Doubts Raised About Government Plan to Boost Consumer Lending

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Jonathan Ernst / Reuters

U.S. Treasury Secretary Timothy Geithner

Get ready for the Toxic Asset Loan Factory. TALF, the U.S. government's effort to boost consumer lending, finally launches next week. The program — officially the Term Asset-Backed-Securities Loan Facility — is targeted at restarting the market banks use to fund credit-card, auto and other consumer loans. But some worry TALF could create even more risky bonds that our nation's wobbly financial firms don't want and can't sell — a perverse unintended consequence of a well-intended program.

Critics contend the plan does too much to stimulate demand for top-rated securities and not enough to draw in buyers for riskier bonds that have always been harder for banks to sell. "We need to get credit buyers back into the market," says John McElravey, director of asset-backed research at Wachovia Capital Markets. "But TALF only addresses part of the problem." (See the top 10 financial-crisis buzzwords.)

At the heart of the program — and the biggest cause of complaints — is an effort to reignite the process by which most banks get the money they use to make consumer loans. To fund credit-card, auto and education lending, banks typically gather up loans they already have made and pass them off to an investment bank. Wall Street firms then package these into bonds that pay interest based on borrowers' loan payments. Completing the money-recycling loop, investors buy the bonds, and investment banks pass most of that money, minus a fee, back to the lenders. The lenders can then use that money to make new loans. The process is called securitization, and for much of the past few decades it has worked wonders to fuel our ever growing consumer economy.

But sometime last year, the mechanism broke down. Investors backed away from all types of consumer credit after getting burned in the mortgage market. Less than $200 billion in asset-backed loans was securitized in 2008, down from an annual rate of a trillion dollars at the height of the credit boom. This year there has been only a few billion dollars in securitized-debt deals. (See the worst business deals of 2008.)

The government hopes to revive securitizations by luring buyers back into the market. To do so, the TALF program offers cheap loans to investors who want to buy bonds backed by consumer loans. Even better, some of the TALF loans won't have to be paid back. If the bonds pay as expected, investors will have to repay the government loans with interest. But if the bonds go bust, investors are off the hook, after losing the small down payment they made on the original loan. To limit taxpayer losses, the government is going to make loans only against bonds rated AAA, the highest rank.

And that's what causes the problem. Every securitization deal creates some AAA-rated bonds and some lower-quality debts. In a typical credit-card securitization, as much as 15% of the bonds created will have ratings lower than AAA. And the government plan does nothing to help banks get those riskier bonds off their books. Worse, TALF might actually discourage investors who would normally be interested in these higher-yielding bonds from buying them.

That's because TALF significantly sweetens the returns that can be earned from buying the AAA-rated bonds. Take a typical auto-loan bond. A top-rated auto ABS bond pays a dividend these days of about 3.5%, or a return of $3.5 million on an investment of $100 million, as long as the bond doesn't go into default. That's actually not a terrible yield right now. Just ask anyone with a savings account. (See 5 reasons for economic optimism.)

Under TALF, though, an investor has to make a down payment of just $8 million to get a loan from the government to buy $100 million in auto bonds. The loan costs 1.5% a year, or $1.5 million on $100 million, which lowers the investor's take-home return to $2 million. But remember, the investor had to put up just $8 million. That means the annual return on the much smaller up-front investment zooms to a fat 25%. Lower-rated auto loans can pay as much as 30%, but they have a much higher rate of default — and potential buyers will not get access to those low-cost government loans. Plus, these days, few investors are willing to take more risk than they have to. With no one to sell the lower-quality stuff to, banks may be stuck holding it. The good news is that so far, credit-card and auto loans have not had the same high rates of default as home loans. But as the economic downturn worsens, analysts say it will become harder and harder for consumers to make even the minimum payments on credit-card debts that have racked up over years of overspending.

In the end, TALF may beget Son of TALF to deal with the sins of the father. And that will mean more taxpayer dollars.

Read "How to Know When the Economy Is Turning Up."

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