The Fed Is Now A Hedge Fund

Actually, thanks to the TALF, it is the Federal Reserve Bank of New York (FRBNY) that is now a Hedge Fund.

You knew this was coming. It was telegraphed last year by Paulson, when he first started to mention “The Super SIV” (think a gigantic Enron). I have been writing about it for months. Geithner’s appointment guaranteed its enactment.

Today the details of The TALF were announced. I want to deconstruct TALF, because it will be the tool used to reflate the Financial System, with the last, epic round of massive leverage.

TALF – Term Asset-Backed Loan Facility
First, an “Asset Backed Security” is created when a bank takes a bunch of loans, pools them together and then turns the pool into a security - splitting it into shares and selling them at a specific price per share. Assets types include mortgages, student loans, auto loans, construction loans, commercial real estate loans, credit card debt, consumer debt …

Asset Backed Securities (ABS) had one glaring flaw – they were priced by the Rating Agencies (S&P, Moody’s) as if the underlying loans were of the highest credit quality, with minimal potential for future defaults. This allowed the banks to issue these loans at artificially low interest rates. It also allowed banks to make loans at artificially low interest rates, relative to the real risk of default by the borrower.

Remember what I told you last week, that banks are pricing this ABS at artificially high prices, so as to make themselves look solvent. But we know that the highest “Rated” stuff is trading at 32 cents on the dollar and the “Junk” stuff is trading at 6 cents.

Bring on the TALF!
The TALF is now under the management of the FRBNY (the bank Geithner used to run). It has been created in the following structure. The Fed will take $20 billion of TARP funds and loan them to the FRBNY. The FRNBY will leverage that money 10 to 1 and buy $200 billion in newly-created loans.

That’s right, the FRBNY is going to invent $180 billion via the Fed (+ $20 billion more via the US Taxpayer) to buy loans that the banks can’t sell, because the yields are too low (prices are too high) to attract any other buyers! We all know that if the banks priced the new ABS to sell at market, then it would be at rates so high, that they could not do any lending.

Remember, the Obama Administration wants to do another round of TARP (TARP II) for $750 billion. That would allow them to buy $7.5 Trillion of loans. They also have at least $200 billion of TARP I funds left. So you would expect to see the FRBNY end up with a pool of about $10 trillion in loans on the books…

The Goal of TALF
TALF is ultimately designed to transfer the junk loans from the balance sheets of banks to the balance sheet of the US Taxpayer.

How
Remember, TALF is only designed to buy newly issued ABS. So the first wave of purchases will be ABS created by refinanced mortgages.

Here is the game they are trying to play -
Bank A has $100 million in a Mortgage ABS
At origination, the average house value was $500k (2,000 mortgages in the pool)
The mortgage was a Neg Am loan, and is now worth $550k
The borrower financed 100% of the purchase price
The minimum payment was made each month
The house is now worth $300k.

The Fed has continued to allow the bank to price the ABS at $100 million
The ABS still holds a AAA rating
The Market knows that the Bank owns this stuff and is factoring the value of the ABS at $6 million

Under TALF, the homeowner will be allowed to refi their mortgage at 4.5% and stretch the term of the mortgage to 40 years. All appraisal requirements will be waived on these new mortgages. You paid $500k for a house and your mortgage is now $550k, but the house is only worth $300k? “No problemo” says Uncle Sam, we will refi the whole balance! No questions asked. Just sign here!

You now have the bank getting repaid $550k cash, on a loan that is about to recast, and put the homeowner into foreclosure. The bank should have to repo the property and sell it at auction for $250k. But the TALF is stepping in to put the Taxpayer on the hook for $550k.

This is a de facto government subsidy to the bank for $300k per mortgage, or $60 million on this $100 million ABS.

The FRBNY will try and buy all of the crap held by the US Banks, European Banks and Central Banks of places like China and Japan.

Why the Urgency?
The Reason this is going on right now, is because there is an enormous wave of Alt-A mortgages recasting in 2009 and 2010. The size of this mortgage recast dwarfs the size of the Sub-Prime default wave of 2007-2008.

The Fed needs to get this stuff out of the banks, credit unions, pension plans and insurance companies before the coming defaults make all of these institutions insolvent.

So I expect to see the Fed soon use the TALF to buy existing ABS loans off the balance sheets of banks at ridiculously high prices, relative to the real value of the paper held in each ABS (100 but worth 32 or 100 but worth 6).

Either way, the Taxpayer is going to get royally hosed.

What to Do?
If TALF works the way I think it will, then you should see an enormous rally in the stocks of the banks that survive the next few weeks.

This will be the greatest theft of taxpayer money in the history of mankind. But it will put a bottom in on the stock market and lead to a multi-year rally before the US Dollar and US Treasury Bond collapse.