What if the Fed threw a party and no one came?
The US Federal Reserve has been trying to get credit flowing through the financial system, creating a variety of lending facilities with that end in mind.
Direct lending to banks and securities dealers; purchasing or financing the purchase of money market instruments, such as commercial paper; buying agency, mortgage-back and treasury securities for its portfolio; increasing swap lines to foreign central banks: the Fed’s various liquidity provisions have had the desired effect of increasing the availability of credit and lowering the price.
Restarting the securitization market is proving more difficult.
Last November, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility, or Talf, to increase credit available to households and small businesses. With the Fed lending as much as $200 billion (Rs9.9 trillion) on a non-recourse basis to investors to purchase AAA-rated asset-backed securities, banks presumably would be more willing to extend credit because they can get the loans off their books. (The Fed will lend an amount equal to the market value less a haircut.)
After months of legal complications, Talf debuted in March with $4.7 billion of non-recourse loans from the Fed. This month’s auction resulted in a total of $1.7 billion.
If Talf is designed to restart the securitization markets, these types of volumes are simply not going to get it done, says Jim Bianco, president of Bianco Research, an independent research firm in Chicago.
One disincentive to participation is political. Investors are afraid Congress will find a way to confiscate any excess profits (definition: anything Barney Frank thinks is too big), even retroactively.
That’s what happened last month, when the House of Representatives approved a 90% retroactive tax on bonuses paid to employees of firms receiving money from the Troubled Asset Relief Programme (TARP). The treasury is providing as much as $20 billion of TARP funds to protect the Fed from losses. That means Talf investors may be subject to TARP constraints, unless the six degrees of separation somehow creates an exemption.
What’s more, Talf investors, like all recipients of Fed funding under section 13 of the Federal Reserve Act (the lending to non-banks in unusual or exigent circumstances clause), are subject to restrictions on hiring skilled workers from abroad.
The second disincentive to Talf participation is the lack of an independent third party arbiter of risk, Bianco says. What made the securitization market go was the credit rating agencies. Their reputation is not going to come back.
Most investors have neither the time nor the temperament to pick through individual loans that are pooled, sliced, diced and transformed into something with a credit rating and a cash flow to determine their viability. That job was designated to three credit rating companies—Moody’s Investors Service, Standard and Poor’s and Fitch—which were paid by the issuer of the securities, not the investor.
That wasn’t always the case, according to Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. Prior to the 1970s, the onus was on the investor to pay for ratings.
That relationship removes the conflicts of interest inherent in the current system. Investors should be the one paying for credit evaluation, Kasriel says. They’re getting a free ride. They also got what they paid for.
A free market in credit rating companies, with many firms competing for business instead of the three anointed by the Securities and Exchange Commission in 1975, would result in more independent analysis on the part of investors going forward, he says. (It’s refreshing to hear someone say the free market is the solution, not the problem.)
Kasriel doesn’t think credit risk is an issue with Talf because treasury is taking the first loss, with the Fed shouldering most of the rest. Bianco disagrees.
Who told the Fed it was AAA? Bianco says, referring to a potential deal approved for Talf financing. Answer, the rating agencies. The Fed is offering non-recourse financing on securities of an uncertain riskiness because AAA has no meaning any more.
Last week, Moody’s issued its first ever negative outlook for all local US governments. The credit quality of municipalities across the country didn’t deteriorate yesterday, Bianco says.
Instead, Moody’s warning is a piece with other rating company success stories. Enron Corp. and WorldCom still carried investment-grade ratings three days before they collapsed.
Not to worry. Barney Frank, Democratic chairman of the House financial services committee, will hold a hearing next month to explore the unfair treatment, which could result in higher borrowing costs to municipalities. That sounds almost like a threat.
Last month, Frank’s colleague on the committee, Paul Kanjorski, played the legislative card at a hearing of the capital markets sub-committee he chairs. Kanjorski told Financial Accounting Standards Board (FASB) chairman Robert Herz that if regulators didn’t ease mark-to-market accounting rules, then Congress will have no other option than to act itself.
FASB changed the rules. At least Frank can say he’s following precedent.
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