The Board of Governors of the Federal Reserve System (the "Federal Reserve") announced on May 19 that, beginning in July, it will include certain outstanding, U.S. dollar-denominated commercial mortgage-backed securities not issued by a U.S. government agency, instrumentality, or sponsored enterprise ("CMBS") issued before January 1, 2009 ("Legacy CMBS") as eligible collateral under the Federal Reserve's Term Asset-Backed Securities Loan Facility ("TALF"). The announcement follows the Federal Reserve's May 1 announcement that CMBS issued after January 1 will be TALF-eligible collateral beginning on June 16. Because CMBS include about 20 percent of outstanding commercial mortgages, these developments may be important to the market and to purchasers of Legacy CMBS.
The Federal Reserve expects that the inclusion of Legacy CMBS will improve the liquidity of the Legacy CMBS market. The inclusion of Legacy CMBS collateral is the first addition of a legacy asset class to the list of eligible TALF collateral.
Initial TALF Provisions Governing Loans Secured by Legacy CMBS
To qualify for TALF loans, Legacy CMBS must be senior in payment priority to all other interests in the underlying pool of commercial mortgages. Where the timing of payment is delayed in comparison to other similar priority CMBS, senior CMBS should qualify. In addition, Legacy CMBS must consist of fully funded mortgage loans, and not other CMBS or other securities or hedging instruments. Loan participation interests may qualify if, following a default under the loan, the participation grants the participant an ownership interest that is senior to or equal in right of payment of interest and principal. No zero coupon interests are permitted, and the underlying loans must be secured by a mortgage or similar instrument on a fee or leasehold interest on income-producing property. As of the TALF subscription date, at least 95 percent of the principal amount of the underlying loans must be secured by real properties located in the U.S. and its territories.
TALF loans must be used to fund recent secondary market transactions in Legacy CMBS that are executed on an arm's-length basis. Further, as of the TALF closing date, the Legacy CMBS must have a "AAA" credit rating from at least two of the "TALF CMBS-eligible rating agencies," which are DBRS, Inc., Fitch Ratings, Moody's Investors Services, Realpoint LLC, and Standard & Poor's, and not less than a AAA from any of them. DBRS and Realpoint are not recognized for other TALF-eligible assets.
Generally, any eligible borrower that posts eligible collateral should have "every expectation" of receiving TALF financing. However, in the case of Legacy CMBS, the Federal Reserve Bank of New York (the "New York Fed") retains broad discretion to reject any Legacy CMBS as TALF collateral based on the risk assessment of the New York Fed or its service providers.
The TALF loan amount for each Legacy CMBS will be the current market price for the CMBS less the "base dollar haircut." The base dollar haircut for each CMBS with an average life of five years or less will be 15 percent of par. The base dollar haircut is increased 1 percent for each year of average life above five years. The percentage haircut equals the base dollar haircut divided by the current market price of the Legacy CMBS. The size of the haircut increases with the discount of the market price from par. The New York Fed indicates that the greater the discount from par, the greater the credit risk, although this may also reflect poor market liquidity. Legacy CMBS with a purchase price less than its base dollar haircut will be ineligible for TALF loans.
Any remittance of principal on the CMBS must be used immediately to reduce the principal amount of the TALF loan in proportion to the haircut percentage. In addition, the excess of CMBS interest distributions over TALF loan interest payable will be remitted to the TALF borrower only until the excess equals a certain percentage of the haircut each year during the term of the loan. The remainder of such excess will be applied against the TALF loan principal.
The New York Fed is contemplating requiring default-related circumstances to be considered in calculating the weighted average life of Legacy CMBS. Note that all CMBS, whether newly issued or Legacy CMBS, must have an average life of 10 years or less. The average life for CMBS cannot be greater than 10 years.
Why a Proposed TALF Loan Might Be Rejected
Factors that may cause the New York Fed to reject a proposed TALF loan secured by Legacy CMBS include unacceptable performance of the Legacy CMBS, such as high cumulative losses, a high percentage of delinquent loans, amounts of loans on servicer watch lists or that are being specially serviced, and a high percentage of subordinate priority loans. Other factors may be forecasted pool losses under various stress scenarios and unacceptable concentrations, such as borrower sponsorship, property type, and geographic location.
Other TALF Changes
In connection with the announcement of the Legacy CMBS addition to the TALF program, the Federal Reserve made various modifications to its Frequently Asked Questions ("FAQs") about TALF. Also on May 22, the New York Fed released an amended version of its Master Loan and Securities Agreement for TALF. Various other forms have been developed and should be considered by potential TALF borrowers. The revised TALF FAQs as well as the Legacy CMBS program reflect various actions taken as a result of the Special Inspector General for TARP's ("SIGTARP") recommendations in its April 21 Quarterly Report to Congress.
Important changes in the TALF program and the FAQs include the following.
- The Employ American Workers Act ("EAWA") limitations on hiring new employees who are in H-1B nonimmigrant status have been made applicable to TALF borrowers. For investment funds, the EAWA also applies to any entity that owns or controls the investment fund.
- "Control" now includes the ownership or holding of 25 percent or more of a class of voting securities, and also 25 percent or more of the total equity of a borrower. "Eligible business entities" now include all limited liability companies, partnerships, banks, corporations, and business and other nonpersonal trusts.
- The definition of an "investment fund" continues to include any pooled investment vehicle that is organized as a business entity or institution, including hedge funds, private equity funds, and mutual funds, as well as any type of single investor vehicle that is organized as a business entity or institution. It no longer includes a "vehicle that primarily or exclusively invests in eligible collateral and borrowers from the TALF."
- All or substantially all of the credit exposures underlying eligible ABS must be exposures that are both (1) originated by U.S.-organized entities or institutions or U.S. branches or agencies of foreign banks and (2) are made to U.S.-domiciled obligors or with respect to real property located in the U.S. or one its territories. U.S. branches or agencies of foreign banks have been added specifically by this FAQ as eligible originators.
- Borrowers may use SBA Pool Certificates or Development Company Participation Certificates as TALF collateral, even where some of the underlying loans were originated by such borrower or its affiliates; provided that the borrower has no knowledge of the loans so originated.
- The New York Fed has reserved the option to consider accepting ABS where the issuer has an option to redeem such ABS other than in a customary "cleanup call" if the option does not increase the risk to the New York Fed and the ABS otherwise meets the TALF collateral eligibility criteria. Each borrower must confirm that the ABS issuer has received acceptance of any redemption option from the New York Fed. A customary cleanup call is one exercisable by the servicer or the depositor of ABS when the remaining balance of the assets or the liabilities of the issuer are not more than 10 percent or a higher percentage of the original balance of such assets or liabilities customarily used by the sponsor in its securitizations prior to the TALF program. The New York Fed intends to review the relevant documents, which may delay acceptance of ABS securities with such redemption features.
- Eligible auto loan receivables will include commercial loans secured by vehicles and the related fleet leases of such vehicles to rental car companies. Retail (non-fleet) leases to commercial obligors may be permitted in amounts not to exceed 15 percent of the total pooled leases in prime auto retail lease ABS.
- Receivables that finance medium- and heavy-duty trucks may be included in an auto floor plan receivables securitization, provided these do not exceed 5 percent of the total pool of receivables in that ABS.
- Premium finance receivables, including those used to finance premiums for property and casualty insurance, will continue to be permitted but will expressly exclude deferred payment obligations acquired from insurance companies. In addition, the ABS issuer must acquire ownership of each premium finance loan in its entirety, not just participations or other beneficial interests.
- Any securitization of insurance premium finance receivables must include a back-up servicer obligated to service the loans upon the resignation or termination of the initial servicer. It is now clear that both operating and financing leases are acceptable for eligible ABS.
- The Federal Reserve (not just the New York Fed) will periodically review its use of rating agencies for the purpose of determining TALF-eligible ABS. The issuer certifications, prospectus, and the offering document requirements and auditor assurances have been revised. The forms of issuer certification and indemnity for newly issued CMBS as well as for Legacy CMBS are pending.
- The New York Fed indicates that the prepayment assumptions on ABS will be revisited periodically. For newly issued CMBS, the weighted average will be based on the assumption that each loan amortizes according to its amortization schedule and prepays in full on the first day that prepayment is permitted without penalty. This may expand the universe of new CMBS. The original average life for SBA pool certificates is the average life reported in the undertaking of the final prospectus or offering document.
- The TALF loan custodian must receive final prospectus/offering documents at least three business days prior to the applicable TALF loan settlement date, although such documents are not required for SBA Pool Certificates. Certifications as to TALF eligibility by the issuer of the ABS and the sponsor must be made no later than the date of the final prospectus or offering document but may be made as of the preliminary prospectus or offering document. The auditor attestation must be as of the same date as the issuer and sponsor certifications and only needs to be submitted to the New York Fed once for each securities' CUSIP number.
- The New York Fed may consider permitting interested issuers, in a process to be developed, to reserve prospective funding of TALF loans secured by newly issued CMBS. A monthly reservation fee assessed as a fraction of the amount reserved will be charged by the New York Fed. CMBS subscription dates for TALF will be on or about June 16 for the first newly issued CMBS and later in June for Legacy CMBS. Non-CMBS ABS subscriptions will continue in the first half of each month.
- The New York Fed will monitor interest distributions and has determined that any excess distributions must be applied to loan repayments as received. The amount of "excess" interest distributions will be based on current rather than the original haircut amount pursuant to calculations to be published by the New York Fed.
- TALF borrowers are not permitted to exercise any voting, consent, or waiver rights with respect to CMBS collateral without the prior written consent of the New York Fed, which may be withheld or conditioned in the New York Fed's sole discretion.
- With respect to each TALF loan that is secured by collateral subject to an early amortization event, 100 percent of the principal receipts paid to the borrower will be used to repay the principal amount of, and any monthly interest deficiency relating to, the TALF loan.
- The New York Fed continues to develop measures to discourage fraudulent activity associated with TALF and has established 24-hour telephone- and internet-based hotlines for reporting fraudulent conduct. The New York Fed is also developing an on-site inspection program to carry out its inspection rights under the Master Loan and Security Agreement.
Increasing delinquencies and deterioration in commercial mortgage performance, quality, and rating agency downgrades may limit Legacy CMBS loans from TALF. As the program gains clarity, however, we expect the Legacy CMBS program will be an attractive source of liquidity and relatively inexpensive financing.
While the New York Fed understands that more details will be required and intends to publish these well in advance of the late July subscription date for Legacy CMBS loans from TALF, market participants will have little advance certainty to engage in the requisite secondary transactions. Purchasers of Legacy CMBS that wish to use TALF funding may consider making their purchases conditioned on TALF eligibility, with settlements delayed until TALF acceptance under the final rules. This may affect the prices that sellers are willing to accept for Legacy CMBS.
For more information on TALF, please see Jones Day Commentary, "The Federal Reserve's Term Asset-Backed Securities Loan Facility ("TALF")—Expanding New Credit for Consumers and Businesses," at http://www.jonesday.com/pubs/pubs_detail.aspx?pubID=S6069 and "The Federal Reserve's Term Asset-Backed Securities Loan Facility ("TALF") Update," at http://www.jonesday.com/pubs/pubs_detail.aspx?pubID=S6236.