July 08, 2020
Corporate Trust Alert
Author(s): Steven Hanton
On March 23, 2020, the board of governors of the Federal Reserve System (the Fed) issued a press release where it announced the establishment of the Term Asset-Backed Securities Loan Facility (TALF) to “support the flow of credit to consumers and businesses” by providing liquidity to the asset-backed securitization market. The first TALF subscription dates occurred on June 17, 2020, and July 6, 2020, and, interestingly, there have been no borrowings in the collateralized loan obligation (CLO) market. This should come as no surprise: there are reasons to doubt whether TALF will provide an effective boost to the CLO market.
A reiteration of a similar program enacted during the 2008 financial crisis, TALF relies on $100 billion dollars in funding from the Federal Reserve Bank of New York and the Department of the Treasury. Utilizing a special purpose vehicle (SPV), TALF makes non-recourse loans available to “eligible borrowers” for three-year terms, secured by pledges of “eligible collateral.” Under TALF, “eligible borrowers” are U.S. entities that (i) have significant operations and a majority of their employees in the United States and (ii) maintain an account relationship with a “primary dealer” or a trading counterparty of the Fed. “Eligible collateral” includes several types of asset-backed securities (ABS), like CLOs.
There are several issues that may limit TALF’s effectiveness for the CLO market. The first is structural—under TALF’s terms and conditions, only static CLOs, or CLOs where the asset pools remain unchanged, constitute eligible collateral. Because static CLOs are only a small piece of the CLO market in comparison to actively managed CLOs, the use of TALF is limited. Additionally, TALF’s funds are only available for borrowings covering ABS with the highest credit ratings available from a nationally recognized rating agency. Presumably, this requirement exists because the federal government is not interested in taking on credit risk, particularly in light of the non-recourse nature of TALF loans. However, by making funds available solely to the highest-rated tranches of securities, TALF serves only to boost those securities that have not experienced much in the way of weakened demand. With current downgrades of lower-rated CLO securities,  TALF’s funds might have more of an effect on the CLO market if TALF could be used for the purchase of CLO securities with lower ratings. Financial support for lower-rated tranches may prove more of a boost to demand and a signal from the Fed of its support of the CLO market.
The second issue with TALF is how it limits eligibility. For CLO securities to constitute eligible collateral under TALF, the “sponsor” of the CLO must (i) certify that the CLO securities are eligible collateral and (ii) indemnify the TALF SPV and the Fed for any losses they may incur if the sponsor’s certification is untrue. With respect to CLOs, the Fed has clarified in its FAQs (frequently asked questions) that the sponsor is the collateral manager. Additionally, for CLO securities to constitute eligible collateral, (i) the underlying leveraged loans must have been originated (or refinanced) on or after January 1, 2019, (ii) any LIBOR-based underlying loans must contain “adequate” fallback language, (iii) the CLO transaction documents have to impose specific portfolio limitations on loan categories like covenant-lite loans and second lien loans, and (iv) the transaction must adhere to additional rules with respect to permitted CLO redemption mechanics. The Fed’s requirements to qualify CLO securities as eligible collateral under TALF are stringent, and according to its FAQs, the Fed reserves the right to reject CLO securities in its sole discretion, even if they meet its specifications. Thus, there is a risk that parties may structure a transaction and undertake costs in connection with meeting the Fed’s conditions for TALF eligibility only to find themselves unable to borrow funds.
A third issue is operational. The Fed has imposed heavy disclosure requirements on TALF borrowers. According to its FAQs, the Fed will publicly disclose information on a monthly basis, including information identifying each borrower, each borrower’s material investors, and any other facility participants. A “material investor” is any party that owns, directly or indirectly, 10% or more of any outstanding class of securities of an entity, so a borrower will have to be comfortable with this level of public disclosure of its investors. Under a TALF Master Loan and Servicing Agreement, the borrower is required to make a continuous representation that it meets TALF’s eligibility requirements, so any borrower will need to implement a mechanic to monitor these requirements on an ongoing basis to remain in compliance. All TALF borrowers also have to certify that they are unable to secure “adequate credit accommodations from other banking institutions” to purchase CLO collateral, which might be based on unusual economic conditions in the CLO market or elevated rates or haircuts in the financing market, among other potential reasons.
TALF is not an easy program to navigate with respect to the CLO market. Its use is limited from the outset to cover only securities with the highest credit ratings issued by static CLOs—a small segment of the CLO market—and it imposes labyrinthine requirements with respect to eligibility for collateral and borrowers. While the funds signal support from the federal government at a much needed time, it is questionable whether they will actually be used, given the risks and costs associated with gaining access to those funds. Since the first subscription dates have come and gone without any borrowings on CLO collateral, market participants hoping to see a boost in CLO activity may be disappointed.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.
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