The Federal Reserve Board of Governors (the “Fed“) issued a revised term sheet (the “Updated Term Sheet”) for the Term Asset-Backed Securities Loan Facility (“TALF“) program on 9 April 2020. Although the Updated Term Sheet offered additional information and more clarity on the Fed’s announcement of the re-establishment of the TALF program on 23 March 2020, it also created ambiguities that make it unlikely that the TALF program would serve its intended function until it has been fixed.
The Updated Term Sheet both extended and narrowed the TALF program by expanding the range of ABS that could be financed by the system (“Eligible Collateral”) to include certain legacy CMBS and newly issued static pool CLOs (each as mentioned below), while restricting the category of U.S. companies qualified to borrow under the program (‘Eligible Borrowers‘) and allowing the issuers of asset-backed securities (“ABS”) to be financed by U.S. companies to be financed as Eligible Collateral under TALF. U.S. companies are now identified as businesses formed or established in the U.S. or under U.S. law and with substantial operations in and a majority of their U.S.-based employees. Restricting all eligible borrowers and eligible ABS issuers to U.S. firms with large operations in and a majority of their employees in the U.S. effectively prevents most investment funds from being eligible borrowers, and more seriously prevents ABS from being eligible collateral which must be provided by a remote special purpose company for bankruptcy. Neither such of a problem existed in the March 23, 2020 Term Sheet1 nor in the predecessor TALF.2.
While the expansion of the types of ABS that constitute Eligible Collateral should help banks and non-bank lenders that rely on these CMBS and CLO markets to free up a portion of their balance sheets in order to provide additional credit and liquidity to businesses, the change to the U.S. company’s definition will occur in order for the new TALF program to operate.
The Fed extended the Eligible Collateral to include AAA-rated tranches of both (I) commercial mortgage-backed securities (“CMBS“) issued prior to 23 March 2020 and (II) static pool collateralized loan obligations (“CLO“) issued on or after 23 March 2020. The Fed however excluded all commercial real estate CLOs and single-asset single-borrower CMBS from Eligible Collateral. The Fed has also failed to clarify whether mortgage-backed securities backed by pools of single-family mortgage rental loans will qualify as CMBS for TALF purposes.
The Fed has also extended the scope of underlying collateral exposures supporting the ABS, which comprises Eligible Collateral to include equipment leases, leveraged loans and commercial mortgages on real property located in the United States or one of its territories, thus excluding eligible service advance receivables as a credit exposure that can back Eligible Collateral.
Eligible Borrowers and Issuers of ABS
Both Eligible Borrowers and ABS issuers making up Eligible Collateral must be U.S. firms. The Fed has modified the concept of U.S. companies to allow any such organization not only to be formed or established under or in compliance with U.S. laws, but also to have substantial operations in the United States and a majority of its employees have to be based there. This creates major impediments for the ABS market and its investors, as stated in the introductory paragraph, to be able to use the TALF system effectively to free up credit and liquidity for customers and businesses. Whether this move was an deliberate limitation on the software or not is uncertain and we will look for more clarification on this issue in subsequent releases.
The announcement by the Fed also created new pricing measures for Eligible-Collateral-backed loans, including differing rates for Small Business Administration (“SBA“) guarantees on ABS. Pricing for CLOs will be based on the 30-day average overnight funding rate (“SOFR“), and pricing for non-CLOs will be based, as appropriate, on a 2- or 3-year federal funds overnight index swap rate (“OIS“).
- CLO interest rate: SOFR + 150 basis points.
- SBA-backed ABS:
- SBA Pool Certificates (7(a) loans)- top of the goal amount of federal funds + 75 basis points, or
- SBA Development Company Certificates of Participation (504 loans) – OIS rate 3 years + 75 basis points.
- ABS which is not backed by SBA:
- Securities with a weighted average life span of less than two years, OIS rate of 2 years + 125 basis points or
- Securities with a weighted average life span of more than two years or 2 years, the OIS rate of three years + 125 basis points.
The Fed’s decision to use SOFR and OIS, respectively, as the reference rates for the new pricing measures are likely to generate a benchmark discrepancy with the related Eligible Collateral, given that floating debt liabilities in the securitisation markets (and the underlying assets that support them) tend to primarily use LIBOR as the applicable reference rate. It is not currently clear how any such malfunctioning basis will be accounted for once the TALF program begins.
The Updated Term Sheet includes the Eligible Collateral haircut schedule which will include financing from the Eligible Borrower. The Schedule is substantially consistent with the haircut schedule established during the 2008 financial crisis from the predecessor TALF program.
The haircuts are determined by asset class and the asset’s weighted average life. All asset classes, other than CMBS, static CLOs, student loans, and SBA loans, must have a weighted average life of five years or less. Such four asset groups can have a weighted average life over five years but not more than ten years, with the exception that for each additional year the haircuts may increase by a percentage point greater than a weighted average life of five years.
The haircuts schedule is set out below:
ABS Average Life (years) *
|Auto||Prime retail lease||10%||11%||12%||13%||14%|
|Auto||Prime retail loan||6%||7%||8%||9%||10%|
|Auto||Subprime retail loan||9%||10%||11%||12%||13%|
|Auto||Motorcycle / other recreational vehicles||7%||8%||9%||10%||11%|
|Auto||Commercial and government fleets||9%||10%||11%||12%||13%|
|Equipment||Loans and Leases||5%||6%||7%||8%||9%|
|Premium Finance||Property and casaulty||5%||6%||7%||8%||9%|
|Small Business||SBA Loans||5%||5%||5%||5%||5%||6%||6%|
|Commercial Mortgages||Legacy, Conduit||15%||15%||15%||15%||15%||16%||17%|
What is the Same?
The Fed has retained the scale of the TALF programme at US$ 100 billion. The Eligible Collateral remains ABS released on or after March 23, 2020, with the exception of legacy CMBS. In addition, all or substantially all of the underlying credit exposures must be newly-released, other than for legacy CMBS, in order to be Eligible Collateral. And as before,the Department of Treasury (the “Treasury”) must spend US$ 10 billion in the special purpose vehicle (“SPV“) using the Exchange Stabilization Fund.
Unique CLO Considerations
The inclusion of CLO securities as Eligible Collateral for the TALF program is a welcome addition, both for lenders and owners of leveraged loans who look to CLO issuers to receive leveraged loans from them to free up capital so that they can continue to lend, and also for banks to be able to offer additional warehouse loans to prospective CLO issuers and other leveraged loan owners. However, other limitations in the Updated Term Sheet (beyond the criteria for Eligible Borrowers and ABS issuers to be U.S. companies as mentioned above, which present issues for several groups of ABS) make it difficult for us to see how the TALF system can effectively facilitate this objective.
In particular, the combination of the requirement that the leveraged loans constituting the CLO’s underlying credit exposures must be newly issued, and the requirement that the CLO be a completely ramped static pool issued on or before September 30th, 2020, would make it difficult for Eligible Borrowers to access the TALF system using CLO securities as Eligible Collateral. First, the provision for new issuance of all credit exposures ensures that loans accrued in warehouses or on balance sheets since prior to the recent downturn can not be included in TALF-eligible CLO’s. This eliminates the ability of large commercial banks that currently hold or provide warehouse financing for pre-existing leveraged loans, and of non-bank lenders, financial institutions and funds that currently own such leveraged loans, to transfer these loans to new TALF-eligible CLOs to free up capital for additional lending or investment in new loans. Secondly, it will be difficult for investment managers of entities planning to issue new CLOs to find a warehouse and create a sufficiently diversified pool of newly issued loans to ramp up the entire portfolio of static pool loans, and to close the issuance of new loan extensions under the TALF program by 30 September 2020 (unless that deadline is extended).
While future changes to the TALF program can not be predicted, for the program to be meaningful to the CLO market – and for CLO market participants to be able to significantly free up capital for additional loans to U.S. businesses – we would look for (I) a ban on pre-existing loans to be eased and for TALF-eligible CLOs to hold pre-existing loans from a lookback period (as allowable ABS in the original TALF), including new loans, (II) an extension for static pool CLOs deadline set for September 30, 2020 and (III) explanation that the concept of a static pool CLO allows sales of a defaulted loan, a credit risk loan and reinvesting proceeds received therefrom. We should therefore request and anticipate more guidance from the Fed that (x) eliminates the condition that the CLO issuer be a U.S. corporation with significant activities and staff in the country, and merely allows it to be a business incorporated in the U.S. or any state thereof, and (y) adjusts the concept of a U.S. company for the purposes of the Eligible Borrower classification to be what was included in the term sheet of March 23 or the explanation used in the old TALF program.
As described above, the April 9 term sheet does not allow U.S. investment funds to be eligible borrowers under the TALF programme, if they do not have significant operations in the States and a majority of their employees being based in the U.S. We would look at the definition of Eligible Borrower and want to see it changed either to the description used in the term sheet of March 23 or to that used in the predecessor TALF programme. If such a change is made, many investment management companies are currently exploring fund creation and investment strategies to take advantage of the TALF system to invest in Eligible Collateral. These funds would have to be designed to take advantage of the specific business opportunities posed by TALF and the current financial uncertainties. Such complexities will pose unique challenges for sponsors and investors alike.
The latest term sheet from the Fed offers more clarification on some of the specifics of the TALF program as noted above but continues to generate ambiguities that may challenge market participants when utilizing the program entirely. Despite the additional terms and conditions that are yet to come, we hope the system will understand its expected benefits. Both the Fed and the Treasury can make further modifications during the TALF program and may make changes whenever necessary. We will continue to watch closely all changes related to the Fed’s announcements.