TALF

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The Term Asset-Backed Securities Loan Facility (TALF) is the name of a program created by the Federal Reserve (the Fed), announced on November 25, 2008.

The facility will support the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). On May 19 the Federal Reserve announced that it will expand the TALF to include certain legacy commercial mortgage backed securities (CMBS).

Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $1 trillion (originally $200 billion) on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. As TALF money does not originate from the US Treasury, the program does not require congressional approval to disburse funds.

The Federal Reserve and Treasury jointly issued releases announcing the extension of the Term Asset-Backed Securities Loan Facility (TALF).

The TALF, which was originally scheduled to terminate December 31, 2009, will now be extended through March 31, 2010, for TALF loans against newly issued asset-backed securities (ABS) backed by consumer and business loans and legacy commercial mortgage-backed securities (CMBS), and through June 30, 2010, for TALF loans against newly issued CMBS.

Contents

Current results for the TALF

Developers Diversified deal ends CMBS drought

U.S. mall owner Developers Diversified Realty Corp (DDR.N) snapped an 18-month dry spell in the U.S. commercial mortgage bond market by selling $400 million of securities on Monday with help from an emergency Federal Reserve lending program.

The deal was the first to be sold under the Fed's Term Asset-Backed Securities Loan Facility, known as TALF, for new issue commercial mortgage-backed securities (CMBS), a key funding tool for office, retail and apartment buildings during the real estate boom.

"We believe the deal is a crucial first step in restarting the private-label CMBS market, which has been closed since June 2008, and channeling a much-needed source of capital to the commercial real estate universe," Barclays Capital said of the first TALF deal in that segment.

The sale is an important stepping stone in the $700 billion CMBS market, seen by central bankers as one of the biggest risks to the fragile U.S. economic recovery. The market has suffered badly as the deep recession severely cut the rent revenue from commercial properties needed to pay debt service on bonds.

Met with strong investor interest, Developers Diversified was able to price the deal below existing levels for CMBS issues. Its $323 million AAA-rated five-year notes came at a narrower 1.4 percentage point premium to the five-year interest rate swap benchmark, for a yield of 3.807 percent, market sources said.

Underwriter Goldman Sachs lowered yield premiums from earlier guidance levels of 1.6 to 1.75 percentage points due to the strong buyer interest.

"The deal looked pretty clean from a collateral standpoint and the credit protection, between the over-collateralization and subordination, was incredibly high," said Dan Castro, chief risk officer at Huxley Capital Management in New York.

The offering also included two smaller non-TALF-eligible AA-rated and A-rated issues, which priced with 5.75 percent and 6.25 percent yields and also drew strong interest.

"It was the first deal in about a year and a half, so there was big demand for the small sale," said Castro.

Through its TALF program, the Fed aims to lower funding costs for issuers by offering investors financing to purchase the securities.

Laying the groundwork has been difficult for Cleveland, Ohio-based Developers Diversified and other borrowers trying to use the TALF program, investors said.

Developers Diversified, which owns 670 shopping centers in the United States, Brazil and Canada, began discussing the deal in June but faced an arduous task of clearing the collateral with the Fed, according to sources. Some properties may have not made the Fed's cut, since Developers had been working on a pair of issues totaling $550 million.

With funding nearly frozen by the lingering credit crunch, borrowers with maturing loans have had to endure grueling negotiations to extend current terms or face default.

Fed responds to call to extend support for commercial real estate

Source: Fed Extends TALF Program for Commercial Real Estate Bloomberg, August 17, 2009

"The Federal Reserve extended by three to six months an emergency program aimed at restarting credit markets, a move that may cushion the commercial real- estate industry from rising defaults and falling prices.

The Term Asset-Backed Securities Loan Facility, with a capacity of as much as $1 trillion, will expire June 30 for newly issued commercial mortgage-backed securities, instead of Dec. 31, the Fed and U.S. Treasury said today in a statement in Washington. For other asset-backed securities and CMBS sold before Jan. 1, the plan was extended three months to March 31.

Commercial property values have fallen 35 percent since peaking in October 2007, according to Moody’s Investors Service. The extension may help firms such as Vornado Realty Trust, which is considering the sale of commercial MBS through the TALF. Almost $165 billion of mortgages for skyscrapers, shopping malls and hotels are due this year.

While financial-market conditions “have improved considerably in recent months,” the markets for ABS and CMBS “are still impaired and seem likely to remain so for some time,” the Fed and Treasury said.

The central bank said it doesn’t intend to make other types of collateral eligible for the program, indicating officials rejected adding residential mortgage-backed securities after considering such a move for several months. The Fed didn’t rule out a future expansion."

Source: Fed Focusing on Real-Estate Recession as Bernanke Convenes FOMC Bloomberg, August 10, 2009

"Commercial property is “certainly going to be a significant drag” on growth, said Dean Maki, a former Fed researcher who is now chief U.S. economist in New York at Barclays Capital Inc., the investment-banking division of London-based Barclays Plc. “The bigger risk from it would be if it causes unexpected losses to financial firms that lead to another financial crisis.”

The Fed is “paying very close attention,” Bernanke, 55, told the Senate Banking Committee on July 22, the second of two days of semiannual monetary-policy testimony before the House and Senate. “As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices, and so, more pressure on commercial real estate.”

Bank of America offers $2 billion TALF deal

Source: Bank of America Offers $2 Billion TALF Deal WSJ, August 27, 2009

"Bank of America/Merrill Lynch is in the market with a $2 billion auto loan-backed deal, according to a person familiar with the matter.

The deal is eligible for a Federal Reserve program, the Term Asset Backed Securities Loan Facility, or TALF, through which investors can procure cheap loans to buy newly created consumer loan-backed and new and existing commercial mortgage-backed bonds.

Bank of America Corp.'s deal, dubbed BAAT 2009-2, is jointly led by Bank of America/Merrill Lynch, Barclays Capital, Citigroup, Credit Suisse and Royal Bank of Scotland.

Bank of America is in the market with its second deal under the TALF program. Last month, Bank of America sold a $3.993 billion auto-loan backed deal at 135 basis points over a benchmark. That was the bank's first deal eligible under TALF."

GE secures floorplan loans for marine, power sports through TALF

Source: GE issues floorplan security under TALF program, August 14, 2009,

GE Capital has issued the first dealer floorplan asset-backed security under the Term Asset Backed Securities Lending Facility, or TALF, a program to help unfreeze credit markets, the National Marine Manufacturers Association reports.

"This is the first real sign that liquidity is coming back to the floorplan space in the secondary markets," NMMA legislative director Matthew Dunn told Soundings Trade Only this morning.

"It's very difficult to say what impact these kinds of things are going to have in the current market, but it's certainly good news and we hope that it signals a thawing of the credit market," he added.

On Aug. 6, GE brought $500 million in securitized floorplan loans to market under TALF through its GE Dealer Floorplan Master Note Trust, including floorplan loans for marine, power sports, and others.

The marine component was the largest product share.

Dunn said the NMMA has been working to communicate that marine assets are well performing assets, and although the industry is struggling, delinquency rates are still very low.

"The only way we're going to get back to a position where lending is done on reasonable terms is that increased liquidity," Dunn said. "It is absolutely imperative that for interest rates to come down for the individual dealer, for spreads to tighten, for money to be cheaper and for lending to increase, that the securitization market in the floorplan space has to become liquid again."

Fed to adopt new rules for rating agencies for ABS

On Monday, the Federal Reserve announced a couple of substantive changes to its criteria for evaluating asset backed securities pledged as collateral for the Talf.

Beginning in November, the Fed will conduct a “formal risk assessment” of all collateral proposed for acceptance by the Talf scheme. This requirement already applies to CMBS deals.

According to the Fed:

The change to the collateral review process will enhance the Federal Reserve’s ability to ensure that TALF collateral complies with its existing high standards for credit quality, transparency, and simplicity of structure.

To facilitate the risk assessment, each issuer wishing to bring a TALF-eligible ABS transaction to market will be required to provide, at least three weeks prior to the subscription date, information including, but not limited to, all data on the transaction the issuer has provided to any NRSRO.

On the topic of NRSROs - or Nationally Recognized Statistical Rating Organizations, like Moody’s and S&P - the Fed had this to say (emphasis FT Alphaville’s):

it has proposed a rule that would establish criteria for the Federal Reserve Bank of New York to determine the Nationally Recognized Statistical Rating Organizations (NRSROs) whose ratings are accepted for determining the eligibility of ABS to be pledged as collateral at the TALF.

The proposed rule, which would require a certain minimum level of experience in rating deals of any particular type, would likely result in an expansion of TALF-eligible NRSROs for ABS. It is intended to promote competition among NRSROs and ensure appropriate protection against credit risk for the U.S. taxpayer.

Here’s one of the more interesting bits of the proposed rule:

Registration with the SEC as an NRSRO is not, however, a guarantee of the quality of the credit ratings issued. The CRARA expressly prohibits the SEC and any state from regulating the substance of credit ratings or the procedures and methodologies by which any NRSRO determines credit ratings. Therefore, the Board believes additional criteria should be established to ensure that the Federal Reserve Bank of New York only accepts credit ratings that are reasonably likely to assist in the Federal Reserve Bank of New York’s risk assessment to determine eligibility of ABS pledged as collateral to the TALF. The Board specifically solicits public comment regarding whether NRSRO registration is an appropriate threshold requirement for being accepted at TALF and whether NRSRO registration should be the sole requirement for eligibility for use in TALF. In responding, a commenter should explain how credit risk can be controlled with NRSRO registration as the sole criteria.

The proposed rule would substitute the current requirement of attestations from a particular number of qualified institutional buyers that rely upon the ratings of a given agency for something more stringent:

the rule would require that the NRSRO had issued ratings on at least ten transactions within a specified asset category.

The asset categories are:

  • Category 1 – auto loans, floorplan loans, and equipment loans TALF sectors;
  • Category 2 – credit card receivables and insurance premium finance loans TALF sectors;
  • Category 3 – mortgage servicing advance receivables TALF sector18;
  • Category 4 – student loans TALF sector.

The proposed rule would permit an NRSRO to aggregate ratings on residential mortgage-backed securities (not currently included in the TALF) for purposes of meeting the ten-transaction requirement for Category 3 (mortgage servicing advance loans TALF sector).

And:

Experience across asset categories would not, however, be permitted to be aggregated under the proposed rule because the Board believes that the competencies required for ratings of ABS across different categories are not sufficiently similar. The four asset categories defined in the rule are significantly narrower than the “ABS” category in which a credit rating agency may be approved as an NRSRO by the SEC. Relying upon the issuance of a minimal number of ratings as opposed to attestations from QIBs in each of the four asset categories should ensure a minimal level of expertise in rating the types of assets for which the ratings will be accepted.

Recent eligibility-ratings controversy

Source: S&P tweaks CMBS model, reverses week-old downgrades July 21, 2009, Reuters

"Standard & Poor's on Tuesday reversed some controversial downgrades of widely watched commercial mortgage-backed securities in a highly unusual response to investor ire.

In a rare and dramatic reversal from just a week ago, S&P upgraded the bonds to the top AAA rating. The move reinstates their coveted eligibility under a Federal Reserve lending program that is behind a strong rally for the $700 billion market.

Among upgrades, S&P raised ratings on the A2, A3 and A-AB classes in Goldman Sach's 2007-GG10 transaction, considered a benchmark for CMBS, back to AAA from BBB-minus.

Investors and analysts for a month have decried more conservative models proposed and then adopted by S&P, claiming they are too harsh and overstate the effects of the U.S. recession on office, retail and apartment building revenue. On Tuesday, S&P said it responded to investors with "refinements" that would likely result in upgrades to seven classes of securities from three bonds.

One analyst at a New York dealer said S&P was "crushed with client calls" and then realized its models were faulty.

Specifically,the models failed to acknowledge that some shorter-dated bonds should retain top ratings because they would mature before incurring losses, said Bill Bemis, portfolio manager of structured products at Aviva Investors in Des Moines, Iowa.

"S&P's methodology change will make a lot of bonds that may not have been eligible under the TALF, eligible," said Bemis.

Michael DuVally, spokesman for Goldman Sachs, declined to comment on the ratings actions.

S&P analysts said in a report: "We have received a number of inquiries from market constituents regarding methodology for applying losses under our AAA rating, which prompted us to clarify our approach."

News of a July 14 ratings downgrade to billions of dollars worth of CMBS, including those of Goldman Sachs, Credit Suisse, JPMorgan Chase, Wachovia Bank and Morgan Stanley, threatened to undermine the Fed's Term Asset-Backed Securities program aimed at salvaging a sector ravaged by the credit crisis.

S&P also reversed its downgrade of some of Credit Suisse's CMBS ratings on Tuesday, raising A2 and A3 classes of its CMBS 2007-C3 ratings to AAA from BBB-plus."

TALF administrative structure

  • To manage the TALF loans, FRBNY will create a special-purpose vehicle (SPV).
  • The U.S. Treasury Department under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008 — will provide $20 billion of credit protection to the FRBNY in connection with the TALF, by buying debt in the SPV.

Eligible collateral

Eligible collateral will include U.S. dollar-denominated cash ABS that have a long-term credit rating in the highest investment-grade rating category from two or more major nationally recognized statistical rating organizations (NRSROs) and do not have a long-term credit rating of below the highest investment-grade rating category from a major NRSRO.

Synthetic ABSs do not qualify as eligible collateral.

Federal Reserve rejects AAA bonds as collateral

"That is JPMCC 2007-LDPX A2S, part of a CMBS deal put together by JPM two years ago.

The New York Fed didn’t mention the exact reason the bond was rejected, the only one which was, when it posted a list of the 35 bonds accepted under the first subscription for the legacy CMBS portion of the Talf. It did, however, reportedly mention something along the lines of “rejected bonds either did not meet the requirements of the Talf programme or they were rejected on the basis of the NY Fed’s risk assessment.”

That must have been some risk assessment since bonds that were accepted for Talf loans included WBCMT 2007-C30 A2 and MLCFC 2007-5, which have heavy exposure to stuff like the Peter Cooper & Stuyvesant Town loan. Three bonds reportedly also come from deals where the current 60-day delinquency rate is over 7 per cent. Nevertheless Of course all of the bonds, including JPMCC 2007-LDPX A2S, are rated triple-A.

JPMCC 2007-LDPX A2S itself appears to be primarily composed of interest-only loans on rather scary things like loans sponsored by General Growth Properties, the bankrupt real estate investment trust, or loans to Solana, the Texan property development owned by Robert Maguire. Not exactly the kind of stuff that would make a central banker squeal with delight, but considering its Talf-accepted competition, one has to wonder."

Source: The Fed’s enigmatic CMBS portfolio, an update Financial Times, September 10, 2009

"The Fed’s criteria for accepting and rejecting legacy CMBS as collateral in its Talf programme has been much scrutinised, yet its selection methodology remains a bit of a puzzle to most analysts.

For instance, the central bank has accepted stuff with exposure to General Growth Properties, the bankrupt mall operator, and Peter Cooper & Stuyvesant Town, which is teetering on the edge of default. Yet it’s rejected other CMBS bonds which seem to have a similar risk profile. Very mysterious.

All of the CMBS is, incidentally, triple-A rated per the Fed’s rules for the programme.

However, we couldn’t help but notice that six of the circa-115 Talf-accepted CMBS look to now be on Fitch’s list of problem loans — that is, they are either `of concern’ to the ratings agency, are the largest delinquent loans or the biggest that are being specially-serviced.

They are as follows:

MLFCFC 2007-5 ASB/CUSIP #55312YaD4 WBCMT 2007-C30/CUSIP #92978QAc1 Peter Cooper Village/Stuyvesant Town — The $3 billion loan is secured by 56 multistory buildings with 110 different addresses situated on 80 acres that include 11,227 residential apartments in New York City. The borrowers, Tishman Speyer Properties, LP and BlackRock Realty, acquired the property with the intent of converting rent-stabilized units to market rents. As of July 2009 there were 4,461 market units and 6,768 rent-stabilized units, with a vacancy rate of 4.1%.

BACM 2007-1/CUSIP #059497AU1 Solana — The $360 million Solana loan is backed by 1.79 million square feet of office space, 43,685 square feet of retail, a 38,000-square-foot health club, and a 198-room full-service Marriott hotel in Westlake, TX. The loan is sponsored by Maguire Partners. The special servicer is discussing workout options.

JPMCC 2005-LDP1/CUSIP #46625YGP2 Woodbridge Center — The $207.9 million loan is secured by the 556,835-square-foot in-line portion of the Woodbridge Center, a super-regional mall in Woodbridge, N,J totaling 1.64 million square feet. The loan is sponsored by General Growth Properties (GGP) and was included in its April 2009 chapter 11 bankruptcy filing. (Nonperforming Matured)

JPMCC 2005-LDP5/CUSIP #46625YXP3 Jordan Creek Town Center — The $164.8 million loan is secured by a 939,085-square-foot retail property in West Des Moines, IA. The borrower is an entity owned by General Growth Properties. (90 days delinquent)

LB-UBS 2005-C5/ CUSIP #50180JAB1 Providence Place Mall — The $258.5 million loan is secured by a 1.29 million-square-foot four-level super-regional mall in the heart of downtown Providence, RI. The sponsor is General Growth Properties.

Admittedly, such problem CMBS does not make up a huge proportion of the Fed’s accepted bonds, but it does make one wonder how the central bank is going about choosing these things. Little wonder, then, that we are seeing analysts call for more transparency in the programme."

The P-PIP's Legacy Securities Program

On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Program (P-PIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on the day of the announcement rising by over six percent with the shares of bank stocks leading the way. P-PIP has two primary programs.

The Legacy Loans Program will attempt to buy residential loans from bank's balance sheets. The FDIC will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF).

The initial size of the Public Private Investment Program is projected to be $500 billion.

Economist Paul Krugman has been very critical of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors.

Banking analyst Meridith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs.

Assistant professor Linus Wilson argued that removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is a call option on a firm's assets, this lost volatility will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.

The NY Fed on ABS markets and TALF

Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Securities Industry and Financial Markets Association and Pension Real Estate Association's Public-Private Investment Program Summit, New York, 4 June 2009.

What has transpired in the asset-backed securities market over the past two years has been dramatic. Prior to August 2007, as much as 60% of private credit creation in the U.S. was not held on the books of depository institutions but was instead distributed onwards through the ABS markets into the so-called “shadow banking system.” Through the use of ABS, banks were able to package consumer loans, credit card receivables, student loans, residential and commercial mortgages, as well as other types of loans into securities that were then sold to investors.

However, since August 2007, the ABS market collapsed in a series of stages – first subprime mortgages, then alt-A mortgages and non-agency Residential Mortgage Backed Securities, and finally consumer ABS and Commercial Mortgage Backed Securities or CMBS. The collapse spanned every area outside of the agency mortgage-backed securities market, which is supported by the government-sponsored enterprises, Fannie Mae and Freddie Mac.

The final stage of collapse of the ABS markets occurred following the failure of Lehman Brothers last fall, when the yields on outstanding ABS issues soared and new originations virtually disappeared. This increase in yields did not solely reflect an increase in credit risk; it also reflected a genuine loss of confidence and an accompanying increase in risk aversion. Yield spreads on even the very safest ABS obligations soared hundreds of basis points. This can be seen in the fact that AAA-rated student loan tranches, with underlying loans 97% guaranteed by the federal government, climbed to yield levels as much as 400 basis points over LIBOR.

With the spike in yields, the economic incentives to issue evaporated – issuance was just too costly and there was no active market. After averaging around $50 billion per quarter of new originations in 2007 and the first three quarters of 2008, consumer ABS issuance plunged to only $4 billion during the fourth quarter of 2008. Issuance of commercial mortgage backed securities ground to a complete halt and this market currently remains closed.

So why did the ABS market collapse? There are many reasons.

One factor was that in some areas, the risk management incentives of banks and other issuers of ABS were misaligned with those of the end investors in these securities. This misalignment manifested itself in the overall deterioration in lending standards that took place across the economy beginning during the middle part of this decade. Some originators did not do an adequate job of due diligence because the underlying loans were swiftly moved off their balance sheets through the securitization process. This dynamic should have been mitigated to some extent by the rating agencies as they assigned ratings to these new securities, but that process too proved inadequate, especially for residential real estate-related securities. The problems associated with these misaligned incentives for issuers and inadequate rigor on the part of the rating agencies became apparent as the housing sector turned down and the economy weakened. The result was a dramatic spike in credit losses and an almost complete loss of investor appetite for non-agency, residential mortgage-backed product.

A second factor contributing to the collapse of the ABS market was that the benefits of pooling and distributing risk more widely proved to be somewhat illusory. In practice, the performance across different loans that collateralized the securities was much more highly correlated than was anticipated, and the risks associated with these securities was significantly more concentrated than had been assumed. Some banks that were unable to sell the highest-rated tranches kept them on their books. In other cases, the sales were made to off-balance sheet vehicles, in which the banks retained residual risk. This correlation contributed to the aversion of investors to the asset class as a whole.

A third contributing factor was the fact that these securities were often complex and heterogeneous and, thus, hard to value. In a stressed economic environment, this complexity exacerbated the erosion in market liquidity conditions, which in turn led to a vicious circle of falling prices and even further diminished liquidity. The result was that some bank conduits and buyers of securitized products such as SIVs became distressed and failed as mark-to-market losses increased. In the post-Lehman bankruptcy world – when liquidity was paramount – securitized products were very difficult to trade, in part, because they were very difficult to value.

The cessation of new asset-backed securitizations has been problematic because banks have not had the capacity to keep credit flowing freely. This is especially true given that bank balance sheets were already under strain – bank capital has been depleted by credit losses and bank balance sheet capacity has been strained by an inability of banks to securitize new loan originations and by the need for banks to honor their off-balance sheet obligations. For all these reasons, the Federal Reserve determined that it was important to augment the balance sheet capacity of the financial system by supporting the ABS market. This was the purpose of the TALF. By providing non-recourse, term financing for new AAA-rated consumer asset-backed securities to investors, the TALF essentially provides the balance sheet capacity necessary to facilitate the continued flow of credit to households and businesses. The TALF offers three attributes that the private sector has had difficulty providing during this time of financial and economic distress: 1) leverage to purchase highly-rated, low-risk assets, 2) term financing and 3) protection against very adverse economic outcomes. TALF loans are leveraged – haircuts against the AAA-rated collateral average about 10%; the loan terms are three or five years; and the loans are non-recourse, which means that if the economy performs very badly and the securities fall sharply in value, an investor can put the collateral that secures its TALF loan back to the Fed, only losing the collateral haircut. The loan is then extinguished.

Because term, non-recourse financing is not readily available from the private sector currently and the spreads on asset-backed securities remain elevated, TALF provides an opportunity for investors to purchase AAA-rated consumer asset-backed securities and earn relatively high returns. Although some observers are concerned by the prospect of TALF investors achieving relatively high returns, I think that concern is misplaced. Investor participation is absolutely essential in order for the TALF to improve the availability of credit and to bring down the cost of credit for households and business. The prospect of relatively high expected risk-adjusted returns is precisely what gives investors an incentive to participate in the program. As investors begin to take advantage of the attractive TALF terms, spreads on ABS securities contracts, and rates of return go down, and most importantly, the costs of funds for the issuers of the underlying securities falls.

Investors’ actions to seek attractive returns lead to lower borrowing costs for households and businesses. Does the possibility of attractive returns for TALF investors mean that the Federal Reserve is taking on large credit risks? I think the answer is a clear “no,” principally because the returns earned by investors primarily are due to the absence of sufficient private balance sheet capacity rather than underlying credit risk. In fact, from the Federal Reserve’s perspective, the risk of loss is very low. Indeed, there are three layers of protection that stand between the Federal Reserve and losses.

First, the underlying securities are AAA-rated, which means that losses on the underlying loans have to be unusually large to move that high up in the capital structure. And although some of the rating agency models have not held up well in the crisis, the consumer ABS models have proven to be reasonably robust. In other words, a AAA-rating still means quite a bit in this market. This is in contrast to the collateralized debt obligation or CDO market, where AAA-rated securities often used subprime and Alt-A mortgage loans as their raw ingredient.

Second, as noted earlier, the Fed has taken additional haircuts against the underlying securities averaging about 10%. These haircuts provide additional protection to the Fed. Third, if the underlying collateral is put back to the Fed, the Fed puts the collateral into a special purpose vehicle. In such a situation, the Fed would be protected by the excess spread earned on the TALF loans and Treasury-provided TARP capital. Only if those buffers were wiped out, would the Fed suffer losses.

We have done stress simulations on the underlying loans. We think it is unlikely that the Treasury will lose money on this program, and it sits ahead of the Fed in terms of its loss exposure. The risk posed to the Federal Reserve therefore seems quite remote. Instead, we expect that the program will be profitable for the taxpayers and will be successful in pushing down yields and increasing credit availability.

Turning from the issues of design and risk to issues concerning implementation and effectiveness, we have been rolling the TALF out in stages – first the consumer ABS market, with the first subscriptions for TALF loans in March; second, new CMBS securitizations that will start in early summer; and third, legacy CMBS and, possibly legacy RMBS, later this summer.

By legacy assets, we mean highly-rated existing securitized assets that are already outstanding. The legacy TALF program will help support asset-backed-securities prices. This should help aid market liquidity and make financial firms that hold such assets less vulnerable to the risk of further losses.

So far, the evidence indicates that the program is working as designed.

Purpose

The Fed explained the reasoning behind the TALF as follows:

"New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads."

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