To TALF or not to TALF

In February the Federal Reserve Bank of New York announced the terms of the Term Asset-Backed Securities Loan Facility (TALF), the government's plan to jump start the lending markets by providing loans to investors who purchase certain asset-backed securities. President Barack Obama's Troubled Asset Relief Program (TARP) is putting up $200 billion for the programme, and the New York Fed will loan $800 billion. The programme was launched on 3 March, and at press time the first funds from TALF were scheduled to be disbursed on 25 March.

This programme will be welcomed by private equity funds in possession of portfolio companies in the financial services industry. Companies that provide commercial mortgage-backed loans, auto loans, student loans, credit card loans, and small business loans would certainly benefit from the opportunity to get some of these loans off their books.

“We've seen interest in the programme from private equity shops and hedge funds that, because of the times, are getting involved in debt trading and other strategies that maybe a couple of years ago wouldn't have looked attractive”

But some intrepid private equity firms – among them The Blackstone Group, Cerberus Capital Management, and Fortress Investment Group – have indicated that they are interested in using TALF funds to invest in debt.

“The programme is structured in an extremely broad way so that any US person or entity can participate,” says David Huntington, counsel in Paul, Weiss, Rifkind, Wharton & Garrison's corporate group. “We've seen interest in the programme from private equity shops and hedge funds that, because of the times, are getting involved in debt trading and other strategies that maybe a couple of years ago wouldn't have looked attractive.”

But before rushing eagerly into the fray, there are a few things a private equity investor should know about the programme.

First of all, TALF loans will be fully secured by the most senior tranche in the ABS. This could pose difficulties for borrowers persuing traditional securitisation, Huntington says.

“The markets for all types of asset-backed securities are dried up, but it's not the AAA paper that is suffering the most, it's the lower rated tranches,” he says. “So to the extent that you build a traditional securitisation, and the sponsor puts in some equity, you've still got the question of who is going to buy the subordinate tranches? There's no TALF money for that.”

Second, all TALF loans will have a three-year tenure. There is a potential for maturity mismatch if the AAA tranches pledged as collateral for the TALF loans have a maturity exceeding three years, exposing the borrower to refinancing risk.

And finally, the New York Fed will apply haircuts that vary by the type and expected life of the pledged ABS, meaning anyone funding these loans will have to put up some equity. The exact amounts of these haircuts have been changed in the weeks following the initial release of the rules, but they range from between 5 percent and 16 percent.

Harvard Law School professor Lucien Bebchuk suggested in a recent interview in The Wall Street Journal that the current haircut mechanism may not be the most efficient system. He suggested that the government invite bids to determine what the highest haircut the market is willing to accept. Eight to 15 percent might be too low, he said. Of course it could also be too high to tempt a private equity investor.

“The proposed haircuts were a little larger than people originally expected,” Huntington says. “The success of the programme is ultimately going to boil down to the economics of it.”

But if one breakingviews.com analysis is right, savvy participants should be able to earn returns of 15 percent per year of more. The analysis cannily noted that the risks of great success and great failure could be equally deadly for participants:

“If they make a packet, they could be lambasted for profiteering at the taxpayers' expense,” writes the site's US editor Rob Cox. “But if their bets don't pay off, they could be raked over the coals for losing taxpayers billions.”