In the fall of 2008, investors stopped participating in securitization markets. They fled not only the residential mortgage-backed securities that triggered the financial crisis, but also consumer and business asset-backed securities (ABS), which had a long track record of strong performance, and commercial mortgage-backed securities (CMBS).
The rapid disintermediation of money market funds following the collapse of Lehman Brothers had a dramatic impact on the investor base for structured credit, which included short-term funding from money funds through repurchase agreements and asset-backed commercial paper (ABCP) issuance. With no buyers and plenty of distressed sellers, the price of structured credit bonds quickly incorporated large liquidity premiums, which significantly increased the cost of new issues and, consequently, the cost of originating new loans. The unprecedented widening of structured credit spreads rendered new issuance uneconomical, and the shutdown in term funding markets for issuers contributed to a contraction in credit that threatened to exacerbate the downturn in the economy.
Programs such as the U.S. Treasury's guarantee of money funds and the Federal Reserve's Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) supported the orderly liquidation of prime money market fund positions. However, it was the Term Asset-Backed Securities Loan Facility (TALF) and Commercial Paper Funding Facility (CPFF) that helped stabilize funding markets for issuers. TALF extended term loans, collateralized by the securities, to buyers of certain high-quality asset-backed securities and commercial mortgage-backed securities.
Without support by the public sector, it could have taken considerable time for a market-clearing price of leverage to reemerge, and that likely would have initially occurred only at financing rates and other terms that would have made funding costs prohibitive for well-underwritten structured credit. TALF endeavored to fill the balance sheet vacuum left in the wake of the withdrawal of levered ABS investors and to short-circuit the seemingly endless cycle of ABS spread-widening, by providing term asset-backed funding otherwise unavailable to investors. By reopening the new-issue ABS market, the regular flow of assets from loan originators to loan warehouses and to new-issue ABS and finally ABS investors would be restored, ultimately supporting the provision of credit to consumers and small businesses.
An important liquidity effect of the shutdown of securitization markets was the disappearance of price observations. In the absence of benchmark securitization transactions and secondary-market trading, lenders had poor information about their cost of funding. By promoting the new issue and trading of structured credit, TALF aimed to reduce uncertainty to issuers about their funding costs, making it more attractive to originate new loans.
TALF loans could be secured by certain newly issued ABS and CMBS as well as by certain previously issued, or "legacy," CMBS. The legacy CMBS program was intended to support new-issue CMBS by facilitating trading and price discovery, while also reducing liquidity premiums. Secondary-market spreads constitute hurdle rates for new issuance, since potential investors have the choice of buying bonds in the secondary market rather than the new-issue market. These spreads were wide enough in late 2008 to make ultimate loan rates uneconomical. Even after accounting for investors' distaste for the low underwriting standards associated with late-vintage CMBS deals, secondary-market spreads were an impediment to making the economics of new issuance work. To the extent that the market was expressing aversion to legacy CMBS assets as opposed to the CMBS asset class as a whole, the legacy program could address this by funding leveraged investors' purchases of even the safest …