As we watch the TALF’s travails, we fear for the success of a program with the financial
market riding on it. It isn’t that TALF itself is all that critical, although it surely can’t
hurt. Rather, it’s that the Treasury rescue plan can’t take any more hits without
undermining the fragile market confidence just beginning to creep out of hibernation.
And, if TALF tanks, it could doom the public-private investment facilities (PPIF) which
Treasury plans to launch as soon as – or whenever – TALF takes off.
What’s wrong with TALF? First, even thinking about TALF makes our head hurt – the
complexity of the program makes the average finance doctoral dissertation look like kid
stuff. Second, it relies on private actors – most notably primary dealers – to act as agents
of the federal government. This is like asking the kids on the corner to police the
neighborhood. It isn’t their job, they don’t know how to do it and they’ve got more than
a few conflicts of interest.
Indeed, these two problems feed on each other. The TALF is so complex that the
primary dealers have had to take on even greater roles. This of course compounds the
conflicts, making primary dealers ever more reluctant to act on behalf of the Fed without
a clear safe harbor for doing so – they know their customers. The bigger the safe harbor
the primary dealers craft, the less enthusiastic hedge funds and other potential TALF
borrowers become. None of them has the capital to take real risk, and the prospect of
collateral puts, reps and warrants and similar safeguards gave them the heaving willies.
This came even after the Fed tried to sweeten the pot and took out the executive-
compensation restrictions that, when announced last November, froze TALF in its tracks.
This would be problematic on its own – TALF is set to balloon to $1 trillion or even
more, taking on its next round of complex securitizations as early as next month. Worse,
though, is the PPIF precedent. That program will almost certainly prove at least as
complex as the TALF – in many ways, it’s a still more formidable challenge to construct a partnership than to design a collateralized credit facility. If PPIF goes poof, the new
Treasury Department will be under still more merciless criticism as markets founder.
Our advice: launch a few paper airplanes and see if they fly before trying to build a space
shuttle. We like financial engineering as well as the next Tech tool. But, when we were
at MIT, we learned that one tries simple models first, sees if they work and then builds on
them. For PPIF, the Treasury should look first to tried-and-true, relatively-simple
structures. Asset guarantees and reinsurance here come quickly to mind. The more
Treasury tries to execute on untested structures that are supposed at launch to handle
billions of dollars, the greater the risk it runs at a time when almost any risk is all too
quickly realized.