Results From May 5 Subscription Date

On May 5th, the Federal Reserve Bank of New York (the “New York Fed”) announced the results of the Term Asset-Backed Securities Loan Facility (“TALF”) subscription period for the month of May. The New York Fed received requests for more than $10.5 billion worth of TALF loans backed by asset-backed securities (“ABS”), which was the largest monthly request since the program’s initial funding in March. Of that total, approximately $5.5 billion was in the credit card sector, $2.2 billion in the auto sector and $2.3 billion in the student loan sector.

TALF is a New York Fed lending program that is funded in part by funds from the Troubled Asset Relief Program. A summary of the general terms and conditions of TALF for currently eligible asset classes can be found on Annex 1. Unless extended by the Board of Governors of the Federal Reserve, TALF will cease to be available after December 31, 2009.

Framework For New CMBS Announced

On May 1st, the New York Fed announced revised terms and conditions (the “CMBS Terms and Conditions”) to provide the framework for the expansion of eligible collateral in TALF to include non-agency (or “private label”) commercial mortgage-backed pass-through securities (“CMBS”).

TALF loans secured by CMBS are expected to begin in late June 2009 and will run on a different subscription and closing cycle than other TALF loans (i.e., TALF loans secured by CMBS will occur late in the month whereas other asset classes will continue to occur earlier in the month).

TALF was designed originally to jump-start lending markets by providing government loans to investors who purchase qualifying ABS. Consistent with this intention, the CMBS Terms and Conditions cover CMBS issued on or after January 1, 2009, with the underlying mortgage loans originated on or after July 1, 2008.

Although the basic elements are the same, the CMBS Term and Conditions differ from the non- CMBS term and conditions in a number of ways that may be interesting to investors. We have highlighted below some key differences as well as several aspects of the CMBS framework that are still under development by the New York Fed:

  • Availability of five-year maturities: In comments to the New York Fed regarding TALF, representatives of the real estate industry had argued that the normal three-year term of TALF loans was too short for TALF loans secured by CMBS because of the longer terms of many commercial mortgages. Possibly in response to such concerns, TALF loans secured by CMBS may have, at the election of the borrower, three- or fiveyear terms. A three-year loan will bear interest at 100 basis points over the 3-year LIBOR swap rate and a five-year loan is expected to have an interest rate equal to 100 basis points over the 5-year LIBOR swap rate. If a borrower chooses a five-year TALF loan, however, the excess in any TALF loan year of the interest distributions on the pledged CMBS over the TALF interest payable to the New York Fed will be remitted to the borrower only until such excess equals 25% (10% in the fourth loan year and 5% in the fifth loan year) of the haircut amount, and the remainder of such excess will be applied to TALF loan principal. (As with other asset classes, TALF loans secured by CMBS will be made to eligible U.S. companies as borrowers and will be non-recourse to the borrowers except for breaches of certain representations, warranties and covenants specified in the Master Loan and Security Agreement (the “MLSA”) between the New York Fed and the primary dealers acting as agents for the borrowers.)  
  • Fixed rate non-IO/PO CMBS collateral only: The CMBS Terms and Conditions provide that the CMBS pledged to secure a TALF loan must entitle its holders to payments of principal and interest and cannot be interest-only or principal-only securities. In addition, the pledged CMBS must bear a fixed rate of interest or an interest rate based upon the weighted average of the underlying fixed mortgage rates. The underlying mortgage loans must be fixed rate.  
  • First priority U.S. commercial mortgage loan: Eligible collateral will include U.S. dollar-denominated, cash (i.e., not synthetic) CMBS. The collateral backing the qualifying CMBS must be fully-funded, first-priority loans that are current in payment at the time of securitization and not other CMBS, other securities or interest rate swap or cap instruments or other hedging instruments. Each property securing a loan must be located in the United States or one of its territories and the security for each loan must include a mortgage or similar instrument on a fee or leasehold interest in one or more income-generating commercial properties. In addition, all mortgage loans must have been underwritten or re-underwritten recently prior to the issuance of the CMBS, generally on the basis of then-current in place, stabilized and recurring net operating income and then-current property appraisals.  
  • New York Fed to retain consent over voting rights: A borrower who pledges CMBS as collateral for a TALF loan must agree not to exercise, or refrain from exercising, any voting, consent or waiver rights under the CMBS without the consent of the New York Fed.  
  • Minimum CMBS collateral haircuts of 15%: Under TALF, the New York Fed will lend to each borrower an amount equal to the value of the pledged securities minus a haircut. If the pledged securities are CMBS, the haircut is 15% (which is on the high end of the scale for other ABS classes in TALF) for all CMBS with an average life of five years or less. The haircut increases 1% for each additional year of average life of the collateral beyond five years. No pledged CMBS may have an average life longer than ten years.  
  • New York Fed to engage collateral monitor: Unlike other ABS asset classes eligible for TALF loans, for CMBS-backed TALF loans the New York Fed will engage a collateral monitor to review pools of pledged collateral. The New York Fed expects the pools to be diversified as to loan size, geography, property type, borrower sponsorship and other characteristics but it will consider nondiversified collateral on a case-by-case basis. The New York Fed also retains the right (until the issuance of the CMBS) to exclude specific loans from a collateral pool and reject any CMBS based on the New York Fed’s risk assessment.  
  • Required characteristics of pooling and servicing agreements and other underlying agreements: The CMBS Terms and Conditions specify a number provisions that are required to be included in the pooling and servicing agreements and related agreements that govern the issuance and servicing of the pledged CMBS. These provisions include the following:
    • The mortgage loan seller must represent that, upon the origination of each mortgage loan, the improvements at each related property were in material compliance with applicable law.  
    • If the class of pledged CMBS is one of two or more time-tranched classes of the same distribution priority, distributions of principal must be made on a pro rata basis to all such classes once the credit support is reduced to zero as a result of both actual realized losses and “appraisal reduction amounts.”  
    • Control over the servicing of the assets (whether through approval, consultation or servicer appointment rights) must not be held by investors in a subordinate class of CMBS once the principal balance of that class is reduced to less than 25% of its initial principal balance as a result of both actual realized losses and “appraisal reduction amounts.”  
    • A post-securitization property appraisal may not be recognized for any purpose if the appraisal was obtained at the demand or request of any person other than the servicer or the trustee.  
    • The agreements governing the issuance of the CMBS and the servicing of the CMBS assets, and the terms and conditions of the underlying loans, are expected to permit the New York Fed to monitor and evaluate its position as a secured lender.  
  • AAA collateral only: Like TALF loans secured by other ABS asset classes, each TALF loan secured by CMBS must have a credit rating in the highest long-term investment grade category and must not (i) have a credit rating below the highest investment-grade category, (ii) obtain its credit rating based on the benefit of a thirdparty guarantee or (iii) have been placed on review or watch for a downgrade. Unlike the other TALF-eligible ABS asset classes, however, the New York Fed expects to identify specific CMBS-eligible rating agencies, although the review process for identifying such rating agencies is continuing.  
  • Additional guidance to be forthcoming: The CMBS frequently asked questions posted by the New York Fed indicate that additional guidance will be issued with respect to the framework for an issuer/sponsor and auditor certification for TALFeligible CMBS. In addition, the New York Fed is considering a process to permit interested issuers to reserve, for a monthly fee, prospective funding of TALF loans collateralized by newly issued CMBS.  

For the New York Fed TALF website, please see: http://www.newyorkfed.org/markets/talf.html.   

Certain Issues to Consider

Issues for investors and borrowers presented by the CMBS Terms and Conditions include the following:

New York Fed to have consent rights over pledged CMBS collateral, even in pre-default situations

The CMBS Terms and Conditions provide that a borrower must agree not to exercise any voting, consent or waiver rights under pledged CMBS without the consent of the New York Fed. These consent rights do not appear to be limited to a situation in which the New York Fed has enforced its rights under the MLSA. Therefore, it appears that if a borrower chooses to pledge CMBS as collateral for a TALF loan, it will have to relinquish control over its voting, consent and waiver rights in the underlying transaction to the New York Fed. Given the lack of an identifiable track record and the various constituencies the New York Fed may be considering whenever it is called upon to give (or withhold) consent, a sponsor, issuer and borrower may have a difficult time evaluating the effect these consent rights may have on the CMBS. In addition, investors who purchase the non-TALF supported tranches (including equity) in a CMBS securitization that has been financed in part through a TALF loan will need to consider the fact that the NY Fed will have a consent right over certain actions of the pledged tranche(s).

Significant haircuts—and principal paydown requirements for five-year loans—may deter interest in pledging CMBS collateral

The minimum haircut for CMBS collateral is 15% and can go as high as 20% for CMBS with an average life of 10 years. Requiring borrowers to provide 15-20% equity for CMBS may deter interest when combined with the other restrictive elements of the CMBS Terms and Conditions. In addition, if the borrower chooses a five-year loan, the excess of any interest distributions on the CMBS over the TALF interest payable will be remitted to the TALF borrower only until such excess equals 25% (10% in the fourth loan year and 5% in the fifth loan year) of the haircut amount, and the remainder of such excess will be applied to principal. Therefore, if a borrower chooses a five-year loan, a significant portion of excess interest will be used by the New York Fed to reduce loan principal which may have a significant impact on the economic viability of TALF for CMBS investors.

Pooling and servicing agreement requirements may overly restrict the scope of eligible CMBS collateral

The CMBS Terms and Conditions include specific provisions that each CMBS pooling and servicing agreement must contain to be eligible for TALF. These include loan-level representations and warranties and servicing control standards. For instance, the CMBS Terms and Conditions require that the mortgage loan seller represent that, upon the origination of each mortgage loan, the improvements at each related property were in material compliance with applicable law. Mortgage loan sellers may be reluctant to make such representations and this reluctance may unduly restrict the scope of eligible CMBS collateral.  

New York Fed will engage a collateral monitor and reserves the right to exclude collateral

The CMBS Terms and Conditions provide that the New York Fed will engage a collateral monitor and reserves the right—“until the issuance of the CMBS”— to exclude specific loans from each pool. This raises the implication that the New York Fed—and, by extension, the collateral monitor—would be involved in the determination of the pool of mortgage loans prior to the issuance of the CMBS. In addition, the New York Fed will retain the right to reject any CMBS as TALF collateral based upon its risk assessment. Therefore, unlike other TALFeligible asset classes, it appears that the New York Fed—either itself or through the collateral monitor—will have an active role in determining collateral eligibility. It is unclear at this point how this will impact the amount of eligible CMBS collateral, but if the New York Fed acts conservatively, it may significantly impact the scope of eligible CMBS collateral.

The Employ American Workers Act applies to TALF borrowers

Under the Employ American Workers Act (“EAWA”) enacted on February 17 as part of the stimulus legislation, any recipient of TALF funding will be deemed to be an H-1B dependent employer and subject to certain attestation requirements to the Department of Labor when hiring or placing H-1B nonimmigrant employees. The recipient of TALF funding is deemed to be the borrower and, if the borrower is a special purpose vehicle, any entity that owns or controls 25% or more of the equity of the special purpose vehicle.

Only the most senior tranche directly benefits from TALF

The security for a TALF loan can only include collateral that has a credit rating in the highest investment grade rating category (the “AAA Tranche”). The purpose of limiting collateral to the AAA Tranche is to protect taxpayers against losses. A stated goal of TALF is to facilitate the issuance of ABS at more normal interest rate spreads. In order for an issuer to securitize a pool of assets at a commercially acceptable price, however, it is often important that a liquid market exist for other portions of the capital structure so as not to render the entire structure economically inefficient. TALF loans do not address the senior subordinated, mezzanine or subordinate debt tranches or equity portions of a securitization’s capital structure.

Credit ratings remain a key element of any TALF loan analysis

Credit ratings remain a key element of the analysis as to whether collateral will qualify for purposes of a TALF loan because the collateral that may be pledged is limited to the AAA Tranche. This raises a number of potential issues for borrowers in the TALF program. Structures of AAA Tranches may differ from existing structures in the marketplace because eligible collateral will not include ABS that obtain credit ratings based on the benefit of a thirdparty guarantee. In addition, it is unclear whether placing so much importance upon credit ratings will aid or inhibit the use of the TALF loans. Potential borrowers in the TALF program – and any investors in structures where the AAA Tranche has been financed through a TALF loan – will want to carefully evaluate how the AAA Tranche ratings will be achieved.  

Potential refinancing risks may arise due to potential mismatches in tenor of TALF loans and underlying collateral

TALF loans will have a three year (or, in some cases, five year) tenor and are prepayable in whole or in part at the option of the borrower. In the past, securitizations frequently had senior tranches with maturities that were significantly longer. If there is a maturity mismatch between the TALF loan and the AAA Tranche that is pledged as security for such a loan, borrowers in TALF loans must be aware of the refinancing risk inherent in such a mismatch. Although TALF loans are generally non-recourse to the borrower, the proposed collateral haircuts are not insignificant and therefore a TALF borrower may have a sizable equity stake in the AAA Tranche. In the event the TALF borrower does not want to surrender the collateral to the NY Fed when the TALF loan matures, it will need to refinance the TALF loan. In the event the TALF borrower surrenders the collateral when the loan matures, the TALF borrower risks losing its entire equity stake in the AAA Tranche if the collateral has underperformed and the borrower has not recouped its equity investment during the term of the TALF loan.

Please click here to view Annex 1.