TALF – The credit card bailout and auto loan bailout in sheep’s clothing
The Federal Reserve Bank of New York (FRBNY) rolled out the newest plan designed to get the banks to start lending again. Its primary goal is to increase credit availability and support economic activity to consumers and small business owners that need to borrow through auto loans, credit card loans, student loans and S.B.A. Small Business Administration loans. It’s entitled the Term Asset-Backed Securities Loan Facility (TALF), was sketched out on November 25th and then tweaked in a recent release by the Federal Reserve Bank of New York on December 19th.
As a business banker, I could not have been happier. Regardless of what the banks say in their endless rhetoric to the public, there is simply not much lending going on. Inside every bank, the lenders gather round the water cooler and ponder just how long the credit freeze will last. So my first glimpse of the TALF program was like a ray of sunshine peeking through the clouds looming overhead. Then, I read it again, and yet again, and all hope was gone.
Because, my friend, sometimes it’s not what you say or do, but how you say or do it.
I tried to find the right word to describe the Federal Reserve Board’s release on the T.A.L.F program, and I finally came up with, what I believe, is the perfect word.
Duplicitous: given to or marked by deliberate deceptiveness in behavior or speech.
I read and re-read the original and updated releases, with the help of my dictionary and more than one glass of wine. I drew little pictures, with arrows and dollar signs. And I traced the flow of the money and the guarantees. And then I started writing. Not for you, but for me. I desperately wanted TALF to be meaningful in a positive way. Sadly, here’s what I came up with.
My simplified summary of their proposal is this: In an effort to increase credit availability and support economic activity, the F.R.B.N.Y (Federal Reserve Bank of NewYork) will agree to lend money, on a non-recourse basis, to investors who purchase Asset Backed Securities from banks. The banks must originate, the loans, that is actually be the lenders, and the loans must be recently originated consumer and small business loans such as student loans, auto loans, credit card loans and loans guaranteed by the S.B.A. The big question is will TALF work?
In theory, this plan has merit if, but only if, we have stable economic conditions. The banks would then happily make these small loans to consumers and small business owners because they could easily bundle them up and sell them to investors such as mutual funds, pension plans, insurance companies, and other banks through an investment vehicle called an asset-backed security.
This process doesn’t work when our country is facing an economic crisis. These types of loans are vital to our nation’s economic recovery, but the banks are refusing to make them. The banks can’t bundle them upand sell them (securitization) because the usual investors (e.g. other banks, mutual funds, pension funds) don’t want to invest in them right now. There is simply no confidence in the marketplace, and the banks, because they are so concerned about their own financial viability refuse to hold them on their books. The banks either desperately need to improve their capital positions to save their own skin or they are simply hoarding capital.
Therefore, despite T.A.L.F, the credit market for loans to households and small business is frozen. The banks are not meeting their fundamental obligation under T.A.R.P to lend money to this sector, and in fact, across the industry, they are withdrawing their existing commitments to lend. Presumably, under T.A.L.F, if it worked, the banks would start to make loans to the consumer and small business. They would then bundle up the loans, and sell them to outside investors. Those investors (again, banks, mutual funds, pension plans) would borrow money from the FRBNY and use the funds from the FRBNY to buy the loans from the bank. This process would replenish the money supply in the banks, so that they could then lend and relend it, time after time…thus, the credit cycle continues.
At the risk of being repetitive, I want to make sure that the reader understands the flow of money and risk, in this process. First, the banks make the loans to the consumer and small business owner. At this point, the bank carries the risk of those loans on its books. If there are losses, the bank must take the loss. However, when the bank succeeds in the securitization or bundling and selling of those loans, then the risk passes along to the investor. The banks are then risk-free and reimbursed, WITH AN IMMEDIATE PROFIT, for the value of that bundle of loans. They have also received ALL the money it originally lent to the consumer and small business owner …and could now, perhaps, lend it again.
The main problem is that, right now, there are no investors willing to buy the original loans from the bank. So, in order to make those bundles of loans attractive to the investor, the government, under TALF, will lend the money to the investor to buy the bundle of loans. The Federal Reserve Bank has already earmarked $200 Billion dollars for this program.
However, the FRBNY knows that merely providing loans to the investor isn’t going to be enough to encourage them to buy these assets from the banks. So they have sweetened the offer by providing the investor with a guarantee. This guarantee transfers the RISK away from the investor and onto the Federal Reserve Bank of New York, who is then further guaranteed by the US Treasury. In the best case scenario, the repayment will come from the payments made by the consumers and small businesses who took out the loans out in the first place.
So I sat back and asked myself why a little spot in the pit of my stomach was screaming out warning signals. The plan seemed to have merit. Why then was I so concerned? Suddenly I realized that I resented the duplicity of the plan. I realized that the plan hadn’t addressed the banking industry’s lack of due diligence in properly evaluating the credit worthiness (capacity to repay) of the individuals and business borrowers to whom the loan is first granted. The banks are simply lending more money to the same kind of borrowers who aren’t able to repay their mortgages.
In order to understand how this plan will fail, one needs to first understand that it all STARTS with the banks approval and granting of the credit card or auto loan. It is, in fact, the performance of these loans that the government is guaranteeing. And as I have previously said, the regulators have done nothing to make sure that the banks are applying safe and sound lending practices when consumers apply for auto loans and credit card loans. The banks have refused and continue to refuse to apply any income verification standards in the credit evaluation process. They simply take the borrower’s word on his income, which is called no-income verification lending. It is the same lack of underwriting that banks applied when they issued toxic mortgages. Additionally, under the TALF program, loans that qualify as assets that can be sold by the banks, might have been issued as far back as May 2007. Without addressing credit underwriting standards, the TALF program is simply just another bail-out program designed to transfer existing and new credit risk from the banks, through the investors and then onto the taxpayer by virtue of the new government guarantee.
The second thing one needs to understand is what happens when the consumer or small business makes their monthly payments on their loans. When one buys an asset-backed security, they are buying the principal and interest repayment stream from the initial bank loans along with the lien position on the collateral such as the home or automobile. The consumer or small business borrower makes their monthly principal and interest payments. But since the banks don’t own those loans anymore, those payments are used to pay back the investors that bought the loans from the bank. And the investor pays back the money they borrowed from the Federal Reserve Bank of New York. Some reasonable level of default is expected to occur within each bundle of loans. And so, the rate of interest that is paid by the consumer and small business borrower, and therefore earned on the bundle of loans, is always higher than the interest rate that is paid to the investor. The difference, that extra interest that is earned on the entire bundle, is used to offset losses from consumer and small business loans that default and never get repaid.
Now, let’s look at the proposal: What is a non-recourse loan? Non- recourse means that the F.R.B.N.Y takes the bundle of loans as direct collateral to their loan to the investor. If too many loans default, the investor is unable to meet the principal and interest payments due to the FRBNY. When this happens, the F.R.B.N.Y will seize the collateral, which simply means they will take ownership of the consumer and small business loans. The F.R.B.N.Y’s recourse is limited to the value of that collateral, which consists of the original loans made by the banks to the consumer and small business. This system of non-recourse lending puts the F.R.B.N.Y in the first-loss position with these bundled loans, not the investors and certainly, not the banks!
Non-recourse lending has its place in the banking system. Let’s say you are lending money against a piece of real estate like an apartment building (oops, probably a bad example) and the borrower wants to borrow 50% of the apartment house value. If the monthly rents on the building (cash flow) covers all the building’s expenses, such as real estate taxes, insurance, general repairs and maintenance, and salaries of the superintendent and other employees, with enough left over to more than cover the monthly loan payment and interest; then non-recourse lending may be appropriate.
In the above case, the lender is fully protected because he has lent-out only fifty percent of the apartment house value. If the cash flow fell, so that it could no longer cover the principal and interest payment to the bank, the bank could simply foreclose on the entire building. Even if the loan defaulted, the lender could sell the collateral and recover the full amount of the loan. Non-recourse financing only protects a lender that utilizes prudent underwriting guidelines and, by its very nature, encourages them to only lend a reasonable percentage of the collateral value.
That idea led me to examine the true value of the collateral (that bundle of loans the bank made to the consumer and small business owner without any consideration to the borrower’s capacity to repay). The Federal Reserve Bank of New York may be on the brink of making a tragic mistake here. But I can’t tell because no-where in this proposal do they define what percentage, of the value of the underlying collateral, they will lend against. 80%? 90%? 99%? The smaller the percentage, the less risk of FRBNY’s failure and a call on more of our tax dollars. What I do know is that they are calling this “the haircut”, and that term by its very nature, scares me. Is it a trim? or a crew cut? What level of risk is still being borne by the investor? Without some clarity on this point, I fear that TALF will be a repeat-performance of the mortgage backed security fiasco.
It is important to note here that the banks that originate the consumer and small business loans, cannot directly package them up and securitize them through the program. What this means, is that they can’t make new toxic loans or take existing toxic loans they currently have on their books, and securitize them ……within the same transaction. What does this really mean? Let’s say that Chase bundles up $20 million in loans they originated. And Bank of America bundles up $20 million in loans that they originated. Chase could not use their loans as collateral to borrow through the TALF program. But there is nothing to STOP THEM from selling their $20 Million in toxic loans to Bank of America through the program. And in turn, Bank of America could sell their toxic loans to Chase through the program. In truth, the TALF program COULD be used to simply ‘launder’ the toxic loans between the banks that are already receiving funds from the Emergency Economic Stabilization Act of 2008. And I think that ‘launder’ is exactly the right word because this process will allow the banks to take the toxic loans off their books, pass them through the TALF program, and bring them back onto their books, nice and clean and fully guaranteed by our taxdollars!!!
This loophole does nothing to encourage the banks to improve their credit underwriting standards. Nor does it require the banks to direct the funds they receive, when they sell the loans, back into the market in the form of new loans. When the banks don’t have any skin in the game, as happened with mortgage loans, their credit underwriting guidelines (evaluation of character, capacity, collateral, capital and conditions) cease to exist. The F.R.B and other regulating agencies are not requiring the banks to make changes in their due-diligence process, nor are they enforcing any prudent underwriting criteria.
As of this moment, the banks are not performing even the simplest form of income verification for car and/or credit card loans. Since there are no regulatory requirements dictating specific underwriting criteria regarding confirmation of the borrower’s capcity to repay, the banks simply are …..NOT doing it. I personally hold every auto loan and credit card loan that lacks income verification by the lender as highly suspect, and severely at risk of default. Obviously, our regulating authorities don’t feel the same way I do. They continue to allow banks to carry on, ”business-as-usual”, “buyer-beware” lending practices. TALF gives the banks, yet again, one more means of taking their profits up-front and passing the risks on to the taxpayers.
One of my other problems with TALF is its definition of the term “recently originated”. The latest FRBNY release states that: Auto loans must be originated after October 1, 2007; Small Business Association (SBA) loansafter January 1, 2008; student loans must have had a first disbursement date after May 1, 2007; and for credit card loans, the new asset backed security must be issued to REFINANCE existing credit card Asset-Backed Securities that MATURE in 2009. That’s the worst rule of all because it doesn’t matter when these credit card accounts were initially granted. It permits banks to transform old toxic credit card debt that’s on the bank’s books into government guaranteed credit card debt.
Furthermore, the program states that eligible collateral must have a long-term credit rating in the highest investment grade category. There is an apparent contradiction of terminology: “recently originated” and “long-term credit rating” are mutually exclusive terms. You can’t be both at the same time. Perhaps the writers of the TALF program are being deliberately duplicitous? T.A.L.F. would then simply be a mechanism for our government to buy existing toxic credit card and auto loans from the banks? If that is the case then TALF is the credit-card and auto loan bailout in sheep’s clothing.
Although the release states that the US Treasury will provide $20 Billion dollars worth of credit protection to the FRB, it appears to me that they are using those words because the public can no longer stomach the idea of more Government Guarantees. In the event of default, this is what really happens: The Federal Reserve Bank of New York takes over the bad loans because they are the sole form of collateral that is available. If the F.R.B.N.Y can’t get sufficient value from the repayment of those smaller loans, then the US Treasury will make up the difference with what T.A.L.F. calls credit protection up to $20 Billion dollars.
Why doesn’t TALF call it a government guarantee, since that’s what it really is? In the real world, if there is a default, the U.S. Treasury will have to come up with that $20 Billion dollars and hand it over to the FRBNY. That means it’s really coming from the blood and sweat of the taxpayers, and that’s what they’re doing their best to hide. TALF is being sold to the public as a means to stimulate lending to help our country’s economic recovery. My evaluation of the program indicates otherwise.
My final observation is that T.A.L.F does not clearly define how that $200 Billion dollars must be allocated between the various loan types: student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Since S.B.A loans, by their very nature, carry a government guarantee of between 50% and 75% to the banks, then isn’t there a double guarantee under this program? One guarantee from the S.B.A and one under T.A.L.F? It doesn’t seem possible that the government wants to give two guarantees on the same loan! If they are unconcerned about this, it is because they KNOW that the TALF funds will NOT BE USED to stimulate SBA financing by the banks.
More to the point, however, is that if the program doesn’t require the banks to allocate a percentage of these resources specifically for S.B.A. lending, it is unlikely that the banks will increase their S.B.A lending functions. They will direct these resources to the other unsecured loan categories that carry higher interest rates and therefore higher immediate returns upon their sale under TALF.
I understand what the Federal Reserve Board is trying to accomplish, and applaud it for its efforts. I just think they should be more respectful, transparent and forthcoming in the way they describe the plan. And our leaders should finally realize that the ones that have the money, and ability to commit our taxpayer dollars, get to make the rules. This program, absent major re-regulation of the lending procedures currently used by banks; and minus a clearly defined requirements on allocation of these funds, is just another accident waiting to happen.
If this program was designed to meet it’s fundamental goal: to increase confidence in the Asset-Backed Securities market so that banks would once again lend to the consumer and small business, here’s what they need to do.
Enact legislation that will impose credit underwriting standards on the banks that make the loans. This policy will create confidence in the loans that are being granted and subsequently sold. Confidence based on the actual value of the loan and not based on a government guarantee. The guarantee would be gravy.
Make the TALF funds available ONLY as a means to finance newly generated loans— specifically loans issued after January 1, 2009, and for those loans issued in compliance with the newly defined credit underwriting standards set above.
Require that the proceeds from the sale of loans sold through the TALF program be put BACK into these same types of loans so that banks cannot merely divest themselves of loans already on their books and hoard these new funds.
The program must direct specific amounts of the TALF funding towards specific loan categories such as SBA loans. Without such direction, banks will simply focus on credit cards and other loans that have higher interest rates and that will provide them with higher levels of immediate income. Nothing will be done to help the business owners in this country.
Over the course of this crisis, we have maintained that the confidence in the banking industry and its leadership has been thoroughly eroded. Confidence in our political and regulatory agencies has also vanished. As long as there is no confidence, there can be no recovery.
The Federal Reserve Board’s apparent dissemblance in its presentation of the T.A.L.F program will simply make things worse. False assurance is worse than no assurance. Transparency is more than a virture, it’s a necessity, and the devil in the TALF lies in its details, or lack thereof.
Federal Reserve Act 13 (3)
FRB releases on TALF dated Dec 19, 2008