TALF UPDATE - TALF As The Fed's New Torch: Reigniting the Primary Market for AAA ABS

February 25, 2009

I. Introduction

On February 10, 2009, the Federal Reserve and Treasury announced joint plans to substantially expand the size and scope of the long-awaited Term Asset Backed Securities Lending Facility (TALF) to as much as $1 trillion and ultimately broaden the definition of eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities (CMBS), private-label residential mortgage-backed securities, and other asset-backed securities (ABS). The expansion of the TALF would be a joint initiative using $100 billion from Treasury’s Troubled Asset Relief Program (TARP).^[1]

Later the same week the Federal Reserve Bank of New York (FRBNY) held a conference call outlining to Primary Dealers and potential investors how TALF would operate. It subsequently released on its TALF website[2] the form of the Master Loan and Security Agreement (TALF MLSA) that would govern the right and responsibilities of any Primary Dealer and customer that borrows under TALF.

With the FRBNY on record as planning to conduct its first round of loans under the new TALF in weeks and the Obama Administration’s commitment to increase the program five-fold to as much as $1 trillion, this client alert reviews TALF’s terms, highlights, key legal issues and argues that the program will be both immensely popular amongst investors/borrowers and hugely successful in reducing borrowing costs for new AAA-rated ABS that qualify as Eligible Collateral. We focus on how TALF’s operational framework has been streamlined, since TALF was first announced in November 2008 by the Federal Reserve to make borrowings more attractive and how the Treasury and the Federal Reserve have worked together to, in essence, cap investors’ maximum loss at the applicable haircut. We begin with some background on the evolution of TALF since November, before reviewing the key terms and conditions relevant to participation in the TALF, including: (1) borrower eligibility; (2) eligible collateral; (3) nonrecourse funding; (4) rates and haircuts; (5) operational considerations; (6) assignments of loans and transfers of collateral; and (7) executive compensation.

II. History of TALF Implementation

By way of background, the TALF is a proposed lending facility that was first announced on November 25, 2009 as a joint initiative of the Federal Reserve and the Treasury to facilitate renewed issuance of consumer and small business ABS at more normal interest rate spreads. On December 19, 2008 the Federal Reserve announced that the facility would begin operations in February 2009, and issued both a revised set of terms and conditions and a set of questions and answers detailing the operational aspects of the program. These documents reflected subsequent consultations that the Federal Reserve had with Primary Dealers and other ABS market participants. Major changes announced at that time included: (i) an extension of the TALF loan maturity from one to three years, (ii) clarification regarding eligible ABS collateral and (iii) abandonment of the use of a reverse auction of the loans so that loans provided under TALF could go to all eligible borrowers and not just those institutions that successfully bid in an auction.

On February 6, 2009, the Federal Reserve released additional terms and conditions, including the specific loan rates and collateral haircuts applicable to borrowings under TALF. The new terms and conditions also include a revised definition of the term eligible borrower and additional specifications regarding eligible ABS collateral. The new definition of eligible borrower excluded natural persons and entities owned or controlled by a foreign government while clearly including certain U.S. domiciled hedge funds whose managers have their principal place of business in the United States. Eligible ABS collateral was described at that time to include auto loans, student loans, credit card loans and small business loans with each asset class having a different origination cut-off date. At that time it was clarified that eligible ABS would include neither AAA-rated ABS that obtained such credit ratings based on the benefit of a third-party guarantee nor ABS that a major nationally recognized statistical rating organization (NRSRO) had placed on review or watch for downgrade. The announcement also made clear that eligible collateral would only include ABS that was cleared through the Depository Trust Company.

Subsequent to this release, the FRBNY held a conference call on Thursday, February 12th to discuss questions relating to the TALF and the recently released term sheet and frequently asked questions (FAQ). On that call, they discussed operational issues including borrower eligibility, the legal framework of transactions, the nonrecourse features of the TALF, rates and haircuts related to the TALF, eligible collateral, operational considerations and executive compensation. Later the same week, the form of TALF MLSA was released on the TALF website.

III. Key Terms and Conditions of TALF

The following summarizes key terms and conditions of the TALF, including (1) borrower eligibility; (2) eligible collateral; (3) nonrecourse funding; (4) rates and haircuts; (5) operational considerations; (6) assignments of loans and transfers of collateral; and (7) executive compensation.

A. Borrower Eligibility

Any U.S. company that owns eligible collateral may borrow from the TALF, provided the company maintains an account relationship with a primary dealer.

An entity is a U.S. company for purposes of the TALF if it is:

(i) a business entity or institution that is organized under the laws of the United States or a political subdivision or territory thereof (U.S.-organized) and conducts significant operations or activities in the United States (regardless of whether any such entity has a parent company that is not U.S.-organized), including any U.S.-organized subsidiary of such an entity;

(ii) a U.S. branch or agency of a foreign bank (other than a foreign central bank) that maintains reserves with a Federal Reserve Bank; or

(iii) an investment fund that is U.S.-organized and managed by an investment manager that has its principal place of business in the United States. Notwithstanding the foregoing, a U.S. company excludes any entity that is controlled by a foreign government or is managed by an investment manager controlled by a foreign government.

This does not include entities managed by a foreign government or an entity whose management is controlled by a foreign government.[3] A borrower cannot pledge ABS to the TALF if it or one of its affiliates originated or securitized the underlying collateral.

B. Eligible Collateral

Eligible collateral will include U.S. dollar-denominated cash (that is, not synthetic) ABS that have a credit rating in the highest long-term or short-term investment-grade rating category from two or more major NRSROs and do not have a credit rating below the highest investment-grade rating category from a major NRSRO. Eligible small business ABS also will include U.S. dollar-denominated cash ABS that are, or for which all of the underlying credit exposures are, fully guaranteed as to principal and interest by the full faith and credit of the U.S. government.

All or substantially all of the credit exposures underlying eligible ABS must be exposures to U.S.-domiciled obligors. The underlying credit exposures of eligible ABS must be auto loans, student loans, credit card loans, or small business loans fully guaranteed as to principal and interest by the SBA. The set of permissible underlying credit exposures of eligible ABS may be expanded over time. The underlying credit exposures must not include exposures that are themselves cash or synthetic ABS. The expected life for credit card or auto loan ABS cannot be greater than five years.

Auto-related receivables will include retail loans and leases relating to cars, light trucks, motorcycles and recreational vehicles, and will also include auto dealer floorplan loans. Commercial, government and rental fleet leases of cars, trucks and light trucks will not be eligible.

For TALF purposes, eligible credit card receivables include both consumer and corporate credit card receivables. Student loan receivables include federally guaranteed student loans (including consolidation loans) and private student loans. SBA loans include loans, debentures, or pools originated under the SBA’s 7(a) and 504 programs, provided they are fully guaranteed as to principal and interest by the full faith and credit of the U.S. government and meet all other TALF eligibility requirements.

The Federal Reserve has indicated that future plans include the expansion of eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial MBS, private-label residential mortgage-backed securities, and other asset-backed securities.

C. Nonrecourse Funding

The FRBNY will provide non-recourse funding to any eligible borrower owning eligible collateral. Loan proceeds in amount equal to the value of the pledged ABS minus a haircut will be disbursed to the borrower. As the loan is non-recourse, if the borrower does not repay the loan or exercises their right under the TALF MSLA to put the securities back to the Lender (Collateral Surrender), the FRBNY will enforce its rights in the collateral and sell the collateral to a special purpose vehicle – TALF LLC - established specifically for the purpose of managing such assets.

The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the TALF MLSA. If the collateral provided for a TALF loan or a borrower who has participated in the program is found to be ineligible, the non-recourse feature of the loan becomes inapplicable. Section 4.9 of the TALF MLSA explicitly indicates that should the Lender seek recourse against a Borrower, the outstanding principal amount of the Loan and accrued and unpaid interest shall bear interest at a rate equal to the rate otherwise applicable to the Loan plus 2%. The initial $100 billion from TARP received by the FRBNY from the Treasury will be used to fund TALF LLC, which is authorized to purchase any Collateral from the Federal Reserve upon a Collateral Surrender.

D. Rates & Haircuts

Borrowers will be able to choose either a fixed or floating interest rate on TALF loans. The fixed interest rate will be 100 basis points over the 3-year Libor swap rate, and the floating interest rate will be 100 basis points over 1-month Libor. The FRBNY also will assess an administrative fee equal to 5 basis points of the loan amount on the settlement date of each loan transaction. The purpose of the pricing structure is such that it should be attractive to investors and still protect taxpayers’ interests. The response the FRBNY has received thus far is generally positive, but there are still some ongoing issues under consideration. All rates and haircuts are subject to change in the future based on market conditions.

The current haircut schedule:

E. Operational Considerations

Each eligible borrower must be the customer of a primary dealer, which will act as agent for the borrower, to access the TALF and must deliver eligible collateral to the FRBNY’s custodian bank. Each eligible borrower must execute a customer agreement with its primary dealer providing authority to the Primary Dealer to execute documents, including the TALF MLSA, on behalf of the borrower.

On a fixed day each month (Loan Subscription Date), borrowers will be able to request up to two three-year TALF loans. Prior to each subscription date, each primary dealer will collect from prospective eligible borrowers information regarding the amount of each borrower’s loan request, the interest rate format desired by the borrower (fixed or floating), the CUSIPs of the ABS the borrower expects to deliver and pledge to the FRBNY, and the prospectuses and/or offering documents of the ABS expected to be pledged. On the subscription date each primary dealer will submit this information to the FRBNY’s custodial agent for review and will also submit to the FRBNY an aggregate loan request amount for all its customers that seek a fixed-rate TALF loan, and an aggregate loan request amount for all its customers that seek a floating-rate TALF loan.

No fewer than two business days before the loan settlement date (Loan Closing Date), the custodian will send a confirmation to the primary dealer listing each borrower’s loan amount and the ABS expected to be delivered on the Loan Closing Date. The confirmation will also include the administrative fee and margin (the dollar amount of the haircut), if applicable, to be collected by the primary dealer and paid on the Loan Closing Date.

On the loan settlement date, the borrower or its agent will deliver against payment the ABS collateral, administrative fee and applicable margin to the FRBNY’s settlement account at the custodian.

If a new ABS issue closes on the same day as the TALF Loan Closing Date, the borrower must remit the margin to the FRBNY’s settlement account at the custodian in order for the issuer to receive the full purchase price of the purchase by the investor/borrower. If the borrower is allocated less than expected of the new ABS issue, the borrower must inform the FRBNY through its primary dealer by a specified date so that an adjustment may be made to the margin and administrative fee prior to the Loan Closing Date.

On each Loan Closing Date, the borrower must pay to the FRBNY’s settlement account an administrative fee equal to 5 basis points of the loan amount, which will cover the FRBNY’s fees associated with the facility.

In addition to the foregoing, the issuer and sponsor must sign a certification that the offered securities constitute Eligible Collateral under TALF.[4] In the certification, both parties must attest, among other things, that they have reviewed the terms and conditions of the TALF and that the relevant security is eligible for the program. They must further promise to notify the FRBNY and holders of the securities if the securities no longer fit the terms and conditions of the TALF.

Finally, the FRBNY recently released its Auditor Attestation Form.[5] In the attestation, the auditor must certify that it has reviewed the relevant offering document and that, based on its examination, the Eligibility Assertion made is fairly stated in all material respects.

F. Assignment of Loans & Transfers of Collateral

One of the key suggestions made by market participants last fall was that TALF loans should be assignable and the related securities freely tradable. We are pleased to report that the TALF MLSA does provide that a Borrower may assign all of its rights and obligations with respect to a Loan to another Eligible Borrower, provided certain conditions are met. Amongst the various pre-conditions to an assignment of a Loan are: (i) the Collateral securing the Loan is sold or transferred to the Assignee and (ii) the FRBNY consents to the assignment. Before the TALF MLSA was released, there had been much speculation regarding whether the FRBNY would, in fact, permit a Borrower to sell their ABS position once it has been used to secure a Borrowing under TALF. Unfortunately, while Sections 19.1 and 19.2 do expressly contemplate secondary market trading in Eligible Collateral and the assignment of the related loan to a new Borrower, the FRBNY can “delay or withhold its consent to any Loan Assignment for any reason and for any period of time.” Therefore, it remains unclear how post trade (T +3) settlement will occur in a timely manner (much less, secondary market liquidity preserved in these securities) unless either some pre-approved trading is allowed between Primary Dealers or not all purchases of eligible ABS issuances are funded via TALF.

Another concern amongst market participants was for how long Borrowers would be able to sell their leveraged position in eligible ABS to another Eligible Borrower. While the industry wanted to see a pre-commitment from the Federal Reserve that loans under TALF would be freely assignable along with the securities for the full three years of the Loan, Section 13(3) of the Federal Reserve Act (FRA) made such a guarantee impossible. Section 13(3) grants the Federal Reserve special temporary emergency authority to make certain loans, but only after a finding of “exigent circumstances” and then only on a temporary basis. While the FRBNY can make 3 year TALF related loans under 13(3) today to an Eligible Borrower due to the current market conditions, the subsequent approval by FRBNY of a Loan Assignment is in essence a new loan to a new Borrower. Therefore, Section 19.4 of the TALF MLSA provides that the FRBNY does not have to consent to an assignment after December 31, 2009 unless it has determined that “unusual and exigent circumstances exist in the financial markets.” It is unclear what impact this will have on secondary market demand for TALF Eligible Collateral.

G. Executive Compensation

In order for ABS to be eligible collateral for a TALF loan, the sponsor of the securitization that issues the ABS must be in compliance with the executive compensation requirements of the TALF. The chief executive officer or other authorized representative of the sponsor or other applicable entity must complete the executive compensation certification form and submit it to the FRBNY before the sponsor or entity’s ABS can be offered as eligible collateral. Compliance must be certified on an annual basis. If an entity fails to certify its compliance annually, its securities will not be accepted as eligible collateral on subsequent TALF subscription dates. These requirements do not apply to borrowers in the TALF.

Attorney advertising materials. This publication is a service to our clients and friends. It is designed only to give general information on the developments actually covered. It is not a comprehensive summary of recent developments in the law and is not intended to treat exhaustively the subjects covered, provide legal advice or render a legal opinion. Please note that past representations are no guarantee of future outcomes.

Written by Eric L. Foster, Matthew Kulkin, and Kirsten Wegner