May 14, 2020 - On Tuesday, the Federal Reserve released an updated TALF term sheet and FAQs. An early review finds significant refinements that make the program more useable for CLOs. However, several (non-trivial!) challenges remain. We are covering both the refinements and the challenges in an LSTA “TALF: Take Two” Webcast on Friday, May 15th at 1PM (ET) and in the article below.
In the LSTA’s original TALF comment letter, we noted that for the programs to be effective they should both meet the objectives of the Fed and be workable for CLO investors and rating agencies. The Fed’s refinements do make program more workable. At the same time we believe that, economically, the TALF program remains a “Lender of Last Resort”. Bottom line: Mechanically, it is better (but still has potential show stoppers); economically, it may remain unattractive for a functioning market.
Key Mechanical Fixes: We note that TALF remains a lending facility for AAA notes of static CLOs, but we did not believe that necessarily was a show stopper. Instead, the two key gating issues discussed in our comment letter were i) the requirement that all or substantially of the credit exposures be newly issued and ii) the TALF Borrower, Issuer and Credit Exposure definitions all required them to be U.S. companies.
First, the TALF program simply wouldn’t work for CLOs if it only financed securitizations of “new” leveraged loans originated after March 2020. Unlike most other securitizations, CLOs buy pieces of loans, which take time to aggregate into a portfolio. By the time a CLO could invest in enough loans originated after March 2020 to fully ramp, the TALF window would be closed (and so, a rational CLO investor would never start providing credit under the TALF program in the first place). The TALF FAQs address this problem by requiring 95% of leveraged loans underlying the CLOs to be originated on or after January 1, 2019. This amount of existing credits could jumpstart the CLO ramping process and allow them to provide new liquidity to companies.
Second, the original definitions of TALF Borrower, ABS Issuer and Credit Exposure (loan) all tied back to their being U.S. companies. This was highly problematic inasmuch as some of these entities aren’t even companies. In the new formulation, there is no requirement that the ABS Issuer be domiciled in the U.S., but CLO manager must have its principal place of business in the U.S. CLOs also must have a lead or co-lead arranger that is a U.S. organized entity (including a U.S. branch of a foreign bank) and 95% of the underlying loans must be arranged by a lead or co-lead arranger that is a U.S. organized entity and be U.S. domiciled obligors. In general, we believe this resolves a number of our Borrower, Issuer and Credit Exposure definitional problems.
Key Remaining Mechanical Issues: Unfortunately, several issues in the mechanics of the program remain (or have arisen). First, redemption rights. No optional redemption of the ABS Securities are permitted other than “customary clean up calls” or a redemption three years after the disbursement of the TALF loan. For comparison purposes, static CLOs done after March typically have a non-call period of one year (or less). In reality, something that is, effectively, a three-year non-call period for a static CLO may be very unattractive to equity and might make the program infeasible.
In addition, the FAQs note that the TALF program is responding to ABS market dislocations and, consequently, the Fed must obtain attestations from the TALF borrower that it is unable to secure adequate credit accommodations – at rates consistent with a normal, well-functioning market – from other banking institutions. Market participants have said that TALF borrowers may be unwilling to make such attestations, and this may be show stopper.
Economic Challenges: The economics of the TALF program demonstrate that the Fed really is acting as a “lender of last resort” to address disrupted markets that cannot source funding elsewhere. The TALF loans that will be collateralized by the CLO AAA notes will be priced at 30-day SOFR+150. New issue CLOs are seeing AAA notes price around LIB+200. Thus, the difference between the rates in the private market and the TALF lending facility level is not that large. Moreover, the TALF program comes with a 20% haircut. In effect, the TALF Borrower pledges $100 million of AAA CLO note collateral for $80 million of financing. This is the highest haircut of all the asset classes and market participants say that this, combined with a lending rate close to the market clearing level, makes the financing less attractive. There are a number of other nuances in the program that will be discussed in the LSTA TALF: Take Two Webcast at 1PM ET on Friday, May 15th. But, bottom line, the mechanics of the program have improved significantly (though showstoppers remain) and the economics underline the fact that it is a rescue financing package and is meant to be utilized that way.