The Fed releases more specifics and a start date for its Term Asset Backed Loan Facility (TALF) program, but overall the picture which emerges makes it less likely that the program will facilitate the flow of credit to US companies through new TALF- eligible CLO issuance.
Introduction
The Federal Reserve Board of Governors (the “Federal Reserve”) and the Federal Reserve Bank of New York (“New York Fed”) on May 12, 2020 released an updated term sheet (the “New Term Sheet”) for the Term Asset-Backed Securities Loan Facility (”TALF”) program and updated their FAQs on TALF (“TALF FAQs”). On May 19, 2020, we released a Dechert OnPoint describing the New Term Sheet and the TALF FAQs and their impact on CLOs. Shortly thereafter, on May 20, 2020 and again on May 26, 2020, the Federal Reserve and the New York Fed updated their FAQs on the TALF program (“Updated FAQs”) and announced a start date for the program of June 17, 2020. Unfortunately, the Updated FAQs fail to address most of the major gating items specific to collateralized loan obligation transactions (“CLOs”) and introduce more obstacles for both issuers and buyers of TALF-eligible CLOs.
Obstacles Which Remain
First the bad news. Most of the major gating items specific to CLOs identified in our May 19, 2020 Dechert OnPoint were not addressed, including the following:
- Redemptions. The New York Fed failed to remove or modify the restrictions on redemptions prior to three years after the TALF loan issuance. This may prove completely unworkable from a commercial perspective as new static CLOs generally include the ability to refinance after one year or less.
- Certifications. In response to industry group concerns, the New York Fed noted that it was required by Regulation A to obtain evidence that “adequate credit accommodations” cannot be obtained elsewhere and therefore did not remove the requirement. They did, however, clarify that for purposes of the required certification from participants such determination could be made based on “unusual economic conditions” in the market, such as ABS spreads being “elevated relative to normal market conditions.” It is unclear whether this will sufficiently alleviate the anxiety in the market over making this certification but it does appear to signal an intention on the part of the New York Fed to interpret the standard in a manner that could be more readily satisfied.
- Limitation on Selling Assets. CLOs are still not allowed to sell any assets other than those which have experienced a default in the payment of principal and interest. Loans which experience other types of defaults, experience bankruptcy or become “credit risk” assets may not be sold; this will hamper the CLO manager’s ability to protect the credit quality of the CLO and its investors, including the TALF program itself.
- Duration of TALF Program. The expiration of the TALF program remains set for September 30, 2020. We anticipate that most CLO managers will find it difficult to ramp-up and arrange a sufficiently diverse CLO in this tight timeframe. We do, however, expect that this period will get extended to the end of the year at some point.
- Pricing and Haircuts. The unfavorable pricing and haircuts which apply to CLOs has not changed, which in light of the data about CLO AAA-rated liabilities cannot be explained.
- Ratings. TALF-eligible CLO securities are still required to have ratings from at least two rating agencies, which is not customary for static CLOs. This imposes an unnecessary and added expense on deals, which themselves already have challenging economics.
Additional Obstacles
Second, some more bad news. The Updated FAQs included some additional obstacles as far as CLOs are concerned:
More Discretion, More Uncertainty. The CLO market, like the broader ABS market, functions best when the rules of the game are clear. Unfortunately, the Updated FAQs endow the New York Fed with a considerable amount of discretion in deciding whether key terms of the program have been satisfied:
- Collateral Eligibility. The New York Fed has sole discretion to reject a security as TALF-collateral, even if the security meets the stated collateral eligibility requirements.2
- Price Validation. The Updated FAQs describe a process of price validation for CLO securities prior to the TALF loan settlement date which allows the New York Fed to independently check the “reasonableness” of the price of a CLO security before accepting it as collateral.3 The New York Fed also may reject a loan request on the basis of the price of the related collateral.
For a buyer considering whether to purchase a CLO security (which otherwise satisfies all of the objective criteria of the program), not knowing whether such security will be rejected by the New York Fed, significantly complicates its investment decision. In fact, many buyers of TALF-eligible securities are expected to be funds which are established primarily to invest in TALF-eligible securities and enter into TALF financing for such securities (such funds, “TALF Funds”). The economics of these TALF Funds assume that financing with the TALF program will be secured for all or most of their investments; thus, this additional layer of uncertainty may inadvertently end up hampering the very type of TALF Fund capital formation that made TALF 1.0 such a success. Further, this uncertainty for a TALF borrower will, in turn, create uncertainty for CLO managers as to whether or not they should undertake to structure a TALF eligible CLO.
More Liability for CLO Managers. The issuer and sponsor of a TALF-eligible security must ensure that a signed certification is included in the offering document indicating, among other items, that (i) the security is eligible collateral, (ii) (a) the offering document and (b) the offering document, taken as a whole together with all information provided to any NRSRO, does not contain any untrue statement of material fact or omit to state a material fact necessary in order to make the statements therein not misleading, and (iii) the sponsor has executed and delivered an indemnity undertaking to the TALF SPV and the New York Fed indemnifying them for any losses they may suffer if such certifications are untrue. Unfortunately, the Updated FAQs state that the CLO manager will be considered the “sponsor” for these purposes, even if the CLO manager is not the sponsor for purposes of risk retention rules. Although they attempt to distinguish the “sponsor” analysis from the risk retention rules, the same fundamental disconnect apparent in the risk retention rule making process is present here in that important differences between CLO managers of broadly syndicated loans (who select a portfolio of loans for acquisition from third parties in accordance with characteristics determined by the investors) and traditional ABS servicers (who originate a pool of collateral and use the securitization process as a form of on-balance sheet term financing) are being ignored. We expect that CLO managers of broadly syndicated loans4 will be hesitant to assume this type of liability—especially in light of marginal management fees charged in static CLOs. Furthermore, CLO managers of broadly syndicated loans may struggle to ascertain the amount of diligence necessary on the loans to get comfortable with required representations, given the CLO managers’ lack of involvement in the origination process of those loans.
Data Sent to NRSOs. Issuers of CLOs that are TALF collateral must provide all “data” on the CLO or its underlying exposures that the issuer provided to any NRSRO. “Data” includes any information prepared by or on behalf of the issuer specifically for presentation to the applicable NRSROs (the “rating agency book”), plus any information provided by or on behalf of the issuer to the applicable NRSROs relating to (i) underlying assets of the CLO, (ii) structure of the CLO and (iii) the issuer, sponsor, servicer or originators of the CLO. Although such data does not include oral communications with NRSROs, such data can include emails with NRSROs if such emails contain substantive information that would otherwise constitute “data” as described in the Updated FAQs. Additionally, the issuer must provide a written waiver or consent to every NRSRO to which it has provided “data” on the security or its underlying exposure, permitting such NRSRO to share its view of the credit quality of the CLO and its underlying exposures with the New York Fed.
Accountants’ Reports. In the case of TALF-eligible CLOs, a nationally recognized certified public accounting firm retained by the issuer must provide to the New York Fed an agreed-upon procedures report with respect to factual matters related to the TALF eligibility criteria. Also, if an agreed-upon procedures report is delivered to the initial purchaser in connection with the issuance of a TALF-eligible CLO, such agreed-upon procedures report must also be provided to the New York Fed. These reports must be submitted to the New York Fed on the same day the issuer furnishes such reports on Form ABS-15G. However, these accountants’ reports are typically not shared with outside parties. In order to satisfy this requirement, CLO managers will have to negotiate exceptions with the accounting firm, which can be a process unto itself.
A Few Bright Spots
Notwithstanding the above, there were a handful of helpful clarifications in the Updated FAQs:
More Liability for CLO Managers. The issuer and sponsor of a TALF-eligible security must ensure that a signed certification is included in the offering document indicating, among other items, that (i) the security is eligible collateral, (ii) (a) the offering document and (b) the offering document, taken as a whole together with all information provided to any NRSRO, does not contain any untrue statement of material fact or omit to state a material fact necessary in order to make the statements therein not misleading, and (iii) the sponsor has executed and delivered an indemnity undertaking to the TALF SPV and the New York Fed indemnifying them for any losses they may suffer if such certifications are untrue. Unfortunately, the Updated FAQs state that the CLO manager will be considered the “sponsor” for these purposes, even if the CLO manager is not the sponsor for purposes of risk retention rules. Although they attempt to distinguish the “sponsor” analysis from the risk retention rules, the same fundamental disconnect apparent in the risk retention rule making process is present here in that important differences between CLO managers of broadly syndicated loans (who select a portfolio of loans for acquisition from third parties in accordance with characteristics determined by the investors) and traditional ABS servicers (who originate a pool of collateral and use the securitization process as a form of on-balance sheet term financing) are being ignored. We expect that CLO managers of broadly syndicated loans4 will be hesitant to assume this type of liability—especially in light of marginal management fees charged in static CLOs. Furthermore, CLO managers of broadly syndicated loans may struggle to ascertain the amount of diligence necessary on the loans to get comfortable with required representations, given the CLO managers’ lack of involvement in the origination process of those loans.
Data Sent to NRSOs. Issuers of CLOs that are TALF collateral must provide all “data” on the CLO or its underlying exposures that the issuer provided to any NRSRO. “Data” includes any information prepared by or on behalf of the issuer specifically for presentation to the applicable NRSROs (the “rating agency book”), plus any information provided by or on behalf of the issuer to the applicable NRSROs relating to (i) underlying assets of the CLO, (ii) structure of the CLO and (iii) the issuer, sponsor, servicer or originators of the CLO. Although such data does not include oral communications with NRSROs, such data can include emails with NRSROs if such emails contain substantive information that would otherwise constitute “data” as described in the Updated FAQs. Additionally, the issuer must provide a written waiver or consent to every NRSRO to which it has provided “data” on the security or its underlying exposure, permitting such NRSRO to share its view of the credit quality of the CLO and its underlying exposures with the New York Fed.
Accountants’ Reports. In the case of TALF-eligible CLOs, a nationally recognized certified public accounting firm retained by the issuer must provide to the New York Fed an agreed-upon procedures report with respect to factual matters related to the TALF eligibility criteria. Also, if an agreed-upon procedures report is delivered to the initial purchaser in connection with the issuance of a TALF-eligible CLO, such agreed-upon procedures report must also be provided to the New York Fed. These reports must be submitted to the New York Fed on the same day the issuer furnishes such reports on Form ABS-15G. However, these accountants’ reports are typically not shared with outside parties. In order to satisfy this requirement, CLO managers will have to negotiate exceptions with the accounting firm, which can be a process unto itself.
A Few Bright Spots
Notwithstanding the above, there were a handful of helpful clarifications in the Updated FAQs:
Timing of Ownership of TALF-Eligible Collateral. The Updated FAQs provide TALF borrowers with some flexibility as to when they acquire the collateral to back their TALF loans. Specifically, a TALF borrower does not need to own the collateral on the subscription date, so long as it intends to deliver the collateral on the loan settlement date. In addition, a TALF borrower does not need to wait for its TALF loan to settle before it buys collateral for its TALF loan. A TALF borrower may purchase securities issued prior to its TALF loan settlement date up to 30 days before its desired subscription date, as long as the acquisition settles on or before the TALF subscription date and subject to the other requirements specified in the MLSA and the Updated FAQs.
Regulatory Capital Treatment. The Updated FAQs state that the regulatory capital treatment for TALF-financed securities held by a depository institution or bank holding company are the same as those for securities that are not TALF-financed. This clarification should alleviate some concerns for depository institutions and bank holding companies considering investments in TALF-financed CLOs.
Unfinished Business
Overall, the Updated FAQs missed the mark for CLOs. They failed to fix most of the major gating items identified in our May 20, 2020 Dechert OnPoint, such as the three year non-call period. And while they did include a handful of helpful incremental clarifications, they also increased the information burdens and liabilities on CLO managers and endowed the New York Fed with broad discretion to reject otherwise fully qualifying TALF-eligible CLO collateral. Thus, in our view, the updates have a schizophrenic quality indicative of some uncertainty at the New York Fed in terms of how much, and for how long, they actually want the program used. The program also embodies a negative selection bias against CLOs and, perhaps unknowingly, by extension US corporate credit. While we do not anticipate that many CLO managers (at least of broadly syndicated loans) will opt to create TALF-eligible CLOs, the program has had the ancillary benefit of restoring at least some of the animal spirits back to the CLO market by providing a glimpse of a backstop no one hopes to ever have to use.
Dechert will continue to monitor all developments relating to the Federal Reserve's announcements closely, and we encourage our readers to follow our regular updates on our COVID-19 Coronavirus Business Impact website.
Regulatory Capital Treatment. The Updated FAQs state that the regulatory capital treatment for TALF-financed securities held by a depository institution or bank holding company are the same as those for securities that are not TALF-financed. This clarification should alleviate some concerns for depository institutions and bank holding companies considering investments in TALF-financed CLOs.
Unfinished Business
Overall, the Updated FAQs missed the mark for CLOs. They failed to fix most of the major gating items identified in our May 20, 2020 Dechert OnPoint, such as the three year non-call period. And while they did include a handful of helpful incremental clarifications, they also increased the information burdens and liabilities on CLO managers and endowed the New York Fed with broad discretion to reject otherwise fully qualifying TALF-eligible CLO collateral. Thus, in our view, the updates have a schizophrenic quality indicative of some uncertainty at the New York Fed in terms of how much, and for how long, they actually want the program used. The program also embodies a negative selection bias against CLOs and, perhaps unknowingly, by extension US corporate credit. While we do not anticipate that many CLO managers (at least of broadly syndicated loans) will opt to create TALF-eligible CLOs, the program has had the ancillary benefit of restoring at least some of the animal spirits back to the CLO market by providing a glimpse of a backstop no one hopes to ever have to use.
Dechert will continue to monitor all developments relating to the Federal Reserve's announcements closely, and we encourage our readers to follow our regular updates on our COVID-19 Coronavirus Business Impact website.
Footnotes:
1.) See the May 2020 Dechert OnPoint - CLOs and Term Asset-Backed Securities Loan Facility (TALF)—We’re Not That Desperate (Yet). For a general description of the Fed’s announcement of the TALF Program, see the March 2020 Dechert OnPoint - Federal Reserve Established Term Asset-Backed Securities Loan Facility (TALF). For a general description of the April 9, 2020 term sheet, see the April 2020 Dechert OnPoint – Federal Reserve Releases Updated Term Sheet on the Term Asset-Backed Securities Loan Facilities (TALF). For a general description of the Updated Term Sheet, see the May 2020 Dechert OnPoint - Federal Reserve Further Revises Term Sheet and Releases FAQ for the Term Asset-Backed Securities Loan Facility (TALF 2.0).
2.) The New York Fed may consider, among other factors, “credit quality, transparency and simplicity of structure.” Further, the New York Fed will not fund a TALF loan if, in its judgement, a potential borrower is motivated to request a TALF loan due to the economic interest of such borrower, or any of its affiliates, in the loans, or products or services relating to such loans, underlying a CLO, and such economic interest would impact the incentive of such borrower to independently assess the risk of investment in such CLO.
3.) Specifically, the New York Fed will compare the price reflected on the sales confirmation for the purchase of such CLO to various market data sources as of the date of such transaction (on a trade date basis). The New York Fed may utilize the services of agents to perform a valuation under various stress scenarios, and may determine a different price with respect to any purchase price that does not reflect then prevailing market conditions.
4.) In this sense, the role of CLO managers of middle market loans may be considered to be more akin to traditional ABS originators/servicers, and such CLO managers may be more in a position to undertake this exposure.
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