The ABS market remained quiet last week as participants were still waiting for further details about the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF).
Experts have mixed opinions regarding the TALF's impact on the ABS market. Some say it's a boost to the sector - specifically for auto ABS. Meanwhile, others are skeptical about the program's long-term positive impact, as TALF promotes leverage in a market that is, for the most part, trying to de-lever.
More details regarding the program were disclosed by the Fed in December. These included extending the term of TALF loans to three years from one year, as well as clarifying executive compensation requirements.
Jeffrey Taft, a partner at Mayer Brown's Washington, D.C. office, said that one of the important clarifications made by the Federal Reserve regarding the TALF in December was whether originators of the underlying loans were required to comply with the executive compensation requirements for the securities to be eligible under the TALF.
The Fed clarified that the executive compensation restrictions are imposed upon the sponsor of the deal, which might not be the originator. This is helpful, according to Taft, in instances where the originator has already sold the assets to a third party or when the originator is no longer in business.
There are still other clarifications that need to be made, however, including what the haircuts would be for the various classes of eligible collateral. "The great unknown remains what haircut will the Fed apply," Taft said. "There is a delicate balance that the Federal Reserve must strike. It should be such that investors are incented to participate in the program, while not exposing the Fed to potential losses beyond the Treasury backstop."
Edward Gainor, a partner at McKee Nelson, said that the most notable changes that were made in December to the TALF were the increase in loan term from one year to three years as well as the elimination of the auction rate procedure, which was posing great uncertainty to the market. He said that the Federal Reserve Bank of New York also simplified the process to access TALF, making it more straightforward and easier to apply.
Trading TALF Bonds
In a report released earlier this year, Wachovia Securities analysts said that despite the program's shortcomings, they still think that the TALF will offer support to the ABS market by creating incentives for investors to take risk as well as for issuers to access the capital markets.
However, Glenn Schultz, a managing director at Wachovia Securities, stated that the TALF program may create further bifurcation in the ABS market. He believes that there will be tiering between pre-2008/2009 and post-2009 vintage deals. The TALF program may exacerbate tiering further between non-TALF and TALF deals.
"When you look at trading in the pre-2008 deals, they potentially may trade much sloppier than, say, post-09 vintage transactions because of the differences in underwriting, credit enhancement and valuations," Schultz said. This would be much like TALF and non-TALF eligible deals, since the stronger issuers might not want to subject themselves to the limitations under TALF. "In 2009, the bifurcation would be between the issuers that needed TALF and that did not need TALF," he added.
There's also the question of how much of the leveraged bid resulting from TALF is legitimate or subsidized. "The [Honda Motor Co.] deal that just priced would give us an idea of how much access to TALF is driving spreads - if TALF deals are trading inside of non-TALF deals, the difference in spread is a subsidized bid."
Schultz added that the extension in terms announced by the Federal Reserve to three years from a year reduces the pressure on leverage investors as it allows them to hold on to the bond because of the longer-term funding. However, this also limits the participation of cash investors because of the subsidized bid. In the fourth quarter, the Nissan Motor Corp. auto deal came to market based on a reverse inquiry, as the investor in the deal thought that TALF as well as the Troubled Asset Relief Program (TARP) would create a floor on valuations, which these programs have not.
Wiggle Room
The Federal Reserve has not given the full details regarding TALF, even as the program's February implementation draws close. Ron D'Vari, CEO and co-founder of NewOak Capital, said that the lack of clarity gives the Fed some wiggle room.
"There's uncertainty as the market wants the engine to start kicking," D'Vari said. "The lack of definition is making the market nervous. The dilemma that is facing the Fed is that it doesn't want to be too specific that it has to stick with it and deal with accusations if it has to change the program, and yet there's pressure to speed the process up. At this point, the market has to remain patient, the patient's heart is not beating and it needs as much stimulus as possible."
The TALF targets investors rather than giving lenders the money directly. D'Vari said that this is a more efficient way of providing financing. Giving lenders the money directly would require that the government give a guaranty on a loan-by-loan basis. Besides, "it's not the guy who originates who would keep it, if you are going to keep this for three years, it has to be directed at the risk taker," he said.
According to McKee's Gainor, although TARP funds are being used to provide credit support for the TALF, the TALF is not part of the TARP and is not like the latter, which has been used to extend direct financial support to troubled firms. TALF merely provides an attractive form of financing to ABS investors, so there can be no stigma involved for companies that choose to make their deals TALF eligible.
TALF-Induced Volume
As for the TALF spurring ABS volumes, Wachovia Securities holds to its over/under $100 billion estimate for all of 2009, which includes potential ABS issuance related to TALF. "There are two issues here," Schultz said. "The first is that TALF might stimulate participation on the demand side. However, in a recession nobody is lending and consumer debt is coming down. So even if there's infinite demand for ABS securitizations, there is little to no lending, and from that standpoint these factors may offset each other." There might be some collateral left over from 2008 that did not get securitized, but Schultz does not think the market will be carrying that over into this year until the second half.
Undoubtedly, the Treasury and the Fed are hoping that TALF will spur securitization issuance in both the short- and long-term. However, Mayer Brown's Taft said he is unsure about "how much of the short-term flurry spurred by the TALF financing banks and finance companies with eligible assets on their balance sheets will carry forward. The $64,000 question is whether the TALF can spur future securitizations by jumpstarting the market and restoring investor confidence."
Reservations on TALF
Anecdotally, TALF seems to be gaining ground. "From my discussions with auto ABS issuers, they seem very interested. Some student loan ABS issuers have also shown interest," McKee's Gainor said.
However, he believes that to stimulate the full recovery of the securitization market, government programs, in this case the TALF, should target the non-conforming RMBS market as well as the small and large balance CMBS sectors.
"Given what's happened in the markets, we can expect that non-conforming RMBS transactions will be simpler in structure, and that there will be more thorough diligence and increased disclosure in RMBS deals," he said. "However, there should be other ways beyond the Freddie Mac and Fannie Mae model, which clearly did not work, to support the non-conforming sector. It would take a recovery of RMBS before the general housing market could recover - we need securitization to provide the financing to buy homes."
The TALF has certain constraints, according to Gainor. One of them is not allowing the sponsors of securitizations, the originators of the underlying receivables, as well as their affiliates to finance ABS through the TALF. "This is baffling to me because the main aim of this program is supposed to be to stimulate consumer lending, and not necessarily to stimulate the secondary market, so why has the Fed precluded lenders and securitization sponsors from participating in the TALF?" He added that it is also not clear up to this point to what extent non-U.S. investors can participate in the program.
Clearly, not all ABS players are sold on the potential positive effects of the TALF. "I'm a bit of a skeptic," said Samir B. Shah, senior vice president at MF Global. The investor base TALF is targeting are levered players, thus the program benefits mostly hedge funds, Shah said. He added that historically, money managers, property and casualty insurance companies, and pension funds or real money accounts have always been involved in the secondary ABS market. Most of these need to deploy leverage, and TALF does not help them buy assets. "You need much more support to this sector now, in my opinion," Shah said.
He added it was the levered players who bought into the RMBS market, including the banks, hedge funds and CDOs. "Leverage no longer has the buyers, and the reason yields are higher is because of the competing assets more than anything else."
Creating more leverage is not the answer, as the Fed caused some unintended consequences by lowering interest rates, Shah said. This move by the Fed hurt the pension system, which historically has bought bonds and ABS. Since assets were available for lower than 4%, these firms became underfunded and had to take in more risk to meet their obligations, Shah said.
"Creating more leverage is short-sighted," he said. "Assets created using leverage - by definition these assets are uneconomical, and creating TALF doesn't support their prices. It's still the underlying bond that's supporting them."
Shah pointed out that ABS spreads have racheted in, so that with TALF the levered returns or arbitrage would go away. "With 10 to 15 yield for the new stuff, you can't use that for the secondary stuff," he said. "There won't be the same level of sponsorship, the pension fund will be crowded out by the levered players or maybe they will seek yield elsewhere."
Another problem with TALF, Shah said, is that the banks that originate loans cannot use TALF to buy their own originations. For example, Chase can buy Citigroup's origination but it cannot use TALF to buy the paper it originates. Furthermore, Shah added that Federal Deposit Insurance Corp.-backed debt is actually trading pretty tightly, and banks can use that to fund consumer ABS. However, they are not originating ABS, so it's the lack of demand rather than funding that is the issue.
Another question is who would be buying the subordinated tranches of TALF-compliant deals. "Who is going to take the subordinated tranche, that is the magic question," Shah said.
Why TALF is Needed
Like it or not, TALF is building leverage back into the market, which some consider to be necessary.
"Everybody's bandwagon returns are about 10, 15 without risk," D'Vari said. "We cannot survive without leverage, which becomes bad when it falls, but building it back makes the cost of funding cheaper to borrowers."
The important question, according to D'Vari, is what will the rating agency requirements be in terms of attachment points. "What is the rating criteria going to be in rating TALF securities? The rating on these securities is a key factor, and it's still not known to the market," D'Vari said. "Will the rating agencies require a 20% subordination versus 40% - that's going to make all the difference."
According to Kevin Duignan, managing director at Fitch Ratings, a transaction's rating and credit enhancement will be calculated completely independent of whether it's TALF eligible or not. "The TALF issue comes after the rating process," he said.
Meanwhile, McKee's Gainor said that programs like the TALF are intended to extend government credit where the traditional channels have broken down. "Between the Fed and the Treasury, various programs have supported the credit markets by buying commercial paper, guaranteeing certain bank debt, buying mortgage-backed securities, and now providing financing for ABS. But the question is, what happens when these programs end?" He added that when the economy eventually recovers, it is important that programs like the TALF be "gradually and incrementally withdrawn to avoid market disruption."
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