New Policy Moves and the Term Asset-Backed Securities Loan Facility
At its recent meeting on March 18, the Federal Open Market Committee (FOMC) acknowledged that the economy is continuing to contract as “job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.”
Because current economic conditions have rendered the Fed’s traditional interest rate channel no longer viable for stimulating the economy, the FOMC has turned to the use of credit-easing to support to the real economy and the financial system. Credit-easing, as Chairman Bernanke has explained, means making “use of the asset side of the Federal Reserve’s balance sheet.” With credit-easing as its alternative to traditional monetary policy tools, instead of influencing interest rates, the Fed changes the mix of the financial assets it holds, stimulating specific troubled markets in the process.
In line with this new policy framework, the FOMC announced it would increase the size of the balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities and up to $100 billion of agency debt this year. These actions could bring the Fed’s total purchases of agency securities to $1.25 trillion this year and agency debt to $200 billion. (“Agency” refers to the government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.) Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.
The purchase of mortgage-backed securities is focused on reducing the spreads of rates on GSE debt and on GSE-guaranteed mortgages, which, in turn, should reduce the cost of credit for the purchase of homes and increase its availability. Given the magnitude of the Fed’s purchases, the FOMC’s actions should not only foster improved conditions in financial markets but also support the housing market—which is at the heart of the current recession. At the same time, purchases of long-term treasury notes should reduce long-term rates, helping financing long-term projects. At the day of the announcement the 10-year treasury notes fell dramatically while the Fannie Mae 10-year rate had a relatively minor impact.
In addition to the housing market, the Federal Reserve Board, in conjunction with the Treasury, is committed to supporting another specific credit market that has been under strain recently. The Term Asset-Backed Securities Loan Facility (TALF) is a credit-easing tool that aims to directly support the market for securitized assets. The TALF is part of a broader program announced last February by the Obama administration along with the Federal Reserve, the FDIC, and the Comptroller of the Currency that is intended to restore stability to the financial system more broadly.
The TALF is designed to 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. Over the past two decades, those credit markets have grown rapidly and become an important means by which financial institutions fund loans to businesses and consumers. Strong investor demand for securities structured for different risk appetites allowed banks and other financial institutions to sell consumer and business loans in the form of ABSs at relatively low yields. This in turn allowed lenders to increase the availability of credit and lower the rates at which they extended credit to consumers and businesses throughout the economy.
Since the beginning of the financial crisis, however, those ABS markets have been under strain. With the strain accelerating in the third quarter of 2008, the market came to a near-complete halt—the chart below shows the dramatic drop in the issuance of new consumer ABSs.
At the same time, interest rate spreads on AAA-rated tranches of ABSs rose to levels well outside the range of historical experience, reflecting unusually high risk premiums, and these subdued only in part after the first announcement of the TALF in November 2008.
Continued disruption of these markets could significantly limit the availability of credit, contributing to further weakening of U.S. economic activity. The renewed issuance of ABSs at more normal interest rate spreads, which the TALF is intended to foster, should help restore these markets and simulate economic activity.
Under the TALF, the Federal Reserve Bank of New York will provide nonrecourse funding to any eligible borrower owning eligible collateral. On a fixed day each month, borrowers will be able to request one or more three-year TALF loans. As the loan is nonrecourse, if the borrower does not repay the loan, the New York Fed will enforce its rights to the collateral.
Three requirements are intended to protect the Fed from the risk of losses. First, the ABS must have the highest investment-grade rating category from two or more major nationally recognized statistical rating organizations. This requirement should reduce the risk that the ABSs accepted will fall dramatically in value. Second, borrowers will pay a risk premium set to a margin above the Libor (usually 1 percent). Third, “haircuts” ranging from 5 percent to 15 percent will be figured into the loans. That is, the amount the TALF will extend a loan for can be only as high as the par or market value of the ABS minus the haircut. This requirement means that if the borrower defaults on the loan and the Fed seizes the collateral, the Fed loses nothing unless the value of the collateral has fallen more than the haircut.
TALF loans should have a maturity of less than three years, and the underlying loans must have been originated after fall 2007. The TALF is already operational: the initial TALF subscription was held Tuesday, March 17, 2009, with a loan settlement date of Wednesday, March 25, 2009. Going forward, monthly subscriptions are scheduled for the first Tuesday of every month.