Munis next to be included in TALF?

Fed has initiated a new facility  – Term Asset-Backed Securities Loan Facility (TALF).

The Federal Reserve Board on Tuesday announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).

Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans.  The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS.  The U.S. Treasury Department–under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008–will provide $20 billion of credit protection to the FRBNY in connection with the TALF.

I had seen this support for student loans, auto loans, credit card loans etc coming. This along with Fed’s decision to purchase USD 600 bn of securities of GSE, makes it a USD 800 worth of bailout. And if we include USD 326 billion of Citi’s bailout, it is a trillion dollar support from US authorities in a week. I had pointed in my reportthat original TARP plan of USD 700 bn will not be enough at all. The auto companies might also be bailed out soon. All this makes the already huge US budget deficit bigger and the probability of it being a future disaster increases.

However, a look at the recent Minnepolis Fed research (read the entire report here) tells me another type of security is under trouble – Municipal Bonds (called popularly as Munis). Sec chief Cox had said Munis are facing severe stress is reinfoced in this study. Munis are under trouble We could see Munis being extended to TALF or a separate program to resurrect it.

The total outstading Munis in US is about USD 2.9 trillion, out of which 49% is insured. Maximum bonds are issued by California followed by New York and Texas. So, it is quite big.

What was the main problem?

In the investment world, municipal bonds are often described as plain vanilla, for their simplicity.

Over the past decade, however, financial markets have developed sophisticated variable-rate products that delivered cheap financing for municipal bond issuers. Thanks to recent volatility in financial markets, two of those products—so-called auction-rate securities (ARS) and variable-rate demand obligations (VRDO)—now have their own ice-cream name: rocky road.

Both types of bonds are floating-rate, tax-exempt bonds whose rates reset periodically (usually weekly or monthly, depending on the bond). This design allows the borrower to issue long-term debt at very attractive, short-term interest rates because the bond is repeatedly resold in secondary markets, giving investors high liquidity. In essence, these bonds were advertised as money market funds with better returns.

From virtually zero in the mid-1990s, both ARS and VRDO markets have grown considerably (see chart). In 2007, together they captured better than 20 percent of the municipal bond market, according to data from The Bond Buyer.

And then the problems started in Munis with liquidity crisis, downgrading of bond insurers etc leading to higher interest rates and no takers for the bonds. Read the report for details. Another case of financial innovation gone awry.

Now number of market participants hold these bonds and this has become quite illiquid as well. The states would need monies to finance their programs and the pressure is more to spend as crisis worsens. With dry markets either they pay higher rates or get no takers at all. First leads to higher costs and second leads to no resources. Both being uncomfortable situation for states. Hence, they could ask for help from Centre.

13 Responses to “Munis next to be included in TALF?”

  1. » Munis next to be included in TALF? « Mostly Economics Says:

    […] Thanks to recent volatility in financial markets, two of those products—so-called auction -rate securities (ARS) and variable-rate demand obligations (VRDO)—now have their own ice-cream name: rocky road. … More […]

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  3. what is the current fed interest rate | AMD.com Says:

    […] Munis next to be included in TALF? This design allows the borrower to issue long-term debt at very attractive, short-term interest rates because the bond is repeatedly resold in secondary markets, giving investors high liquidity. In essence, these bonds were advertised … […]

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  5. what is a macro | Apple.com Says:

    […] Munis next to be included in TALF? … Maximum bonds are issued by California followed by New York and Texas. So, it is quite big. What was the main problem? In the investment world, municipal bonds are often described as plain vanilla, for their simplicity. Over the past decade, however, financial markets have developed sophisticated … […]

  6. UK to support households directly « Mostly Economics Says:

    […] UK to support households directly By Amol Agrawal Last week, Fed took out a new program to support student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (The scheme was called TALF, my views on TALF are here). […]

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