Friday, June 5, 2009

The ratings shopping mall of TALF

Moody’s is complaining about being left out of the ratings game (and fees) because people are “rating shopping” when it comes to TALF. At least someone is shopping in this economy. A quote from Moody's:
“Those programs don’t differentiate on the quality of the rating. Rating shopping becomes a problem.”

But let's take a quick look at how TALF really works. Let’s say you are thinking about investing in a large portfolio of auto lease receivables (or as a lender you are considering originating this portfolio). People pay on their car lease, you make money. A few will default, so you take some principal losses. But all in all you expect to make money. Let’s say you expect to get an 8% return on the portfolio. That’s OK, but probably not good enough. You want to make closer to 12%. If you buy the portfolio with your money plus some borrowed money (create leverage), you may get to the 12% you want. But where can you get a mortgage on an auto lease portfolio? In the past you would create debt securities collateralized by your portfolio and sell them – and you've got your mortgage. There used to be tons of buyers who would issue commercial paper to finance such securities (but that's a story for another day.) In this environment however how do you sell a security like this?

That’s where TALF comes in. The government won’t lend you the money against your portfolio, but they will lend against the debt security that you created (in what's called a non-recourse loan). Let’s say on a $100 MM portfolio you create a $70 MM senior security. You then pledge it to the government to get a $63 MM loan. So now you put up $37 MM and borrow the rest to buy the portfolio. Not a bad deal. The taxpayer is supposedly protected because the lender will only lose money if the portfolio loses 37% of principal or more.

Other than being concerned about the government capping your pay (because you chose to participate in TALF and just happened to make money), you have one other issue. The $70 MM security you pledge must be rated AAA by two or more “major” nationally recognized statistical ratings organizations (NRSROs). Why would a rating agency give this security collateralized by auto leases a AAA rating? Because it has (in our example) $30 MM of loss cushion before the $70 MM security is impacted.

So you call your friendly neighborhood Moody’s analyst, and show her the senior security. A month later you get a call back with the answer: they can only give it a AA+. That’s a good rating, but it’s not good enough – you won’t be able to pledge the security to get your loan from the goverment. Your whole investment doesn’t work. So what are your options? One is to go to a couple of other rating agencies. If you get two of them to give you AAA, you are done. If not, you just don’t make the investment.

This is not a situation in which a company issues debt and has to get it rated in order to place it. Here the investor doesn’t have to do anything. If they can get the rating, they buy this portfolio, otherwise they move on to something else. The Fed has set it up this way, whether they meant it or not. No rating shopping, no TALF. So the government in effect has put the fate of the whole program in the hands of the rating agencies that were part of the reason TALF was created to begin with.

And now Moody’s complains that investors/borrowers are shopping for ratings. When you get a mortgage for your house, you (hopefully) check with a few banks to get the best deal. Shouldn't the investor? The rating agency model is still broken – to compete for fees an agency simply must be more aggressive.

Through TALF, the government is perpetuating the problem that got us into this mess to begin with – institutions purchasing trillions of debt based entirely on the agency rating. But this time it's the taxpayer who is the buyer.

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