The New York times has a fascinating article on the Fed's new program. The Term Asset-Backed Securities Loan Facility or TALF is an attempt to jump-start lending in the economy. The reason for the credit crunch is not that traditional banks like Bank of America are not lending. The Fed has a fairly firm grip on the balls of the CEOs of these banks since all are on the verge of government takeover. If the Fed says lend, they say "How much?".
The trouble is that over the past few decades a new banking system has arisen. This so called "Shadow Banking System", a term coined by PIMCO's Paul McCully, is just the network set up to securitize credit instruments and move them off bank balance sheets and onto the balance sheets of hedge funds, insurance companies, pension funds and any other investors looking for fixed income type investments. Many but not all of these loans are made by commercial banks. There are also finance companies like AIG's American General Finance or GE's GE Capital. Hedge funds and investment banks were also involved in credit creation and securitization. Someone willing to start a small business could go directly to a hedge fund for capital rather that to Bank of America.
This shadow banking system has collapsed. More accurately, it still exists but has dramatically reduced the amount of credit that it is willing to extend. Insurance companies and pension funds are saying "thanks but no thanks" to those BBB rated tranches of securitized auto loans. They will stick with US Treasuries, thank you very much.
The Fed has concluded that growth cannot resume while this major source of lending has been shut off. So its solution is to try to get it going again by subsidizing it.
It works basically like this. From the New York Times.
"Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment."
So in essence, the Fed is creating a new system of unregulated or lightly regulated banks from the stock of hedge funds and private equity investors around the world. To a hedge fund, it might look like this. You borrow at 2% and buy assets yielding 12%. Maybe your loss rate on these would be 6% so your final yield is 6% with a Net Interest Margin of 4%. Now you get to leverage this by a factor of 10. Now you are making 40% return on invested capital before expenses and taxes. Expenses for running a large fund are small. A team of 20 hot-shot hedge fund guys might run a fund with $10B of capital taking on $100B in assets making $40B on profits per year. They might pay themselves 2% of assets and 20% of profits which is $2B/year + $8B = $10B/year leaving $30B/year in pretax profits for the investors which is a 30% return. The 20 hedge fund guys each make half a billion per year if it is divided equally. If something goes horribly wrong and these credit instruments result in massive losses, the investors lose all of their invested capital but are not on the hook for the losses. The Fed (or maybe the taxpayer) is on the hook for the losses. If the hedge fund makes their expected profit for say three years before the shit hits the fan, they still make $1.5B each and then need to look for new jobs.
Some would say that the cause of the crisis was too much borrowing, too much leverage and too much greed. The Fed's solution appears to be more borrowing, more leverage and more greed. Somehow, I don't think the American people are going to like that plan.
