Housing Plan and Cramdown on TALF

Yesterday, Federal Reserve Chairman Ben Bernanke outlined more details of the government’s long-promised “TALF” (Term Asset-backed securities Loan Facility) program designed to resuscitate the securitization market.

It is impossible to overstate how important this is. As the chart shows, the majority of credit in our economy is provided through securitizations. Mortgages, credit cards, auto and student loans, among other types of credit are all provided through securitizations. Since the onset of the financial crisis, the securitization market has shrunk to about zero. Even if all the banks magically become healthy and start full lending again, there will still be a giant hole in the consumer credit market. A recent study from McKinsey noted:

“…banks may fail to meet approximately $2 trillion of demand for credit origination globally over the next three years in the absence of well-functioning securitization markets.”

Unfortunately, TALF already may be doomed by another Administration priority; the housing rescue plan. Much has already been said of the moral hazard of the plan; the government’s unprecedented move to directly pay a portion of certain people’s mortgages.

The bigger danger is that by forcing a change in the terms of certain mortgages, the plan will further destabilize the securitization market. Every one of the mortgages that would be “modified” is tucked away in one of those “toxic assets” currently sucking a hole in financial balance sheets. Because the borrowers will be paying some dollar amount less than they otherwise would have, those assets would be worth less.

Worse, the plan would allow judges to rewrite mortgage terms during a bankruptcy proceeding, the so-called “cramdown” provision. House Democrats plan a vote on this provision as soon as tomorrow. If the market for mortgage-backed securities ever returns, how would you price for this? How would you model which mortgages might, at some point in the future, go through bankruptcy or how some individual judge might decide to modify the loan? This provision would be a ticking-time bomb, sitting in the middle of the security. Who would want to touch that?

Plus, it raises the prospect of government mucking around in other loan products. If government decides to modify mortgages, why not auto, student or credit card backed securities? In the current political climate, who wants to take that risk? Even if TALF “worked” and new credit-backed securities were issued, would anyone want to buy them?

The Obama housing plan may be a cure that treats the disease, but kills the patient.