Non-recourse loans = you get shafted

Back in early February, I wrote a post (“More on the Geithner Put”) explaining why non-recourse loans are equivalent to a subsidy to private equity and the banking system.  (Although obvious to professionals, this might not be so obvious to laymen.)

During his interview with CNBC last week, Buffett spoke glowingly of a paper by the current President of the New York Fed, William Dudley:

BUFFETT: The trouble is that a lot of people don’t believe in the system. It needs to be clarified. Actually, the head of the New York Fed, Mr. (William) Dudley, on Friday, you can go to their Web site and read it, he describes it perfectly. But nobody’s going to listen to Mr. Dudley very much throughout the United States. The people coming to Furniture Mart today don’t know who he is and they’re not going to go to his Web site. You really need–you need the president of the United States enunciating it.

Thanks for the link, CNBC; I did go to their web site and read it.  And this is what I found.

TALF Version 2.0 will follow. This will broaden the TALF into new asset classes such as Commercial Mortgage Backed Securities. Development of this phase is still in its early days. But it anticipated that the size and scope of TALF will expand sharply in the months ahead.

So how will the TALF restart securitization activity and provide balance sheet capacity to the private sector? By providing leverage and 3-year term, non-recourse financing to investors, the TALF should increase the demand for AAA-rated securitizations. Yields of LIBOR + 400 basis points may not be sufficiently attractive on an unleveraged basis, but at 10 times leverage the returns become very attractive.

The non-recourse nature of the loans is also important. If the price of the security falls considerably, the investor just loses an amount equal to size of the haircut. For example, if the haircut was 10% and the value of the security was $100, the most the investor could lose would be $10. Thus, the facility eliminates much of the downside risk that would arise from a very deep recession or the fire sales of assets that could cause prices to drop sharply temporarily.

This is a very exciting program because it provides balance sheet capacity to risk capital that cannot currently get leverage.

Of course, you cannot “eliminate” risk via financial machinations; you can only transfer it.  The question we should all be asking is from whom and to whom the risk is being transferred.

Mr. Dudley considers this a “very exciting program” because it places the bulk of the credit risk on the taxpayer and the central bank.  But there is no such thing as a free lunch; there are only different ways of deciding who pays for it.  With the Treasury and Fed making non-recourse loans to private equity, you and I are going to pay for Goldman Sachs’s lunch.

Meanwhile, the TALF is being re-worked to encourage more participation from the major financial firms:

KEY CHANGES FROM THE TALF RULES PREVIOUSLY ANNOUNCED
The updated terms and conditions and FAQs issued on March 3 modify a number of the TALF program rules announced in February 2009 and provide more detailed terms. Key changes from the rules announced in February are described below.

Elimination of Executive Compensation Restrictions
The February 2009 version of the TALF terms and conditions and FAQs required the ABS sponsors (but not the borrowers receiving financing under the TALF) to comply with the executive compensation restrictions established under the Emergency Economic Stabilization Act of 2008 (EESA), as amended by the American Recovery and Reinvestment Act of 2009. The updated TALF program rules do not require sponsors, underwriters or borrowers to comply with these EESA restrictions by virtue of their participation in the TALF.

Clarification of Borrowers’ Loan Repayment Obligations
The updated TALF program rules clarify the non-recourse nature of the loans by stating that in lieu of repaying the amounts outstanding on a TALF loan at the three-year maturity (or at any earlier time), the borrower may surrender the ABS collateral in full satisfaction of the loan.

Reduction in Certain Interest Rates and Haircuts
The updated TALF program rules contain a reduction in the interest rates and certain collateral haircuts for ABS backed by student loans guaranteed by the Federal government and ABS backed by small business loans guaranteed by the SBA.

Also, Ben Bernanke is on 60 Minutes tonight.  This is highly unusual.  The Fed Chair does not blow his nose in public without a good reason.  Seriously, every statement he makes in public is part of his job.  If he is going on a program to speak to the average person, there must be something he wants us to do.  Or not to do.  He must be really worried…