TALF Requests Reach $11.5 Billion as CMBS Issues Become Eligible

With commercial mortgage securities poised to become eligible for government help later this month, investor interest in the Federal Reserve's fledging loan program to restore liquidity to frozen capital markets reached a new high in the latest round of subscription requests announced this week.

Demand for loans under the Term Asset-Backed Securities Loan Facility (TALF) reached $11.5 billion in the fourth round of requests that ended June 2 -- up from May’s $10.9 billion and a 145% increase over March, the first month of the program, according to the Fed. Investors applied for $4.7 billion in March and a paltry $1.7 billion in April as reported in CoStar Advisor a few weeks ago.

After a slow start, interest perked up in early May when the Fed agreed to the real estate industry’s request to extend the maturity terms of eligible mortgage loans from three years to five. Spreads on commercial mortgage-backed securities (CMBS) issues tightened and investor demand gained traction when the central bank on May 19 announced plans to expand the program -- which currently covers auto, credit card, equipment, small business and student debt -- to include highly rated commercial real estate mortgage securities.

The program still faces the stiff challenge of winning over skeptical financial markets -- particularly the bond rating agencies, which took heat from Congress and regulators for failing to warn investors about the earlier residential housing bubble and mortgage meltdown. In a report last week that caught the market by surprise, Standard & Poor’s warned that it is likely to downgrade tens of billions in high-quality AAA-rated securities backed by real estate loans issued over the last four years, with 90% of the securities backed by 2007 mortgage vintages likely to face rating cuts.

Re-affirming the power of the rating agencies to turn markets, the S&P report promptly caused the value of the highly rated bonds to plummet, with Citigroup estimating that CMBS issues lost $75 billion in market capitalization in the two days following the announcement. The proposed new rules "will prompt a considerable amount of downgrades in recently issued (2005-2008 vintage) CMBS," S&P said in its request for comments on the changes to its rating methodology.

Even the most senior tranches of outstanding deals are likely to be affected. "We believe these transactions are characterized by increasingly more aggressive underwriting than prior vintages," S&P said. "Furthermore, recent vintage CMBS, particularly those issued since 2006, were originated during a time of peak rents and values," and may be more affected by declines in rental income.

After months of lobbying by the real estate industry, the Fed agreed to make subscriptions available starting June 16 for TALF loans backed by newly issued CBMS backed by loans for multifamily, office, retail and other commercial property. In July, the Fed will begin accepting requests for government help in purchasing older vintage, or legacy, CMBS.

The real estate and broader financial industries believe the inclusion of legacy debt is crucial because it includes some of the largest encumbered assets that are weighing down banks, making them reluctant to lend. Government officials also hope to slow the predicted avalanche of distressed property sales by banks by making the mortgages more attractive to keep on their balance sheets.

Earlier in May, the Fed agreed to extending TALF to CMBS with five-year terms, another move deemed critical to providing liquidity, kick starting investor demand and facilitating lending in the commercial mortgage market, said Christopher Hoeffel, president of the Commercial Mortgage Securities Association.

"A five-year term is more consistent with the longer-term nature of commercial lending and will provide more flexibility to borrowers as they navigate the current real estate cycle," Hoeffel said.

In addition to a complex application and eligibility process, the lack of specificity in the TALF plan caused many financial service firms to shy away from the program in the early months, and many remain wary of government intervention, said Mike Bernstein, a partner in Grant Thornton's Financial Services practice.

"They were fearful of increased government scrutiny and restrictions, such as the prohibition of hiring foreign workers," Bernstein said. "Firms also have been hesitant to draw ire for what could be perceived as earning profits at the expense of taxpayers. There are still some concerns that if investors are seen as profiting too much from the program, the government could change the terms of the program retroactively."

TALF borrowers are subject to visits, inspections and audits of their financial records by the Fed, which has the final say in determining eligibility. But, the loans are also attractive because they’re non-recourse and not subject to mark-to-market or re-margining requirements, Bernstein added. Moreover, borrowers are not subject to the strict executive compensation rules that exist under the Troubled Asset Relief Program (TARP).

According to a report released this week by Morgan Stanley, TALF will be most beneficial to the following:

• Select equity REITs that can supplement TALF financing by tapping into liquidity and raising subordinated capital. Numerous REITs have come to market in recent weeks with subordinate debt and secondary equity offerings, or have renegotiated credit lines. "We believe REITs may be among the first to issue TALF CMBS via single-borrower transactions," the Morgan Stanley report said, citing a comment by Developers Diversified Realty in a recent conference call that it is "in the queue with one of the major investment banks to do a significant self-financing when [TALF] becomes available" to help recapitalize its portfolio of shopping centers.

• Large loan borrowers unable to source mortgage proceeds of more than $100 million from constrained portfolio lenders. To the extent that TALF can channel more funds from the capital markets than can be supported solely by balance sheet lenders, large loan financings will be prime candidates for TALF financing, Morgan Stanley said.

• Owners of lower-tier assets and those lacking strong relationships with portfolio lenders. Such borrowers have suffered the most from the disappearance of CMBS and new loan originations and are either unable to source capital at all, or have to pay mightily to do so.

• Certain insurance companies that still have an appetite for originating commercial mortgages, which may become active in originating TALF-eligible loans. Life insurers have been the traditional portfolio lenders of commercial mortgages and have sold significant balances to CMBS conduit programs. Many insurance companies have scaled back their CMBS exposure. One way back into the securitization market for those firms is to originate and securitize whole loans eligible for TALF, whose investors would purchase the AAA stack while the insurance firm would retain the B-piece. Prudential is reportedly planning a $1 billion equity fund dedicated to originating TALF-eligible commercial mortgages.

The Morgan Stanley report authored by a team headed by analyst Andrew Day said new-issue TALF has the potential to provide leverage and financing terms comparable to those being selectively offered by insurance companies -- a significant step forward for a sizable set of borrowers hindered by the inability to source loans due to lower property quality or large mortgage balances.

Many hope that TALF can blossom into a full-blown "catalyst for a virtuous cycle in which increased mortgage availability helps stabilize property prices and leads to fewer property foreclosures and liquidations," Morgan Stanley said. This utopian scenario would reduce future loan losses and prompt additional CRE lending -- perhaps even resurrecting the non-TALF CMBS market.

"While tightening credit markets, rising equity markets and mounting sightings of ‘green shoots’ warrant a consideration of this best-case outcome, we caution that obstacles such as rating agency treatment, investor yield requirements, subordinate capital requirements, execution risks in bringing CMBS deals to market, and high transaction costs will all challenge the new issue TALF CMBS program," Morgan Stanley concluded.