Government-Sponsored Recovery Programs:
A Compelling Opportunity for Investors?

The severe shocks that permeated the global economy and capital markets throughout the last 18 months have generated an unprecedented wave of policy actions by governments and central banks around the world.

In the United States, the current global financial crisis has compelled the Federal Reserve to slash lending rates to nearly zero amidst record fiscal stimulus being injected by the Federal government. The Fed has also launched a myriad of non-traditional, government-sponsored programs aimed at softening the landing of the worst recession in decades and remedying the ills associated with years of unrestrained consumer and business related overleveraging.

The most recent government program to make media headlines was the Car Allowance Rebate System (CARS), popularly referred to as “Cash for Clunkers.” The terms, conditions, and possible benefits to consumers associated with the CARS program were rather simple and widely understood. For astute investors, there are other government-sponsored programs with more esoteric guidelines which may be worth some consideration. The size and scope of these programs also dwarf that of the popular CARS program. The $3 billion CARS government outlay is a drop in the bucket compared to the $700 billion commitment made to the Troubled Asset Relief Program (TARP) passed in 2008 and the over $200 billion commitments to the Term Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP).

While the CARS program’s narrow aim was to boost consumer spending, specifically automobile sales, the TALF and PPIP programs aim to stimulate lending by increasing the flow of consumer credit and by cleansing bank balance sheets of their “toxic assets.” Many economists believe that these broader goals must be achieved before the U.S. economy can recover and experience any substantial real GDP growth.

The TALF program currently provides financing to stimulate investor demand for asset-backed securities (ABS). The Fed finances the majority (between 85 and 95 percent) of the investor purchases of ABS, which represent newly issued triple-A securitizations(1) of collateralized pools of student loans, auto loans, credit card receivables, and small business loans. By incentivizing investor participation in the consumer credit markets, the Fed anticipates that increased demand will drive down spreads and increase consumer and business related lending activity. The TALF program recently extended its duration and modified its reach to include commercial mortgage-backed securities (CMBS), which could potentially extend the capacity of TALF to $1 trillion. The government’s efforts may be starting to bear fruit as ABS and CMBS issuance has rebounded strongly and credit spreads have begun to narrow.

The PPIP is predicated on a belief that once banks rid their balance sheets of illiquid securities, they will have the confidence to increase their lending activity. Using capital partially funded through TARP and partially funded by private investors, the Treasury has approved nine asset managers to create Public-Private Investment Funds (PPIFs). PPIFs have some of the same core characteristics of a TALF fund (government co-investment, favorable financing terms, attractive yields), with a few important variations.

The major distinction between the TALF funds and the PPIFs is the origination of the underlying securities. While TALF restricts collateralization to newly issued securitizations, PPIFs will make investments in deeply discounted legacy assets(2). Due to this difference in origination, the risk and reward profiles of each program manifests itsself very differently. The PPIFs’ universe of eligible securities is far larger than the TALF program, not being restricted by 2009 origination and initial credit rating. This allows PPIFs to purchase deeply discounted residential mortgage backed securities (RMBS) and lower rated CMBS with the opportunity for greater capital appreciation, along with a favorable yield from the underlying securities’ current income component. The PPIFs may carry up to one times leverage, compared to the five to twenty times implemented by TALF funds. Since the TALF funds acquire triple-A rated ABS at a price close to, or at par, there is less opportunity for capital appreciation and more dependence on higher-leveraged income as the source of return. Further, due to the nature of their underlying investments and financing terms, the TALF funds will generally have a three-year lockup for investor principal compared to the eight to ten year lockup period for the PPIFs.

Market risk associated with the asset-backed sector is directly related to macro economic conditions and drivers such as unemployment, which has risen to levels perilously close to double digits in recent weeks. Possible future political pressures and the government’s ability to make retrospective changes to the terms associated with these programs should also be considered.

The TALF and PPIP may offer appealing options for investors seeking an opportunity to participate in the currently dislocated markets. The benefits of these programs reside in the total return of eligible asset-backed securities and the highly attractive non-recourse financing terms provided by the Federal Reserve and the Treasury. The government’s due diligence and monitoring of the selected managers provides a level of comfort and oversight. Some of the unique risks associated with these instruments should be further mitigated through the selection of asset managers possessing deep fundamental and qualitative resources and skills in the asset-backed and credit markets. Should the economy and credit markets continue to stabilize as they have in recent months, the TALF and PPIP programs may offer investors a very compelling credit related investment opportunity.

(1) Rated triple-A by at least two agencies
(2) Securities issued prior to the enactment of the government program