As the asset-backed securities (ABS) market continues to await the release by the Federal Reserve Board (Fed) of more detailed terms and (Detailed Terms) of the Term Asset-Back Securities Loan Facility (TALF 2020), the Fed released an updated high-level TALF 2020 term sheet on April 9, 2020 (Updated Term Sheet)1, which amends certain aspects of the initial TALF 2020 term sheet released on March 23, 2020 (Initial Term Sheet) as described in more detail below.2
CHANGES TO TALF 2020 ELIGIBLE BORROWERS
Narrowed definition of U.S. company. Consistent with the Initial Term Sheet, U.S. companies that own eligible collateral and maintain an account relationship with a primary dealer remain eligible borrowers under TALF 2020. The definition of “U.S. company” in the Updated Term Sheet, however, represents a significant departure from the initial version, having been redefined as “a business that is created or organized in the United States or under the laws of the United States and that has significant operations in and a majority of its employees based in the United States.”
The requirement that a TALF 2020 eligible borrower have “significant operations in and majority of its employees based” in the U.S. would initially seem to cast doubt upon whether TALF 2020 will be made available to investment funds organized in the U.S. and managed by investment managers with their principal place of business in the U.S., as was expressly permitted under TALF used during the financial crisis of 2007-2009 (Original TALF). However, while the intent behind this definitional change is not yet clear, it seems counterintuitive that the Fed would preclude from TALF 2020 private investment funds, a class of borrowers that proved so integral to the success of the original program. We therefore remain optimistic that the Detailed Terms released by the Fed will either apply the revised eligibility criteria to prospective fund managers rather than to the funds themselves, or include a formulation more in line with that of Original TALF.
In contrast to the Initial Term Sheet, the revised definition of U.S. company does not include U.S. branches or agencies of foreign banks or U.S. entities with non-U.S. parent companies, the former of which could prove problematic in the context of eligible collateralized loan obligations (CLOs) as described in greater detail below, as it would appear to exclude from TALF 2020 participation by Japanese banks, who have historically been major investors in triple-A rated U.S. CLO paper. Whether the Fed truly intended to exclude the entities that had been covered by the newly-removed language from TALF 2020 participation, however, remains an open question that we expect will be clarified by the Detailed Terms.
CHANGES TO ELIGIBLE TALF 2020 COLLATERAL
Newly eligible collateral. The classes of ABS eligible to be pledged under TALF 2020 have been expanded in the Updated Term Sheet to include:
- ABS where the underlying credit exposures are leveraged loans, but limited to static CLOs (Static CLOs) and excluding commercial real estate (CRE) CLOs. While not expressly defined in the Updated Term Sheet, Static CLOs are generally understood to describe CLOs that have no reinvestment period and immediately amortize with the repayment of principal on the underlying leveraged loans.
- ABS where the underlying credit exposures are commercial mortgages relating to property located in the U.S. or one of its territories and issued prior to March 23, 2020 (Legacy CMBS), excluding single-asset single-borrower (SASB) CMBS. Limiting eligible CMBS to Legacy CMBS is a notable departure from the limitations imposed on other classes of TALF 2020 eligible ABS, which are required to be non-legacy (i.e., issued on or after March 23, 2020).
- Equipment leases (in additional to equipment loans, which were included in the Initial Term Sheet).
Further clarification of the Fed’s requirement that all or substantially all of the underlying credit exposures of TALF 2020 eligible ABS (other than Legacy CMBS) be “newly issued” remains crucial. For example, should the Fed construe “newly issued” too narrowly in respect of the underlying leveraged loans of Static CLOs, eligible collateral would be limited to newly originated (or newly refinanced) loans and add-on loans under existing facilities, thereby greatly diminishing TALF 2020’s effectiveness in providing immediate relief to the CLO asset class. We would hope that the Fed’s ultimate interpretation of “newly issued” in the Detailed Terms will be guided by the general parameters of Original TALF and include as eligible collateral underlying loans and receivables originated within a specified period of time prior to TALF 2020’s launch.
CLO market participants will also be paying particular attention to TALF 2020 loan payment schedule. Original TALF required interest on TALF loans to be paid monthly, which would impose challenges on Static CLOs, where a substantial portion of the underlying leveraged loans traditionally pay interest on a quarterly basis. Unless TALF 2020 payment structure is tailored to accommodate the unique nature of leveraged loan collateral, issuers wishing to avail themselves of the program will need to pursue creative solutions for generating sufficient monthly cash flow to timely pay TALF 2020 loan interest, such as interest reserves or basis swaps.
Other CLO-specific clarifications and changes that market participants may consider raising with the Fed for potential inclusion in the Detailed Terms include:
- clarification around the requirement that “all or substantially all” of the leveraged loans underlying Static CLOs be originated by a U.S. company as it relates to customary concentration limitations in respect of loans issued by non-U.S. obligors;
- flexibility around the 3-year TALF 2020 loan term to mitigate refinance risk (although this may be less of a concern in respect of triple-A tranches of Static CLOs); and
- whether sales of defaulted loans or “credit risk” loans will be permitted for Static CLOs funded by 2020 TALF loans.
Servicing advance receivables removed as eligible collateral. The Updated Term Sheet removed servicing advance receivables from the definition of TALF eligible collateral included in the Initial Term Sheet. To date, the Fed has not provided any guidance as to why this change was made.
The issuer of eligible collateral must be a U.S. company. The requirement in the Updated Term Sheet that the issuer of eligible collateral be a U.S. company presents another potential hurdle for Static CLOs. While issuers of U.S. CLOs with collateral consisting of middle-market loans are primarily U.S. entities, issuers of U.S. CLOs collateralized by broadly-syndicated U.S. loans are typically Cayman Island entities, with a Delaware-based entity established as co-issuer for the triple-A rated tranche and certain other rated tranches. While the establishment of a U.S.-domiciled issuer for broadly-syndicated CLOs is not necessarily prohibitive, it may have the effect of limiting potential purchasers of CLO securities. The Fed could preserve the prevailing market standard by tailoring the Detailed Terms in the context of static CLOs to allow for a U.S.-based co-issuer to qualify as an eligible issuer, so long as selection of the underlying collateral is carried out by a collateral manager who satisfies the TALF 2020 definition of U.S. company.
CHANGES TO ADDITIONAL TALF 2020 TERMS
Conflicts of interest. Eligible borrowers and issuers of eligible collateral will be subject to the conflicts of interest section of Section 4019 of the Coronavirus Aid, Relief and Economic Security (CARES Act), which is intended to prohibit companies owned by senior government officials from benefitting from federal stimulus funds.
Collateral Valuation. The Updated Term Sheet includes a collateral haircut schedule, which is consistent with the haircuts imposed by Original TALF to the extent applicable.
Loan Pricing. To account for the expected industry transition away from LIBOR, the Fed revised the loan pricing terms from those set forth in the Initial Term Sheet to reflect the following interest rates:
- for Static CLOs, 150 bps over the 30-day average secured overnight financing rate (SOFR);
- for SBA Pool Certificates, the top of the federal funds target range plus 75 bps;
- for SBA Development Company Participation Certificates, 75 bps over the 3-year fed funds overnight index swap (OIS) rate;
- for all other eligible ABS with underlying credit exposures that do not have a government guarantee, 125 bps over the 2-year OIS rate for securities with a weighted average life of less than two years, or 125 bps over the 3-year OIS rate for securities with a weighted average life of two years or greater; and
- for other eligible ABS, as set forth in the Detailed Terms.
The Fed’s decision to use SOFR as the interest rate benchmark for Static CLOs raises the concern of basis mismatches between the SOFR-based TALF 2020 loans and the traditionally LIBOR-based CLO debt tranches such loans will be funding. Moreover, were debt tranches funded with TALF 2020 loans to use SOFR as a benchmark, this would in turn create mismatches between such debt and the underlying leveraged loan collateral, which itself remains largely benchmarked by LIBOR. It would be up to the market to determine the potential impact, if any, that such mismatches may have on the value of TALF 2020 funded triple-A CLO tranches, which benefit from the mitigating factor of a substantial interest coverage cushion. It would be ideal if the Fed were to adopt a benchmarking mechanic more closely aligned with the LIBOR transition mechanics commonly included in underlying CLO documentation whereby the LIBOR benchmark for TALF loans would transition from to a SOFR benchmark upon the occurrence of certain triggering events, which is consistent with the Fed’s Alternate Reference Rates Committee’s suggested mechanic for replacing LIBOR with SOFR for the securitization market in general.
TALF 2020 NEXT STEPS: STILL ROOM FOR MODIFICATION?
Consistent with the Initial Term Sheet, the Fed reserved the right in the Updated Term Sheet to review and adjust the terms of TALF 2020 (including program size, pricing, loan maturity, collateral haircuts, and asset and borrower eligibility requirements) “consistent with the policy objectives of the TALF.” The Fed further reiterated an express willingness to consider the feasibility of adding other asset classes to TALF 2020 in the future. It would seem from these statements that the Fed continues to be open to considering requests by industry participants and trade associations for more expansive terms and conditions than those set forth in the Updated Term Sheet.
The foregoing is not an exhaustive summary, nor to does it purport to present all considerations relevant to TALF 2020. Seward & Kissel will continue to monitor TALF 2020 and keep clients apprised of any material developments. If you would like additional information about this or any other matter, or wish to discuss TALF 2020 further, please feel free to contact Greg B. Cioffi (email@example.com) or Jeff Berman (firstname.lastname@example.org).
2 This client release is intended to supplement, and in certain cases supersede, the March 30, 2020 Seward & Kissel client release entitled “Return of the TALF” in order to reflect the terms of the Updated Term Sheet. See https://www.sewkis.com/practices/covid-19-crisis-response/publications/return-of-the-talf/.