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The Department of Bad Economic Ideas

By Philip Klein on 3.6.09 @ 10:51AM

It's getting to be a pretty big department, I know, but this latest idea being considered, according to the Washington Post, is especially mind-boggling. Under the proposal, the government would potentially put up close to $1 trillion to subsidize the losses of wealthy hedge fund and private equity investors in an effort to entice them into lending more money.

Today, the plan, dubbed Term Asset-Backed Securities Loan Facility (TARF):

Here's how a typical TALF deal would work: A hedge fund uses $1 million of its own money and gets a $9 million loan from the Fed, payable after three years, to buy a $10 million asset-backed security, which finances consumer loans. Hoping that the market for these assets recovers, the hedge fund would hold the asset for three years.

If the security rises in value to $11 million, the investor would keep the profit, essentially doubling the initial investment. The government, meanwhile, would consider the deal a success because consumer lending was spurred.

If the value fell below $9 million, the hedge fund would lose its down payment but nothing more. The Treasury, using bailout funds approved by Congress, would cover the next set of losses, with the Fed ultimately on the hook for anything more.

This is utterly insane. The reason we're in this mess in the first place is that banks took risky bets using high leverage within an easy money environment, and those are exactly the conditions that this plan would recreate, and then some. What is happening in credit markets right now is a perfectly natural reaction to the recklessness of the earlier part of this decade. Left on its own, eventually investments wll begin to look attractive to those who have cash, and things will recover. Nobody wants to hear it. Nobody wants to accept it. And our president has declared this point of view out of bounds. But simply doing nothing is a far better alternative to this type of central engineering that will only perpetuate the disease. It's like if, following a heart attack, your cardiologist told you to eat two apple smoked bacon double cheeseburgers before bed every night.

View all comments (7) | Leave a comment

ncatty| 3.6.09 @ 12:05PM

The losses have to be realized before the market settles. The losers have to be identified before any investor will get back in. There is nothing wrong with bankruptcy, it is orderly and constititutional.

adagioforstrings| 3.6.09 @ 1:06PM

One minor edit, I would change your acronym to the Department of Economic Bad Tactics (DEBT).

Jeff S.| 3.6.09 @ 1:58PM

I'm beginning to lose track of all the ridiculously bad government programs started just to "remedy" the economic crisis.

CH| 3.6.09 @ 2:15PM

After we eat all of those bacon cheeseburgers we can count on ObamaCare to fix our resultant heart attacks.

AustinG| 3.6.09 @ 3:23PM

More assett backed securities? I could have sworn something went wrong with those not long ago. If loans are good loans then why do you need to securitize them?

jrsm| 3.8.09 @ 1:49PM

First, you idiots show you have no understanding of economics and definitely not securitization. Let's start w/ the basics, the economy is in a deep slide and we will see our worst post-war recession. The problem is whether it becomes a full blown depression (although not nearly as bad as the great one) or simply a recession. While a soft recession might not be that bad (force consumers to unwind and gain sound footing) at this time that scenario is out the door. Therefore, if we don't want to repeat the great one our government has to do something, but to stimulate the economy as well as gain confidence so it doesn't become a self fulfilling prophecy. Now, looking at econ 101, we have two major policy tools: Fiscal and Monetary policy. Being a conservative I agree w/ most of you that fiscal policy most likely won't work (except for the idiots who want permanently lower taxes but doesn't realize that's impossible due to our national debt). Let's look out Monetary policy. Normally we think of this as Uncle Ben dropping the federal funds target rate. Normally this is the extent, but we've already dropped this to zero. Now if I was a follower of ex-economist/now propagandist Krugman I'd think I have no other options (liquidity trap). In reality, just because a nominal measure (that we've only paid attention to since the 1980s) is zero, doesn't mean we can't go back to the old money supply. Going back to 101 (or 102 in my case) we have the formula MV=PY, where M is money supply, V is velocity of money, P is the price level (think inflation) and Y is real gdp. We know that the velocity of money is down (banks reluctant to loan, reserves shot, etc....), so if we want to stabilize the right hand side of the equation (all at once class), we must raise M, the money supply.
Now, assuming we want to help the economy, how do we raise M. We have a number of options, including lowering reserve requirements, making direct loans, etc…. many of them resembling uncle Ben in a helicopter tossing Ben Franklins out the window. This brings us to TALF and the ABS market. First, the ABS market that relates to TALF is call nonmortgage ABS. These include credit cards, student loans, equipment, auto loans and leases, dealer floorplans, trade receivables, expected franchise / royalty / litigation fees, etc….. While some could be seen an extension of the excessive mortgage lending (mainly credit cards), others such as heavy equipment financing (think John Deere) are merely secured (aka more efficient) sources of lending for fundamentally sound companies that are trying their best to remain profitable and in the process continue to hire American workers. Most of these transactions are low duration floaters priced as a spread off of some benchmark (i.e. Libor + 20 bps). With the collapse of leverage, headline risk, etc… we have seen the market for these securities almost completely dry up. Take a Prime AAA credit card ABS for instance. Previously these securities might have yielded LIBOR + 10 bps. Well, since October, there has not been any new issuances (or only one or two) and these rates have spiked to as high at LIBOR + 600 bps. Note, since these are not new issuances, the underlying price paid by the company remains at L+10, but the market value drops such that the yield to maturity reflects this new price. Long story short, the market is dead.
Since the ABS market is vital for many companies, the government via TALF is essentially acting as a direct lender. This will reduce spreads as well as allow companies to obtain financing. Now, let’s look at TALF particulars. First off, TALF loans will only be available for newly originated ABS (since the start of this year). As a result, new issues will carry a market spread and trade at par. So Philip, there won’t be any capital gains unless spreads come in further (which should be a welcome sign). Second, they are only going to finance AAA ABS issuances. Let’s see how this program works. Bank of America (BACC) issues a new $100 mm AAA credit card issuance at 200 bps. The new fed program has a 6% haircut, so Fund Manager (“Manager”) will buy the security for 100, will borrow 94 dollars from the govt and retain the first 6 dollars of risk. They will receive a spread of $2 (2%*100), will pay $0.94 to the government ($94* 1% fee) and net $1.06 ($2-$0.94) for a ROE of 17% (1.06/6). Not a bad deal for the investor, and in fact spreads should come in even further as others compete for the business. Even more importantly, if the pool of ABS investors was only 100 before, it would now be 100/.06=1,667.
Ok, not bad for the investor, but the government is making little and taking all the risk. Well yes, but let’s look at how risky the transaction is. First, let’s look at the BACC issue. The AAA will have a required subordination of 18.8679%, meaning that either other investors or the company are liable for the first 18.8% of losses. Is this sufficient. Well, in December 2008, gross charge-offs were at 8.70%. This means losses are covered 2.17x (18.8/8.7). In addition, there was one month excess spread (interest rate earned by the company – funding costs – losses) of 5.64%, meaning we could cover losses 1.64x with cash ((8.7+5.64)/8.7). Using our back of the envelope analysis we have a loss coverage of 2.17+1.64=3.81, i.e. losses could increase to >33% losses, not impossible but rather large. Note, this amount only represents the first dollar of losses. Since the Manager is on the hook for the 6% haircut, losses would need to approach 40%. Not impossible, but extremely draconian. Note this is a rather simplistic analysis, ignoring payment rates might slow and interest rates might come in (making coverage worse), but also ignoring a number of other beneficial assumptions (purchase rates, payment allocations, etc…).
Will some hedge funds get a nice deal. Yes, but so will insurance companies, pension plans and commercial banks. Would it be more efficient for the government to deal directly w/ the individual obligors, it could be but maybe not. Is this the best idea in the world, probably not, but that doesn’t mean it’s a bad idea.
Also, I realize a lot of mortgage ABS got us into a lot of trouble. This is true, but it's also because the analysis of mortgage abs had two clear faults. First, they assumed that prices will always go up, and two for mortgage related cdo's, they assumed very little correlation not the idea that in a crash it converges to 1. Nonmortgage ABS aren't without their faults, but they're based off a lot more fundamentally sound assumptions.