• A consumer takes out a loan to buy a car (for example)
• That debt is packaged with other debt into a high-grade structure (ABS, MBS, etc)
• An investor buys the asset with a non-recourse loan from the Fed, at a haircut of roughly 10% (depending on the type and term of the asset)
• The investor pays around LIBOR + 1% for the loan
• If the asset defaults, the investor can return it to the Fed in lieu of the loan
If an ABS trades at 150 over LIBOR for example, and the haircut offered is 10%, an investor could buy the ABS, use a TALF loan (at roughly LIBOR + 100) to back 90% of it, and earn roughly 50bps with only 10% exposure, equating to a 5% return on investment. By offering both leverage finance and a cap on losses, the TALF program allows investors to leverage eligible assets and earn high returns on AAA ABS without risking more capital than that invested.
TALF 1.0 was a fairly clear success after the global financial crisis. Economically, a functioning ABS market is critical for allowing credit to be extended for small loans, so supporting the ABS market helped the wider economy recover. Moreover, all loans were repaid in full either at maturity or earlier, meaning the TALF program supported the economy without a direct cost (as opposed to, say, stimulus spending). Investors also benefitted, often with double-digit IRRs.
It would be optimistic to expect returns to be as strong this time round. AAA spreads have already tightened significantly since the end of March, which is exactly the effect the TALF program was intended to achieve. Nonetheless, at the time of writing spreads were still materially higher than the cost of the loan, meaning investors can take a protected holding in a good quality credit and gear it.
These investments will not be risk-free, and the gearing will amplify any mark-to-market or default losses. Nonetheless, they can offer attractive returns with downside protection even in the absence of any spread tightening. For example a 20 basis point tightening, with duration 3 and 6x leverage, would lead to an additional gain of c4%. While the reverse would be true for a spread widening, the protection implicit in the TALF program, coupled with the relatively short horizon of most of the assets, should allow most investors some ability to “ride out” any rougher patches.
Investments using the TALF structure will not be appropriate for all investors - for example, they will be somewhat illiquid. Markets are also moving fast, which means the opportunity could become meaningfully less (or more) attractive very quickly.
But that is no reason to rush decisions. As ever, there are plenty of good investments available, and investors should typically stay more focused on avoiding inappropriate investments, rather than looking to seize every opportunity.
Nonetheless, this could be an opportunity worth considering for a reasonably broad range of investors.
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