Hedge funds will be allowed to borrow from the Federal Reserve for the first time under a landmark $200bn programme intended to support consumer credit.
The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions.
The asset-backed securities to be funded under the programme are pools of credit card receivables, automobile loans and student loans.
The idea is to increase the supply of these loans and reduce borrowing rates by ensuring that the companies that make the loans can sell them on to investors who have guaranteed access to low-cost funding from the Fed.
The TALF is a key plank of the unorthodox strategy set out by the Fed last week as it cut interest rates virtually to zero. Washington insiders expect the programme will be dramatically expanded next year with further capital support from Treasury once the Obama administration takes office.
A senior official in the outgoing Bush administration told the Financial Times it could also be broadened to include new commercial and residential mortgage-backed securities.
The Fed thinks risk premiums or “spreads” for consumer loans are much higher than would be justified by likely default rates, even assuming a nasty recession.
It attributes this to a lack of buying interest in the secondary market where the loans are sold on to investors. By making loans to these investors on attractive terms it aims to increase market liquidity.
Making the scheme open to all US companies is a radical departure for the Fed, which normally supports financial market liquidity indirectly by ensuring banks have adequate liquidity to make loans to other investors.
However, the liquidity the Fed is providing to banks is not flowing through to financial markets, because banks are balance-sheet constrained and risk-averse. So it is channelling funds directly to investors.
The scheme is not designed specifically for hedge funds and a wide range of financial institutions are likely to participate.
Nonetheless, Fed officials hope that hedge funds will be among those investors that take advantage of the low-cost finance to drive down spreads.
The loans will be secured only against the securities and not the borrower. However, the Fed will lend slightly less than the value of the securities pledged as collateral. The Treasury has committed $20bn to cover potential losses.
Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.
“Demand is there for leverage but not supply,” said Sylvan Chackman, head of global equity financing at Merrill Lynch.
In effect, the Fed will now take on the role of prime broker – the lead bank that lends to a hedge fund – for specific assets.
From Accrued Interest:
1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.
2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.
3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.
4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.
So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.
Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.
Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.