The first round of CMBS TALF saw no takers. However, the lackluster reception isn't indicative of a lack of appetite. Market sources said it's just a matter of dealing with a more complex asset class that has required more work and, consequently, will take more time to gather momentum under the Federal Reserve program.
"The program is very well developed, and the Fed has spent lots of time on it, but there are still some issues that need to be worked out," a CMBS expert said. Issues like aggregate risk and hedging risk make the finalization of the program challenging."
One of the reasons behind the lack of takedowns in the initial round of CMBS TALF is that assets don't exist today that are eligible for securitization under the program. The market has to create a whole new set of assets - the aggregation and origination of those assets is what is difficult.
"There is a learning curve at the New York Federal Reserve," the CMBS expert said. "The Fed wants to know how these newly originated assets are going to work, and they are creating a standard for acceptable collateral and that is going to take time." He added that originators also have to gain confidence before they can make a commitment with borrowers. It's a lot easier for originators and borrowers to get to that point of financing new pools of CMBS single-asset origination through TALF.
JPMorgan Securities analysts also said that the slow uptake on CMBS TALF is the result of event risk and of the mountain of uncertainties investors still face. The most recent came via Standard & Poor's proposed rating changes that could result in downgrades of many recent vintage super-senior bonds, which would make the securities ineligible for TALF.
The Fed has, over the course of developing its initiative, warned that it does not intend to make modifications to eligible securitizations. However, its requirement for triple-A assets could cause the eligible pool of legacy CMBS assets to dwindle. This is given the fact that the rating agencies are currently modifying their approach, which could potentially threaten the triple-A pool. "If S&P takes further action, for example, there would be few securitizations of recent vintages that would be eligible," the source said.
Older vintages are unlikely to trade because the pension funds or life insurance companies holding '04 or '05 triple-A bonds believe these bonds will pay off at par and don't have to sell today at a loss. The more recent vintages of '06, '07 and '08, which were far more liquid assets and were traded heavily by the big hedge funds, are the assets that, in the current environment, are the most likely to be affected by the rating agency revisions. The strict requirements by the Fed and the fact that CMBS faces more downgrades mean that the market would have only a few tradable bonds under the legacy program.
"Funding for longer term was a problem in Washington," another market source said. "The Fed from the beginning has resisted expanding the terms to three years. If you remember, the industry had to battle to get it to shift from one to three years and faced an even harder battle to get from three to five years."
Since then, the market has speculated on what the Fed may or may not do to salvage the program. One option that it could consider is to disregard ratings and establish its own list of acceptable collateral, although creating a list might create a dependency akin to how some investors used ratings as the sole guide for buying assets.
"You could find yourself in the situation where investors were once again buying it because it was on the list, and that would be the only reason they invested in it," the market source said. "Producing the list could mean that these investors might be less apt to do the credit work for the bond. A list would essentially devalue the need to do the work, and anything that deteriorates credit work is an unhealthy dynamic in the market."
However, there remains that group of investors that believe by making a list, the Fed will have better guidelines for these uncertain times and create the liquidity needed to get the market off the ground. "The Fed is hearing from a lot of guys, 'How will I know what bonds to buy?' But investors really need to do due diligence and bond credit work because it provides the buyer with the arsenal to distribute bonds across a wider playing field," the source said.
The Fed faces a dilemma where not producing a list would make trades far riskier and less liquid, but the production of a list would create an artificial market. "While the initial terms for legacy TALF were tied to ratings, many believe the most likely course of action may be to move away from ratings," JPMorgan analysts said. "Specifically, the TALF collateral manager could develop a list of CUSIPs they are willing to accept based upon underlying performance. This would afford the Fed the flexibility to size the program as it sees fit and reject whatever collateral it finds troubling."
JPMorgan analysts suggested that the Fed could also modify requirements for participation and allow for all super-senior securities originally rated 'AAA', or it could look at the positive reaction the market had to last week's re-remic news and simply choose to let the TALF for legacy CMBS program 'die on the vine' as current legacy TALF guidelines do not permit re-remics as eligible collateral.
To be sure, last month saw two separate "re-remic" deals that re-tranched super-senior triple-As. "The rationale behind the re-remic is to ultimately create a triple-A bond with an LTV detachment point that is equal to that which was seen in the earlier days of the CMBS market and one that the rating agencies would view as 'truly triple-A,'" JPMorgan analysts said.
Market sources said that the introduction of legacy assets to TALF was meant to help banks attract capital and become better lenders, but the success of the Fed stress tests on the banks went a long way in proving that the banks were in better health than initially believed. It has, in a way, taken away the focus on the legacy program and moved the emphasis on new issue - to help the consumer market.
"The TALF ABS program has taught us that there is a decoupling between old underwritten and newly underwritten product," one market source said. "People are saying they don't want to buy old because it's difficult to understand the risk. Even the traditional ABS investors are coming back to buy new, and they are gaining confidence in the new structures because new has more credibility."
Market players believe that it will be easier to perform financing for a single borrower with single assets because there is less aggregation of risk and no timing risk and the new terms on the new deals will favor very low leverage. According to Fed officials, new CMBS deals are in the pipeline and are expected to come to market in the coming months. "We will see deals, but it won't be the traditional CMBS origination," said Aaron Bryson, an analyst at the bank.
Despite the slow uptake on the CMBS side, what remains clear is that the TALF program has significantly improved the market conditions for consumer and certain commercial ABS markets. "The ABS market represents a significant source of funding for certain lenders and, therefore, impacts the amount of loans lenders can offer to consumers and businesses," said Bank of America/Merrill Lynch analysts. "In the current market environment, we believe some ABS still would have a difficult time accessing the ABS market at reasonable levels without TALF."
Market analysts said that once the terms are set straight, TALF is likely to have a similar impact on new-issue CMBS TALF, just not for the first two rounds of funding.
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