The Federal Reserve Bank of New York ("FRBNY") recently announced that certain commercial mortgage-backed securities ("CMBS") issued before 2009 would become eligible collateral under the Term Asset Backed Securities Loan Facility ("TALF"). The initial subscription deadline for CMBS minted in 2009 closed on June 16; however, no borrowings were requested for the purchase of CMBS.
The move to expand TALF to include CMBS is the latest in a series of changes expanding the availability of TALF loans to hedge funds and other eligible financial investors ("Eligible Borrowers") in an effort to subsidize the securitization market. While the revival of the CMBS market is a substantial goal of the TALF program, according to FRBNY President William C. Dudley, the TALF program will most likely need continued adjustments to ensure its success.
"Developing and implementing the TALF has been challenging." Dudley said in a June 4 speech. "As the program enters into a new phase with the financing of CMBS and legacy CMBS, we will encounter further hurdles that we will have to overcome, adjusting and modifying the program as needed in order to make it more effective."
TALF was organized by the Federal Reserve Board to stimulate the market for securities made up of loans for small businesses and households. Under the program, the FRBNY makes non-recourse loans to Eligible Borrowers who use the proceeds to invest in certain pre-approved asset-backed securities. TALF loans requested during the first two rounds of subscriptions totaled $4.7 billion and $1.7 billon, respectively, and all funds were related to eligible collateral in the auto or credit card sectors. The third round, however, which closed on May 5, 2009, netted nearly $10.6 billion and granted loans in the auto, credit card, student loan, small business and equipment sectors. The loan amount in the fourth round, which closed June 2, was even higher, with $11.5 billion in subscriptions, an increase of 145 percent from the first round.
While the TALF program began as a program to restart securitizations in small business loans, as well as auto, credit card and student borrowing, it was expanded at the beginning of May to include CMBS issued on or after January 1, 2009. The May 10 decision to extend funds to Eligible Borrowers buying CMBS issued before 2009 ("Legacy CMBS") marked a further push by the Federal Reserve Board to stimulate credit markets and spark trading in assets backed by pooled commercial mortgages. CMBS issued in 2009 became TALF-eligible collateral on June 16. Legacy CMBS will become eligible during the July subscription, for which a specific date has yet to be announced.
Much of the Legacy CMBS weighing down bank balance sheets was underwritten during the height of the recent real estate boom. The Federal Reserve Board has said it hopes including Legacy CMBS in TALF will promote price discovery and create liquidity in the CMBS market, freeing up bank balance sheets to underwrite new securitizations of CMBS and other assets. However, even though Legacy CMBS are eligible collateral for the TALF's July subscription, the FRBNY is still considering various program details and has reserved the right to make changes to TALF terms for Legacy CMBS.
One of the challenges the Federal Reserve faces, Dudley said, is to ensure that its efforts to protect itself from financial risk through updates of TALF's terms and conditions don't create legal risk such that Eligible Borrowers refrain from participating in the program. "One challenge is in striking a balance between sufficient protections against abuse of the program, on the one hand, and a degree of red tape and restrictions that could make the program unattractive to issuers and investors, on the other," Dudley explained. "To the extent that issuers and investors are unwilling to participate in TALF because of fears that their involvement might lead to unforeseen complications at a later date, this would lead to the unattractive outcome of underutilization and the achievement of only a portion of the potential benefits."
Another challenge faced by the TALF, Dudley said, is increasing the participation of mutual funds, pension funds and insurance companies, many of which are not permitted to use leverage. "We at the Fed are working through a number of highly complex issues to enable the creation of vehicles that will make it easier for a broader range of investors to have access to financing for ABS securities," he said.
Increasing the number of Eligible Borrowers should help increase subscription rates going forward, according to Dudley. Higher subscription rates should create more liquidity for eligible collateral which, Dudley said, the Federal Reserve Board hopes would ultimately lower yields for securitized debt.
TALF's updated terms and conditions as they pertain to Legacy CMBS include:
• To be eligible, the CMBS must be rated in the highest long-term investment grade category by at least two eligible rating agencies as of the TALF loan closing date.1Eligible rating agencies include Moody's Investors Services, Standard & Poor's and Fitch Ratings, as well as two newly approved firms, DBRS, Inc. and Realpoint LLC. Third-party guarantees and other synthetic credit enhancements used to obtain better ratings are not allowed. Securities that have been placed on review or watch for downgrade are not eligible.
• At issuance, the CMBS must not have been junior to other securities with claims on the same pool of loans.
• The CMBS must not be an interest-only or principal-only security. Each CMBS must bear interest at a pass-through rate that is fixed or based on the weighted average of the underlying fixed mortgage rates.
• Fannie Mae, Freddie Mac and Ginnie Mae securities are not eligible. The issuer of the CMBS must not be an agency or instrumentality of the United States or a government-sponsored enterprise.
• Each CMBS must be cleared through the Depository Trust Company.
• The assets underlying the CMBS must consist of fully-funded mortgage loans (not other CMBS, other securities or interest rate swaps, caps or other hedges). Participations or other ownership interests in qualifying mortgage loans are eligible assets if, following a loan default, such interest is senior to, or pari passu with, all other interests in the same mortgage loan with respect to payments of principal and interest.
• The security for each underlying mortgage loan must include a mortgage or similar instrument on a fee or leasehold interest in one or more income-generating commercial properties.
• As of the TALF loan subscription date, at least 95 percent of the properties, by loan principal balance, must be located in the United States or one of its territories.
• The FRBNY says that it is considering other requirements that will apply to Legacy CMBS.
• The FRBNY reserves the right to reject any CMBS as TALF loan collateral based on its own risk assessment and may limit the volume of TALF loans secured by Legacy CMBS. The FRBNY is considering whether to allocate TALF loans for Legacy CMBS via auction or other procedure. The FRBNY has stated that it will be particularly wary of CMBS with mortgage pools that have suffered large historical losses or delinquencies, include concentrations of loans that are delinquent, in special servicing or on servicer watch lists, include concentrations of subordinated mortgage loans, and CMBS with mortgage pools that are not well diversified with respect to loan size, geography, property type and sponsorship. Other requirements currently under review by the FRBNY include a requirement that TALF loans for Legacy CMBS be used to fund recent, arms-length secondary market transactions and the establishment of a process for validating the prices at which these transactions take place.
• Eligible Borrowers will be able to choose between a three-year or five-year maturity for their TALF loans secured by Legacy CMBS, which will bear interest at an annual fixed rate equal to 100 basis points over the three-year or five-year Libor swap rate, respectively.2
• The TALF loan amount for each Legacy CMBS will be the dollar purchase price of the CMBS less a haircut of 15 percent of par for mortgage pools with an average life of five years or less. For pools with average lives beyond five years, haircuts will increase by one percentage point of par for each additional year of average life beyond five years. No CMBS may have an average life beyond 10 years.
• Any principal payments made on the CMBS securing a TALF loan must be used immediately to reduce the principal owed on the TALF loan in proportion to the haircut. In addition, the difference between interest earned on the CMBS and interest paid on the TALF loan (the "Spread") will be distributed to the TALF borrower only until such distributions equal 25 percent per year of the haircut amount in the first three years of the TALF loan, 10 percent in the fourth year and 5 percent in the fifth year. The remainder of the Spread will be applied to pay TALF loan principal. For three-year TALF loans, distributions of Spread to the TALF borrower will be limited to 30 percent of the haircut amount per year, with the remainder applied to pay TALF loan principal. These limitations are consistent with those for five-year TALF loans secured by SBA Pool Certificates, SBA Development Company Participation Certificates and student loan ABS.
• TALF borrowers must agree to refrain from exercising any voting, consent or waiver rights under a CMBS without the consent of the FRBNY.
Perhaps the most important issue of which investors should be aware in considering the investment opportunities in CMBS (and other assets) that are presented by TALF is that the Federal Reserve Board is developing the program as the underlying policy issues the program is supposed to affect evolve. As a consequence, the terms and conditions of the TALF continue to be a moving target and the scope of the program has increased dramatically in the past several months. There is still significant legal uncertainty surrounding how TALF will be applied to the CMBS market and this is particularly true of how the FRBNY will evaluate eligible collateral. Moreover, given the techniques used to build CMBS during the last several years, the amount of Legacy CMBS eligible as collateral remains unclear.
Prospective TALF borrowers should expect further changes to the program. As long as TALF subscriptions remain relatively small and the overall securitization market anemic, changes to TALF's terms and conditions may become increasingly beneficial to both issuers and borrowers. 1 This represents a change from the original announcement of the Legacy CMBS program, at which time the stated requirement was that the Legacy CMBS must have originally been rated AAA or equivalent.
2The ability to elect a five-year maturity period also was recently extended to TALF loans secured by SBA Pool Certificates, SBA Development Company Participation Certificates and ABS backed by student loans.
John J. Dedyo is a Partner in the corporate department in Weil, Gotshal & Manges' New York office.His practice focuses on structured finance, derivatives and other securitization transactions across a broad range of asset types. Kristen Buppert is an Associate in the corporate department in the firm's Boston office. Arthur Kimball-Stanley is a Summer Associate in the firm's Boston office.