market accepts, the lower the rate the lender needs to charge the borrower. As this market continues to stabilize, even the COP should be able to find evidence that borrowing rates are coming down (the latest G.19 Consumer Credit release from the Federal Reserve has preliminary March data suggesting rates are coming down at auto finance companies). This tide lifts all boats Tighter spreads don’t simply foreshadow lower borrowing rates. They also raise the market value of that old bugaboo “the toxic assets clogging balance sheets and financial markets.” In mid-May, the Citigroup analysts compared an estimate of mark-to-market losses on a broad universe of securitized assets (they have the detailed security databases needed to perform experiments like this) as of January 09 and May 09. They saw improvements from 2.1% on subprime ABS, to 7% on like consumer ABS (not as heavily discounted by the market as many other sectors), about 16% on Alt-A and 20% on CMBS (which have been bludgeoned). What this means is that investors who are holding “legacy” securitized assets are less underwater. Banks have more tangible capital because they have smaller unrealized losses. It also encourages trading -- buyers and sellers emerge when there is a gain to be taken (mark-to-market investors already took the hit) and or anticipated (bonds trading closer to their economic value as demand improves). Considering how little lending (how little risk assumed by taxpayers, how little subsidizing of the hardly deserving) has actually been needed to achieve these results, the COP should be slapping Bernanke, Dudley and Geithner on the back! Innuendo, rhetoric and propaganda Inside the May 7 report, the COP discusses the disappointing demand for TALF loans, conceding that New York Fed officials “also argue that many participants have stayed away from TALF financing because their regulatory regimes do not currently permit them to borrow to buy asset-backed securities.” Please notice that the word “argue” is a rhetorical device in that sentence deployed to cast doubt on what the New York Fed and other capital market experts know to be a fact. The next sentence is a back-handed slam, pure COP muddle-speak: “It is difficult to draw a line in evaluating the level of demand for TALF-funded securitizations between systemic problems and issues created by the design of TALF itself.” (Note to the COP: that sentence needed more commas to be readable.) This is also rhetoric, of the sort that would encourage readers to doubt that any design could meet the TALF’s purposes. (BTW, the specific incentives had by and constraints on individual investors and varieties of investors are not “problems,” they are realities.) Posing as experts The report sweetly begins by claiming that most Americans only learned there was a practice called asset securitization when the subprime MBS triggered the financial crisis. This must go double for the COP and its staff! For a group that has set itself up to critique the TALF and the securitization markets TALF is intended to revive, the COP hasn’t enough facts in hand to do the job. What bothers me most is the repeated mischaracterization of the TALF as a securitization program. (Who knows -- if securitization is a dirty enough word on Main Street, maybe the COP can rouse opposition to TALF just by calling it a securitization program.) Under this so-called securitization program, the COP explains that “securitized pools still may be issued in tranches -- usually based on differing times for repayment in the case of auto loans and in some cases for student loans.” The whole business of tranching (dividing the principal and interest from the collateral pool among two or more discreet bond classes) is a technical tidbit that doesn’t add to the discussion, but it sounds expert and cool. It’s unnecessary, but it stems from (or perpetuates) a profound misunderstanding. Despite the reference to tranching, TALF does not specify structuring strategies. There is nothing “regulatory” about TALF. It’s just an emergency, short run source of liquidity for ABS investors who currently use leverage or can be constituted to take advantage of TALF leverage. It accepts existing security conventions in the various eligible product sectors. You think I’m nuts, I’m reading too much into what could just be sloppy writing? The report babbles on: “These terms represent an improvement over prior securitization structures.” NO, TALF does not improve on structuring strategies. From among the set of bond structures the market –- issuers and investors –- have come to accept over time, the TALF defines some as eligible and specifies haircuts based on underlying collateral and average life. Issuers and their investment bankers are still free to create any structures backed by any assets they like, but TALF funds are for a subset that meets specific criteria intended to balance the benefits of the program with the risk assumed by the Fed and Treasury. Calling TALF "a securitization program" allows the COP further opportunities to mislead and misinform. For example, it can list, as a so-called improvement over prior securitization structures: “Second, the value of pools cannot be inflated by cloaking their credit risks through the use of third-party instruments such as credit default swaps.” Someone help these people! This statement has no basis in reality. The COP doesn’t know what it’s talking about. That doesn’t happen, not in consumer ABS, not in SBA securities, not in MBS. Credit support doesn’t "cloak risks" or "inflate pool values," and credit default swaps are not a common source of third-party credit support in asset securitizations. Credit enhancement The Fed’s guidelines simply require that collateral achieve a AAA rating without the benefit of third-party credit enhancement. This is plain old pragmatism: the presence of a third-party guarantee requires performing a separate credit evaluation of the third-party, an expensive and cumbersome process unsuitable for an emergency liquidity program. Furthermore, most existing third-party guarantors have problems of their own. Most bond insurers have already been famously brought to the brink of extinction by the guarantees they placed on the private RMBS and CDOs earlier in this sad decade. Most mortgage insurers, for their part, are seeing their creditworthiness erode as well, rendering pool insurance of little comfort to investors. Letters of credit -- a bank product -- wouldn’t help to offset default risk in the collateral in the current environment, either. Regardless, third-party credit enhancement was never employed to cloak, conceal or otherwise obfuscate the value of pools. The presence of third-party credit support would be discussed very straightforwardly in the rating reports, the prospectus and any marketing literature permitted under SEC regulations. And if anything, the presence of third-party credit enhancement would be a tip-off that the assets were less-than-prime credits. Investors typically had internal limits on the amount of paper they would accept from each third-party guarantor (you would hear, for example, “Sorry, full up on XYZ Guarantee right now”). Presumably, their due-diligence in this regard included actual credit analysis and not simply requiring grade from the purveyors of ratings, but that’s another issue -- and nothing to do with TALF. CDS on the brain Please notice that my discussion of third-party credit enhancement does not mention CDS. This reflects the reality that CDS were not used in asset securitizations as credit protection. The COP, however, does think they were. That the AAA-rating may not rely on third-party credit enhancement provokes this footnote (number 157):
This condition appears to rule out the use of letters of credit, guarantees or credit default swaps or other derivatives to boost the creditworthiness of a pool of assets sought to be securitized.Very aware my own memory could be flawed (I was not in my Wall Street career an ABS or subprime MBS analyst, per se), I checked with a few folks who examined oodles of ABS deals of all kinds. CDS were not used as internal credit protection. (An investor could hedge, an external protection, with CDS -- but that’s the investor’s business, not a feature of the securitization.) Neither were other derivatives used as credit support. Interest-rate swap contracts were regularly included in deals to transform fixed rate payments from assets into the floating rate coupons demanded by many investors. Investors would separately evaluate the swap provider. Nothing was concealed. Only an outsider to financial markets would misunderstand this mechanism. (And readers, by now you recognize the footnote’s phrase “appears to rule out” as a rhetorical device designed to make you suspect TALF won’t somehow let CDS and other guarantees sneak in.) I think it more likely that the COP is trying to poison readers against securitization in general by invoking the well publicized use of CDS in CDOs (as synthetic collateral). The COP has already (in that March inquiry I mentioned at the outset) tried to make a case that TALF encourages the revival of the CDO market. (It does not!) There are all kinds of asset securitizations, the practices have evolved to fit the underlying assets and investor requirements, all substantively different. It is a fear mongering tactic to conflate consumer ABS with CDOs or, as the COP does in other sections of the report, even subprime MBS. As a matter of fact, synthetic collateral is explicitly not eligible for TALF funding, despite such fear mongering by the COP. The COP acknowledges this in a further gratuitous denigration of asset securitizations: “The prohibition against synthetic securities removes from TALF securitization one of the most serious flaws in the securitization system before the crisis began.” It was a flaw, but not one that in any fairness should be laid at TALF’s door. What this is, instead, is good propaganda. By labeling securitization a multiple-flawed system and the TALF a securitization program, it's easy impugn the TALF for not dealing fully with those flaws. So it’s no surprise that, after such
• Credit for small businesses has contracted, but it’s not clear if the contraction reflects the creditworthiness of the borrowers, or tightening by the banks. • If it’s creditworthiness, TALF can’t fix it. • And even if TALF does provide more funds for lenders to lend, asset-backed securities have never been a significant source of funding for small business. (The COP’s right on this point, though it should hardly count against the TALF. Loans guaranteed by the Small Business Administration, or SBA, do not lend themselves to economic securitizations. For one thing, despite the government guarantee they have relatively high interest rates, which must be stripped away to create the par-priced security investors demand. Extracting the value in the interest-rate residual can be difficult, even in robust market conditions.)Indeed, the SBA program falls short as a source of critically-needed funding for small businesses. I know it’s so, because I have entrepreneurial friends who investigated and quickly ruled out SBA loans for their businesses. The COP has taken field trips (on our dime) and gathered testimony from small businessmen and come to the same conclusion. Their findings are discussed in the body of the report. In fact, they are wasted in this report, because this report is about the TALF. Please read the report and tell me if you don’t think the COP would have better served the small businesses of America by leaving TALF out of it and focusing on the tangle of red tape and buck passing that constitutes SBA lending. I think it’s shabby logic to conclude the TALF is a bad idea because the SBA loan program is a bust. That said, let’s just mention that TALF also is intended to siphon cash into dealer floor plan and equipment lease securities. These aren’t big sectors of the ABS market either, but they do put capital market funds into small businesses. The COP report spares them not even a nod. No help for households, either Regarding consumer credit, the COP contends that “it is noteworthy that even with the sharp contraction in the securitization market, consumer lending has shown only a modest decrease.” Moreover, that contraction is mostly in credit cards and other revolving debt, not in installment loans such as automobile and student loans. The implication is that TALF isn’t necessary, because the pace of securitization isn’t related to the total amount of credit outstanding. This kind of argument used to be called lying with statistics. The COP’s supporting data refers to outstanding debt, not new lending. Outstanding debt changes slowly. It takes months for outstandings to register a significant change in current loan volumes. Even the media has done a better job than the COP of publicizing the fact that households are paying down expensive credit card debt and restraining consumption. They’re not buying new cars -- they’re still paying off the old ones (which are still included in outstanding installment debt)! The COP is ignoring the facts that car sales slowed enough last year to bankrupt manufacturers and that financing -- qua loans or leases -- is a critical component of most car purchases. The COP also is ignoring the fact that the manufacturers use captive finance subsidiaries to make those loans and leases and that these finance companies are the significant issuers of auto ABS, not banks. Why else would the government be trying to keep GMAC going? Not because the global financial system will rock with its passing as it did with the death of Lehman, but because GMAC makes new car loans! As a matter of fact, auto lending has been the biggest beneficiary of the TALF-driven securitization renaissance. Data published by Citigroup Securitized Products Strategy analysts indicates that as of mid-May, auto deals amounted to $13.4 billion, almost 40% of 2009 y-t-d issuance. By comparison, over the same period last year, auto deals totaled $16.8 billion, about 23% of total ABS issuance. Other ABS sectors, by contrast, although revived, still significantly lag past years’ issuance, and total issuance is less than half what it was over the same period last year. (I think I’ve made my point, but for extra credit, readers should compare auto sales reported by manufacturers who have been issuing TALF-able ABS. Watch TV too -- you’ll see that the most aggressive financing advertised is coming from the makers whose finance subs have been bringing TALF-able deals to market.) The COP also concludes in its uninformed way that TALF is irrelevant for student lending. The issue: Congress has cut subsidies for Federal Family Education Loans (FFELP), the public-private program the Administration wants to get rid of (to focus on the reportedly more efficient direct federal loan program). COP says:
Through TALF, the government is effectively lending money to the private lenders to lend to students, at the same time that the government is reducing incentives for private lenders. Some question why TALF is necessary or appropriate in light of the new law and the Administration’s proposal.Those are my italics. I didn’t want you to miss that “logic.” So what if FFELP loans go away? Fully private student loan ABS are also eligible for TALF financing. And private loans are a critical component of student financial aid. According to the College Board, in 2006-7, private loans made up 24% of total education loans in 2006-07, up from 6% percent a decade earlier. Many of these private lenders are banks, but a significant number of non-bank finance companies specializing in student lending rely on securitization for the funds they lend. And who are “some?” Why can’t a body empowered to hold hearings name names? Some smacks of that ever-present “sources familiar with the matter,” the invention of any lazy journalist. Or the result of a dip into the Twitter-scape. The COP could be quoting the midnight ramblings of anyone on earth with a Blogger account. The COP’s report is over 60 pages long, and I could write as many pages dissecting its layered dishonesties. It’s a hatchet job and I am outraged, as a taxpayer and patriot, that this is how the COP performs its mission. When Warren was appointed head COP, I was delighted. On paper, she's the antithesis of Paulson and Wall Street, as pro-consumer, educated, even intellectual, as we could ever have hoped. In practice, however, she has an agenda of her own and if the evidence doesn’t fit, she and her staff will invent it. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC, and is a columnist for Market News International and HousingWire Magazine.