Should You Invest in the TALF Program?

The Term Asset-Backed Securities Loan Facility (TALF) was initiated under the Emergency Economic Stabilization Plan of 2008 as a strategy to help jumpstart the asset-backed securitization market. Under TALF, the government would provide up to $1 trillion in loans to investors to purchase qualifying asset-backed securities, including CMBS (Commercial Mortgage Backed Securities).

Investors who use TALF financing to invest in triple-A rated CMBS investors can obtain returns of as high as 12-15 percent, according to Jun Han, managing principal of the investment advisory firm of JHP Capital. “Where else can you obtain guaranteed 12-15 percent returns?” he says. “The [highest CMBS tranches] will remain attractive compared to alternative investments.”

Indeed, high returns for investing in CMBS that are supposedly backed by the highest quality, cream-of-the-crop, commercial real estate: What is not to like? To consider participating in TALF, however, investors who are not experienced CMBS investors need to become educated about the risks and rewards of investing in CMBS.

Traditionally, commercial real estate developers and investors may not have invested in CMBS, but rather in hard asset or even commercial real estate mortgages. “With CMBS, investors are not buying into the real estate, but they are buying into the capital markets. This is a very indirect way of investing in real estate,” notes Hessam Nadji, managing director, research services, at Marcus and Millichap Real Estate Investment Services.

Investors so far in CMBS under TALF are said to be money managers, fund managers and funds that are set up specifically for this purpose. Nevertheless, the TALF program is available to any U.S. company that owns eligible collateral: Eligible investors are required to be U.S. companies. Other than that, “The TALF program is open to almost any entity,” says Spencer Levy, senior managing director, Recovery and Restructuring Services at CB Richard Ellis.

Potential CMBS investors would want to consider that when the housing market tanked, residential mortgage backed securities backed by these homes suffered, to say the least. And the entire real estate mortgage backed securities market for both housing and commercial real estate virtually ground to a halt because of collapsed investor confidence.

Now, the commercial real estate market is said to be similarly on the brink of a downward spiral, with the lack of capital and lower property revenues further exacerbating the fall in CRE values, which could have an effect on CMBS. Indeed, the 30+ day delinquency/real estate owned rate on loans held in CMBS rose 0.17 percentage points to 4.06 percent between the second and third quarters, according to the Mortgage Bankers Association (MBA).

And research company REIS Inc. projects that CMBS defaults will reach 6 percent by the end of 2009, and increase even further after that. (By comparison, REIS’s CRE delinquency rate in third quarter 2008 was only 1 percent.)

On the other hand, TALF-eligible CMBS is limited to the safest, top-rated securities. According to Han, very few to none of the triple-A CMBS investments have been hit with realized losses as of early this year. And as far as unrealized losses, the second-tier “mezzanine” triple-A CMBS may have seen unrealized losses of 30 percent, and the third-tier “junior” triple-A CMBS may have seen unrealized losses of as much as 50 percent, he says. Investors need to consider these risks.

Moreover, it is no longer the case that the triple-A CMBS are being sold at great, firesale discount, as liquidity is returning to the CMBS market. For “super duper” Triple-A rated CMBS, spreads have declined from as high as 1,200 to 1,500 basis points during the worst of the market panic to 300 to 500 basis points at the beginning of this year. Nevertheless, “[The triple-A rate CMBS] still provide very, very attractive risk-adjusted returns, even though the lowest hanging fruits have been picked,” says Han. Investors just have to work harder to obtain good returns without incurring too much risk, he emphasizes.

For all its advantages, participation in TALF had a slow start. The government extended the TALF program to CMBS last year, and in July, the first round, only $669 million in TALF financing had been requested by investors to purchase CMBS (all of it for legacy CMBS). However, that number increased to $2.28 billion in August, and it was $1.4 billion in September. And $1.32 million was requested by the Dec. 14, 2009 facility.

Many industry players say the TALF program has been a success so far. A $400 million CMBS issuance last summer backed by properties in the portfolio of the shopping center REIT Developers Diversified Realty (DDR) was the first commercial property TALF-approved CMBS new issuance. Most of the TALF financing has been used by investors, however, to purchase existing CMBS issuances, rather than new issuances. “The offerings have been very successful,” observed Nadji, “They were well-subscribed to, and the reason is that [the bonds] are very low risk.”

The borrower of TALF funds has to have minimum capital means. The TALF participant is required to borrow at least $10 million for the program, and put in risk capital‑“haircut”‑of at least five percent, which translates to at least $500,000. The required risk capital differs according to the CMBS. For legacy (existing) CMBS with average life of five years or less, for example, the required base dollar haircut (or risk capital) is 15 percent of the par value of the security.

Investors who borrow funds to purchase CMBS under TALF are required to participate in the program through one of the TALF agents that have been pre-approved to act as such by the Federal Reserve Bank of New York, which administers the program. In order to participate in TALF, the investor is required to select and establish an account relationship with a TALF agent. The TALF agent, a financial institution, acts as a primary dealer and agent on behalf of the TALF borrower.

On fixed days each month, investors will be able to request one or more TALF loans based on the CMBS collateral they have delivered. The amount of loan from the New York Fed is based on the par or market value of the CMBS minus the haircut and the administrative fee. The term of the loan is three years, and also has been extended to an option of five years for CMBS collateral.

The interest rate charged on both the three- and five-year loans backed by CMBS as collateral is 100 basis points over the LIBOR swap rate for the comparable period. Han says these interest rates make for “very, very low” funding costs. Another advantage, he notes, is the term funding. The low interest rates, essentially, allow investors to leverage and increase their returns. “CMBS investors can realize very high returns if they can borrow from the Fed because this allows them to juice up their returns,” says Han.

According to Han, for example investors can purchase the triple-A security at 90 cents on the dollar, and are paid an interest of swap plus 250 basis points. If the investors can borrow from the New York Fed at swap plus 100 basis points, they can net a return at a spread of 150 basis points. Taking into account the haircut of 15 percent, they can calculate the leveraged returns are pretty substantial. “You can make low teen returns with relatively low risk to you. That’s the contribution of TALF, and as a result, CMBS prices have increased,” says Han.

For all its benefits, the downside of the TALF financing program thus far include the wait times and some degree of perceived lack of consistency in approval criteria. This lack of reliability is said to lead some investors to opt not to borrow under TALF to purchase some of the recent legacy or new CMBS issuances this year.

Investors also have to come up initially with their own capital to buy the bonds, or obtain their own financing to cover the period before they get the TALF loan. In this regard, one difficulty is that TALF may offer limited financing, says Ryan Severino, CFA, economist at REIS. The amount the investor can borrow for the bond under TALF may often fall slightly below the outstanding amount of the bond, especially given the updated lower valuations of the securities under new underwriting guidelines, he says.

REIS says that investors must also go through a waiting period of up to three weeks between purchasing the bonds and applying for TALF financing, and actually receiving the New York Fed’s acceptance or rejection. The bond eligibility requirement the New York Fed lists is that the CMBS are triple-A quality and must not be on any rating agency’s watch list for potential downgrade. But the New York Fed says that even CMBS that meet these criteria may not qualify, notes REIS. And if the TALF financing is rejected, the investors may be left with bonds with a lower value of what they paid for.

Despite some of the kinks in the program that discourage investors, overall, investors still seem to be participating in the program for acquiring at least legacy CMBS. Indeed, increasing investor interest in the TALF program may have driven down the yields for CMBS. CBRE’s Levy says that the first few investors borrowing funds to purchase CMBS were obtaining returns as high as the mid- to high-teens, compared to the returns of 10 percent or less by the end of 2009.

The TALF program is set to sunset on June 30, for legacy CMBS, and by March 31, for legacy CMBS, but industry observers say the program may well be extended considering the need for it. If the investor decides CMBS satisfies its risk returns criteria, then in TALF, “you are obtaining guaranteed funds from the government at relatively good rates,” notes Severino. “If the deals are high quality, that would be a good program.” The financing is also non-recourse, meaning investors will have only their risk capital and CMBS collateral to lose. “

Still, considering the risks of the CMBS market and the recent history of the mortgage-backed securities market, however, it is fair to say the risk-returns of CMBS‑as opposed to just an analysis of TALF‑is an analysis investors may still need to consider very carefully.

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