Credit: Fed help is on the way

December 5, 2008
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Now, it appears, it’s the people’s turn to be “rescued” by the federal government.

The Federal Reserve stepped up efforts to ease the strain on the nation’s credit markets with the creation of a new lending facility designed to pump liquidity into the small business finance market through a vehicle called the Term Asset-Backed Securities Loan Facility.

Under TALF, the federal government will buy up to $600 billion of debt issued or backed by Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Banks, all of which are government-sponsored enterprises. Additionally, the Fed will lend up to $200 billion in financing to investors that buy securities tied to student loans, car loans, credit card debt and small business loans.

According to the Fed, the actions will reduce the cost and increase the availability of credit, which in turn is expected to improve general conditions in the financial markets. However, by midweek last week, the nation was seeing only a slight easing in credit conditions.

Kirby Wallick, CFA, senior investment manager at Legacy Trust, said the government had two main purposes in the new $800 billion plan: The first was to drive down mortgage rates, and the second was to free-up liquidity in the consumer loan market.

The Fed can influence short-term interest rates and has done so by aggresively cutting the federal funds rate from 4.5 percent 12 months ago to 1 percent today. The banks followed suit, lowering the interest rates they charge their best customers. Subsequently, the prime rate dropped from 7.5 percent to 4 percent over that same 12-month period.

“While this has benefited variable rate home equity loans, it has not had the desired stimulus on the rest of the economy,” Wallick said. “In a sense, the Fed has had both feet on the accelerator, but the fianical transmission is broken and the economic car continues to sputter.”

Thirty-year fixed mortgage rates are traditionally tied very closely to the rate on 10-year Treasuries, but that didn’t prove true in the spring of this year when Treasury rates fell but mortgage rates did not, Wallick pointed out. He noted that over the past six months, the yield on the 10-year Treasury note declined roughly 33 percent to 2.73 percent, while 30-year mortgage rates declined only 2 percent to 5.83 percent over that six-month period.

“Since the announcement of the TALF, national mortgage rates have dropped to 5.1 percent,” Wallick observed. “This still brings their six-month decline to only 15 percent, but at least the TALF has initially moved them in the right direction. Lower mortgage rates coupled with lower home prices will eventually stabilize the housing market.”

The secondary market for asset-backed loans is the source of liquidity for consumer loans, car loans, student loans and small business loans. Wallick said the concern is that the secondary market will seize up just like the mortgage market did earlier this year. As consumers fall behind on car, appliance and other payments, investors will become less willing to buy those loans from their orginators, which in turn means the originators will have less capital to lend, so credit becomes less available to the consumer, he explained.

“While a good dose of deleveraging would be healthy, the economy still relies heavily on consumers continuing to spend. Improving the liquidity of the asset-backed market helps ensure that credit will continue to be available to help them do so,” Wallick said.

Under TALF, the Federal Reserve Bank of New York will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated asset backed securities backed by new and recently originated consumer and small business loans. A non-recourse loan is a loan secured by a borrower’s pledge of collateral. If the borrower defaults, the lender can seize the collateral. The bank will lend an amount equal to the market value of the asset-backed security —  minus a “haircut” — and the amount will be secured at all times by the asset-backed security.

John Koczara, CFA, a principal with AMBS Investment Counsel, noted that  Treasury’s recently introduced Troubled Assets Relief Program provides $20 billion in credit protection for the Federal Reserve Bank of New York to carry out that mission. He also noted that since the bank will be lending up to $200 million in non-recourse loans, some of that money will eventually be returned to taxpayers.

U.S. Small Business Administration Acting Administrator Sandy K. Baruah called the recent Fed action “a significant breakthrough” in the effort to unclog the secondary market and restore the flow of credit.

About $4 billion in securities backed by SBA-guaranteed loans are bought and sold in the secondary market each year, according to SBA. But the number of SBA loans made through the 7(a) program has dropped 30 percent this year from 2007, and lending has declined by more than 50 percent since Sept. 15 when the financial markets more or less shut down.

“SBA lending has dropped so far and so fast that small businesses have few places to turn right now for financing,” said Congresswoman Nydia M. Velazques, D-N.Y., chair of the House Small Business Committee. “Restoring SBA as a source of lending is absolutely critical for jumpstarting the economy.”

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