Saturday, February 7, 2009

U.S. Weighs Fed Program to Loosen Lending

By Liz Rappaport and Jon Hilsenrath in the Wall Street Journal:

Hoping to jump-start the financial system, the Obama administration is considering turning to a new program run by the Federal Reserve that has been a challenge to launch and depends heavily on hedge funds.

The Term Asset-backed Securities Loan Facility, or TALF, was announced in November after investors stopped buying securities backed by consumer debt. Under the $200 billion program, the Fed will make loans to almost any U.S. firm that is willing to use the government financing to buy securities tied to credit-card, small-business, student and auto loans.

In essence, the government, which doesn't want to buy these securities itself, is lending money to professional investors so they can buy them. In some cases, the government itself is guaranteeing payment on the loans that back these securities.

The Fed on Friday announced terms of the loans it will make available to investors. As the Fed moves toward launching the program this month, Mr. Obama's economic team is exploring ways to expand it to help its financial-rescue efforts. Treasury Secretary Timothy Geithner is expected to announce his financial-rescue efforts in a speech Monday.

Some hedge funds, which often use borrowed money to boost returns, are lining up to get in on the Fed program, seeing a chance to make high double-digit-percentage returns with little downside using low-cost loans made on easy terms. Some officials inside the Fed are nervous about relying on unregulated hedge funds. But they see it as a trade-off in order to get capital to consumers.

"This is exactly what the financial system needs," said Andrew Feldstein, chief executive of Blue Mountain Capital Management LLC, a multibillion hedge fund that is gearing up to participate in the Fed program. The program, he said, "is like sending an ambulance through a traffic jam."

Officials have spent weeks trying to hash out details of how to make loans to private investors and how to safeguard the program. Fed lending, even its emergency programs, typically runs through banks. To get this program going, the Fed has had to consider questions it hasn't dealt with before, such as whether it should do business with offshore accounts of a U.S. hedge fund, which it has found a way to do.

Because the Fed is so eager to attract participants, it has limited restrictions on which firms can participate.

Broader philosophical issues could arise if the program is expanded. The White House has promised more transparency in how its funds are used. But lending to hedge funds may be problematic because their operations are opaque. Moreover, the program depends on many of the practices that helped to fell Wall Street firms in the first place, such as leverage, structured-debt investments and a dependence on credit ratings.

Depending on the different types of collateral, investors will get roughly $100 of lending for every $5 to $16 of cash they put up to invest. The rate investors will have to pay will be set at one percentage point over interest rates based on London interbank offered rates.

The loans the Fed makes to investors are nonrecourse, meaning investors can't lose any more than the money they put upfront on the security. If a hedge fund defaults to the Fed, its collateral is the securities themselves. There also are no margin calls, meaning the Fed can't demand additional payments of cash from borrowers if the underlying securities fall in value.

Investors see these as important inducements to the program. But a Treasury Department inspector general warned that the program was vulnerable to fraud by the private sector.

A Fed spokeswoman said the central bank is working closely with the Treasury to establish a strong compliance program for TALF.

The activities of hedge funds are another potential issue. Some investors have privately expressed worries that hedge funds could game the system to use cheap Fed financing to fund other trading positions that run counter to U.S. goals. A firm might, for instance, buy debt backed by car loans with Fed financing and use the cash flows from the investment to fund short positions on auto makers that pay off if they struggle.

Some of the largest names in the hedge-fund world have showed initial interest in the Fed-lending program.

Among funds that bankers and investors have spoken to about the TALF are Magnetar Capital LLC, a multibillion-dollar Evanston, Ill., fund, which made bets during the housing boom that paid off when mortgage defaults rose. Magnetar also helped to fuel issuance of complex debt instruments known as collateralized debt obligations. Magnetar said it isn't in a position to make a decision given the information available about the program.

Bankers and investors said they have spoken to several funds that may be intrigued by the program, including Citadel Investment Group LLC, and D.E. Shaw & Co., among many others. D.E. Shaw declined to comment.

Traditional money managers, including Pacific Investment Management Co., BlackRock Inc. and Prudential Financial Inc. also have been gearing up for the program. BlackRock said it is interested in the program. Pimco didn't respond to a request for comment.

Another concern is whether credit ratings, which the Fed will depend upon to make decisions about what investments to support, are reliable. Credit-ratings firms have come under fire for missing warning signs on various debt instruments before the crisis hit.

"The rating agencies have lost a tremendous amount of credibility," said Jonathan Lieberman, of Angelo Gordon & Co., a distressed-debt fund that is considering whether to participate. He said his firm doesn't rely on credit ratings.

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