In furtherance of its goals to stabilize the credit markets and the broader economy, on Tuesday, May 19, the Federal Reserve Board (the "Board") expanded the Term Asset-Backed Securities Loan Facility ("TALF") to include commercial mortgage-backed securities issued before January 1, 2009 ("Legacy CMBS") as "eligible collateral" authorized to be pledged to the Federal Reserve Bank of New York (the "NY Fed") to secure a TALF loan. This expansion comes on the heels of the Board's announcement on May 1, 2009 that the NY Fed would accept newly issued CMBS as "eligible collateral" under TALF. The NY Fed is expected to issue its first TALF loans backed by Legacy CMBS collateral in July 2009.
The Board determined that the extension of "eligible collateral" to include Legacy CMBS was necessary in order to "restart the market for legacy securities and, by doing so, stimulate the extension of new credit by helping to ease balance sheet pressures on banks and other financial institutions." The expanded program is further intended to promote price discovery and liquidity for Legacy CMBS. The Legacy CMBS program under TALF may also be used in connection with the Legacy Securities Program announced under the Public-Private Investment Program ("PPIP").
In addition to further requirements being considered and not currently outlined in the program guidelines, the program terms and conditions state that the NY Fed will include a requirement that the Legacy CMBS program be used to fund "recent secondary market transactions between unaffiliated parties that are executed on an arm's length basis." Moreover, the NY Fed may limit the amount of TALF Loans which can be secured by Legacy CMBS. The NY Fed has yet to determine how to implement these requirements, but they expect to announce all information well in advance of the expected late July 2009 initial subscription date.
Legacy CMBS Qualifications
In order for Legacy CMBS to be eligible to be pledged to the NY Fed to secure a TALF loan, the securities must be U.S. dollar-denominated cash securities issued before January 1, 2009, which securities evidence an interest in a trust fund. The underlying assets must consist of fully funded mortgage loans, which may include participations or other ownership interests if, following a default on the related mortgage loan, the ownership interest or participation is senior to or pari passu with all other interests in the same mortgage loan. Further, each mortgage loan must be secured by a mortgage or similar interest in one or more "income-generating commercial properties."
Many CMBS deals issued prior to January 1, 2009 included income generating multifamily properties in the collateral pool. Often in deals that included multifamily properties, the description of the mortgage loans would state, "secured by first liens on commercial and multifamily properties." We would hope that it would be clarified that the term "commercial properties" was meant to be inclusive of multifamily properties for purposes of TALF.
Eligible Legacy CMBS must not be junior to other securities issued under the same transaction, thus excluding junior CMBS providing credit support for senior CMBS. However, junior CMBS paid in a later time tranche sequence that are otherwise pari passu with all other senior CMBS issued under the same transaction are eligible. Accordingly, time-tranched CMBS classes that provide for a pari-passu distribution upon the erosion of credit support will be eligible collateral for the Legacy CMBS program.
Like the newly issued TALF CMBS program, Legacy CMBS cannot be backed by other CMBS, other securities, or interest rate swap or cap instruments or other hedging instruments. Further, on the subscription date, at least 95% of underlying properties, by related loan principal balance, must be located in the United Stated or one of its territories. Moreover, the issuer of TALF eligible Legacy CMBS must not be an agency or instrumentality of the United States.
The NY Fed will retain the right to reject any Legacy CMBS as TALF loan collateral based on its independent risk assessment, which shall include the following criteria:
- The CMBS must meet the explicit requirements stated in the Terms and Conditions.
- CMBS that represent interests in pools with high cumulative losses, a high percentage of delinquent loans, loans in special servicing or loans on servicer watch lists or a high percentage of subordinate-priority loans may be rejected. The NY Fed may consider in its decisions forecasts of pool level losses under various stress scenarios.
- CMBS that represent interests in pools that, alone or considered together with loan pools backing other TALF-financed CMBS, possess one or more concentrations (such as borrower sponsorship, property type and geographic region) considered unacceptable to the NY Fed may be rejected.
In connection with the NY Fed's risk assessment of Legacy CMBS, it will be interesting to see how the recent bankruptcy filing by General Growth Properties Inc. (and the related filing of General Growth's solvent SPEs) will impact such risk assessment. The initial ruling by the bankruptcy court has led some to question long-accepted commercial real estate financing structures. The NY Fed's ultimate position on eligibility of Legacy CMBS which includes concentrations of mortgage loans made to General Growth SPEs could impact the general market for Legacy CMBS, outside the scope of the TALF Legacy CMBS program.
As with the newly issued TALF CMBS program, the NY Fed will engage a collateral monitor or one or more agents to assist the NY Fed in assessing the risk characteristics of each Legacy CMBS and the loan pools which secure such Legacy CMBS. It is unclear at this point whom the NY Fed is considering engaging as collateral monitor and whether the collateral monitor under the TALF Legacy CMBS program will be the same entity that provides the collateral monitor services under the newly issued TALF CMBS program.
Eligible Legacy CMBS must have a credit rating in the highest long-term investment grade category (and not be on watch for downgrade) from at least two TALF CMBS eligible rating agencies. TALF provides that the only "eligible rating agencies" for both the Legacy CMBS program and the newly issued CMBS program are DBRS, Inc., Fitch Ratings, Moody's Investor Service, Realpoint LLC and Standard & Poor's. This is distinct from the asset-backed securities TALF program where the "eligible rating agencies" are currently limited to Fitch, Moody's and S&P. In all cases, the rating must be based on the underlying assets and structure of the transaction and cannot rely on a third-party guarantee as a basis for such rating.
As previously mentioned, the TALF Legacy CMBS program may be used in connection with the Legacy Securities Program under PPIP. While the Board and the U.S. Treasury have made clear that these are separate and distinct programs, it is expected that fund managers under the Legacy Securities Program will finance the purchase of "Eligible Assets" through the TALF program. Currently, the definition of "Eligible Assets" under the Legacy Securities Program includes "commercial mortgage backed securities issued prior to 2009 that were originally rated "AAA" or an equivalent rating by two or more nationally recognized statistical rating organizations." [emphasis added]. Thus, as currently constructed, assets eligible for purchase under the Legacy Securities Program will not be eligible to be pledged to the NY Fed to secure a TALF Loan if the current rating requirement under TALF is not met. As the Board and the U.S. Treasury are working together to implement the Legacy Securities Program within the next six weeks, they may address any concerns that fund managers will have with respect to this discrepancy.
In addition to the above noted requirements, TALF eligible Legacy CMBS must pay principal and interest, and each Legacy CMBS must bear interest at a pass-through rate that is fixed or based on the weighted average of the underlying fixed mortgage loans. Lastly, each CMBS must be cleared through the Depository Trust Company.
The terms and conditions of the TALF program will generally apply to TALF loans backed by Legacy CMBS, except as modified by the TALF Legacy CMBS terms and conditions. Identical to the newly issued TALF CMBS program, TALF loans backed by Legacy CMBS may have a three-year or five-year maturity at the election of the borrower, and the interest rate on the TALF loan will be a fixed rate per annum equal to the 3-year LIBOR swap rate or the 5-year LIBOR swap rate, plus 100 basis points, depending on the maturity of the TALF loan.
The "base dollar haircut," expressed as a percentage which is applied to the par amount, for Legacy CMBS with an average life of five years or less, will be 15%. For each CMBS with an average life beyond five years, the "base dollar haircut" will increase by one percentage point for each additional year of average life. The average life of Legacy CMBS will be the remainder of the original weighted average life as determined by the issuer at the time of issuance, provided that the NY Fed is considering including default-related circumstances in the calculation of weighted average life. Unlike the newly issued CMBS program, there is no explicit requirement that the weighted average life be less than ten (10) years, however most "AAA" rated Legacy CMBS had an original weighted average life less than ten (10) years.
The TALF loan amount for pledged Legacy CMBS will be the "current market price" of the Legacy CMBS minus the "base dollar haircut." This results in a collateral haircut equal to the "base dollar haircut" times the par amount. The NY Fed has indicated that the new formulation for TALF loans under the Legacy CMBS program is designed to address increased credit concerns with Legacy CMBS. The current terms and conditions do not address how the "current market price" will be determined, but the NY Fed is considering a price validation process to ensure accurate market prices for secondary market transactions.
As the NY Fed set forth in its example, assuming a CMBS has a par value of $100 and a seven-year weighted average life, with a "base dollar haircut" of 17% of par:
- If the market price is 75% of par, the loan amount is $58 (75-17) and the collateral haircut is 23% (17/75), or $17
- If the market price is 50% of par, the loan amount is $33 (50-17) and the collateral haircut is 34% (17/50), or $17
This increase in haircut percentage relative to market price reflects the recognition that large discounts from par generally indicate credit concerns on the underlying security. In no event will Legacy CMBS be considered "eligible collateral" if the dollar purchase price or "current market value" is less than its base dollar haircut.
As stated previously, the NY Fed will require that Legacy CMBS be subject to a recent secondary market transaction between unaffiliated parties executed on an arm's length basis in order to be considered "eligible collateral." Such a requirement should help to ensure that the "current market price" adequately reflects the actual price the market is willing to pay for such security, albeit with the benefit of the additional leverage provided by TALF, as opposed to the value attributed to such security by its holder. This requirement should provide additional protection to the U.S. Treasury and the NY Fed, but may hinder the success of the TALF Legacy CMBS program as buyers and sellers of CMBS in the marketplace have varying determinations of the value of CMBS.
The NY Fed will likely set forth certain requirements to define exactly what constitutes an arm's length transaction between unaffiliated parties. An important question will be who will be required to confirm compliance with the eligibility requirements set forth by the NY Fed for such a transaction and what verification procedures will be used.
Like the newly issued TALF CMBS program, payments of principal received on the Legacy CMBS must be proportionally used to reduce the principal balance on the TALF loan in proportion to the collateral haircut. Additionally, for a five-year TALF loan, the excess, in any TALF loan year, of Legacy CMBS interest distributions over TALF loan 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 collateral haircut amount (not the "base dollar haircut"), and the remainder of such excess will be applied to TALF loan principal.
A new requirement of the Legacy CMBS program, which is not applicable to any other collateral class under TALF, is that for a three-year TALF loan backed by Legacy CMBS, the excess interest, in any TALF loan year, of Legacy CMBS interest distributions over TALF loan interest payable will be remitted to the borrower in each loan year until it equals 30% per annum of the collateral haircut amount, with the remainder applied to pay down loan principal.
The requirement that a certain percentage of excess interest payments must be used to reduce principal (on both a five-year and a three-year TALF Loan) will mean that the investor is less likely to recoup its full investment during the TALF loan term. This is unlike the existing TALF program for other collateral (other than newly issued CMBS), where all excess interest is paid to the investor without any requirement that excess interest be used to pay down principal. Consequently, investors in Legacy (or new issue) CMBS must be comfortable that the CMBS will be worth more than the TALF Loan at maturity in order to recover their investment and realize a positive return.
Following the lead of the newly issued TALF CMBS program, the NY Fed is requiring that each TALF borrower who has pledged Legacy CMBS must agree not to exercise any voting, consent or waiver rights under the Legacy CMBS governing documents without the consent of the NY Fed.
In connection with the Legacy CMBS program, the NY Fed may revise its deliverables and closing procedures currently set forth in the Master Loan and Security Agreement. The Master Loan and Servicing Agreement currently contemplates delivery of the initial offering documents, sales confirmations and an eligible collateral schedule prior to the closing of the TALF Loan. Also, generally, the primary dealers have been receiving undertakings from the Sponsor and/or Issuer of the transaction stating that the securities are "eligible collateral" under TALF. Due to the nature of the collateral for Legacy CMBS, an interesting question is who will be required to confirm that the securities are "eligible collateral" and provide the indemnity to the primary dealers, as the original sponsor and/or issuer of the transaction never contemplated the creation of TALF as a financing vehicle. Moreover, each primary dealer may require significantly modified customer agreements in order to provide comfort that the transaction is eligible.
In addition to modifications to the Master Loan and Security Agreement, operationally, as currently constructed, both the Legacy CMBS and newly issued CMBS will have a single subscription date in the latter part of the month. Unlike newly issued TALF CMBS, the Legacy CMBS program will rely on secondary market transactions as the vehicle through which securities will be pledged for a TALF Loan. These transactions may occur at any time during any given month. Currently, the NY Fed has made no indication that multiple subscription dates will be available in order to finance the secondary market transactions of the Legacy CMBS. As the Legacy CMBS program begins to mature, the NY Fed may consider establishing multiple subscription dates in order to support a liquid market for these securities.
As discussed earlier, the original announcement of the Legacy CMBS program was made in connection with the U.S. Treasury's announcement of the Legacy Securities program under the Public Private Investment Program. While we expect that once the Legacy Securities program is up and running the fund managers will utilize TALF in order to finance their purchases of Legacy CMBS, we also expect that the Legacy CMBS program will be used as an independent source of financing for secondary market purchases of Legacy CMBS.
Additional updates are expected to be provided by the Board and the NY Fed regarding the specific procedures and processes of the Legacy CMBS program "well in advance" of the July 2009 update. We will continue to monitor this important program to provide updates as they become available.