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There are other credit enhancement techniques which securitzers have employed to improve the credit rating of ABS. Because individual AAA-rated loans are, by themselves, in the minority, in order to create AAA-rated ABS, a securitizer would bundle loans of different ratings and place those same loans into different investment classes, known as tranches. Although the individual loans that comprise the tranches remain disproportionately below AAA-rated, because of how tranches work, they will receive different credit ratings, some AAA-rated.
Without other credit enhancement techniques, tranches are rated differently because each one is paid sequentially, with interest and principal payments on the underlying loans first going to the senior most tranche and the last payments going to the most junior. Effectively, the tranches are, at least in part, rated differently based upon the order in which they receive payment from the underlying loans. In the event of default, the junior most tranche may receive less than their regular return because they are the last tranche to be paid. In order to compensate for the increased risk, the more junior the tranche is, the higher the yield on the investment. Employing this system, loans that individually had varying credit ratings were bundled and tranches were created that were then sold in the secondary market.
Under TALF, the Fed will only finance AAA-rated ABS. Investors are not given an incentive to purchase the riskier tranches. The result is that securitizers would have to keep the riskier tranches on their own balance sheet. And, given banks recent experience with this approach, it is unlikely that they will be eager to do so again. However, in the event a bank wishes to act as a securitizer, they will have no choice.
Nonetheless, despite these obstacles, TALF could succeed in restoring the secondary market for ABS. Although rating agencies have yet to demonstrate that they can accurately assess the credit risk of these instruments, changes in the economy or regulatory action could alter this perception. And in the secondary market, buyers' concerns of ABS resold by investors may be mollified by their ability to secure relevant data on the underlying assets. For home loans, which will be eligible for securitization in future versions of TARP, this data could include the average FICO score of the borrowers, location of the property, the loan-to-value ratio of the loan, and whether the property is occupied. And, arguably, in the event faith is restored in the AAA-rated ABS market, liquidity for lower rated ABS may follow suit.
Unlike economic risks that TALF may be exposed to, political risks may pose a greater threat because they are less susceptible to accurate forecasting. The furor over AIG bonuses demonstrates that the political attitudes of the administration and the legislature are subject to the vagaries of populist outrage. The proposed legislation to impose a tax of 90 percent on the retention bonuses received by AIG executives, currently before the Senate, calls the sanctity of private contracts into question. It demonstrates that the government may retroactively alter the terms of financing agreements between it and private companies. It is likely that these events may cause private investors to reexamine whether they want to participate in TALF. If they believe that these financing agreements could expose them to a similar pattern of attack, they may choose not to participate.
If TALF can reestablish liquidity for ABS in the secondary market, it is likely that investors, including hedge funds and private equity funds, could make a great deal of money. That could cause the public to question why a wealthy financial manager makes millions of dollars from the arrangement while the taxpayer gets very little. That may very well stir memories of excessive AIG compensation in a year or so. Ironically, the success of the secondary market may pose the greatest threat to its revitalization.
Finally, the nature of assistance and type of recipient make TARP and TALF wholly different programs. Under TARP, the government encouraged and even forced banks to accept financing because their financial position was so precarious it was threatening the stability of the entire market. Conversely, under TALF, the Fed and Treasury are seeking to persuade private investors to purchase assets from banks. Although these private investors were an integral part of the issuance of these instruments in the past, they are not seeking assistance from the government. Instead, they have been presented with an opportunity to invest in an uncertain market that the government hopes will revitalize consumer lending.
Many of the best traders and analysts on Wall St. have left their firms to avoid pay restrictions like the ones imposed on AIG executives. These traders have decamped to hedge funds and private equity firms. In their new jobs, they can take advantage of the government's programs to buy newly financed assets and, if the value of that paper improves along with the market's liquidity, the profits from the transactions could be stupendous. As the value of toxic assets comes full circle, many of the people who helped break the system can make huge sums while they help fix it.