COMMENTARY. CREdit FOR CONsuMERs ANd BusiNEsses

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1 March 2009 JONES DAY COMMENTARY The FedERAl ResERve s TERM AssET-BACked securities loan FACiliTY ( TALF ) ExpANding New CREdit FOR CONsuMERs ANd BusiNEsses In 2008, issuances of asset-backed securities ( ABS ) declined by approximately 82 percent, with adverse effects on the availability of consumer credit in the auto, credit card, and student loan sectors. 1 The Federal Reserve reports that ABS issuance has been nonexistent since October Prior to this time, it is estimated that about 25 percent of all non-mortgage consumer credit had been funded by securitizations in recent years. The Term Asset-Backed Securities Loan Facility ( TALF ), where the first loans closed March 25, 2008, is designed to jumpstart the issuance of ABS by providing loans to eligible borrowers to finance their purchase and ownership of such ABS. improved the availability of credit and lowered the costs of credit to consumers and businesses. It also notes: Many traditional investors for AAA-rated ABS have exited the market. Investors have suffered substantial mark-to-market losses in ABS investments, and their ABS portfolios are less liquid and less valuable. Investors, such as hedge funds, have been unable to obtain funding from banks and broker-dealers for ABS investments. As a result, the availability of credit has decreased and interest rates have increased. The Treasury s March 3, 2009, White Paper on the Consumer and Business Lending Initiative (the White Paper ) acknowledges that securitizations have TALF is intended to promote new credit extension and to stimulate the economy by providing credit to eligible borrowers to purchase TALF-eligible ABS. 1. Ellen Simon, Meltdown 101: Asset-backed Securities Comeback?, Associated Press (January 2, 2009); Thomson Reuters, Debt Capital Markets Review (Fourth Quarter 2008), available at PDF/financial/league_tables/de/2008/4Q08_debt_capital.pdf (last visited February 10, 2009) Jones Day. All rights reserved. Printed in the USA.

2 Eligible Borrowers Any U.S. company that owns eligible collateral may apply for TALF lending. A U.S. company is defined as (i) a business entity or institution that is organized under the laws of the United States or a political subdivision or territory thereof ( U.S.-organized ) and conducts significant operations or activities in the United States (regardless of whether any such entity has a parent company that is not U.S.- organized), including any U.S.-organized subsidiary of such an entity; (ii) a U.S. branch or agency of a foreign bank (other than a foreign central bank) that maintains reserves with a Federal Reserve Bank; or (iii) an investment fund that is U.S.- organized and managed by an investment manager that has its principal place of business in the United States. A U.S. company excludes any entity that is controlled by a foreign government or is managed by an investment manager controlled by a foreign government. Eligible borrowers will be required to interface with the Federal Reserve Bank of New York ( FRB-NY ) through a securities broker-dealer that is a primary dealer in government securities (each, a Primary Dealer ) and where the borrower has an account. Primary Dealers act as agents for eligible borrowers for all aspects under TALF and bind them to the TALF loan documentation, including the FRB-NY s Master Loan and Security Agreement ( MLSA ). On February 17, 2009, the Securities and Exchange Commission granted Primary Dealers a limited exemption from the Securities Exchange Act of 1934, Section 11(d) s prohibitions on underwriters arranging credit in connection with new securities offerings to allow Primary Dealers to facilitate TALF loans to purchase new issue, eligible ABS. Features of TALF Loans The FRB-NY will lend up to $200 billion under the TALF program, although an expansion to up to $1 trillion is possible, through monthly offerings of TALF loans. Eligible borrowers must use a primary dealer to access TALF funding and deliver eligible collateral to the FRB-NY s custodian on the eligible borrower s behalf. An administration fee for each TALF loan of five basis points of the loan amount will be payable to the FRB-NY on the TALF loan s settlement date. TALF loans are nonrecourse, except for breaches of the borrower s representations, warranties, and covenants. The loans will be secured only by the eligible ABS collateral and will not be marked-to-market or subject to margin call requirements. The minimum TALF loan will be $10 million. Loan amounts will be calculated by determining the market value of the eligible collateral minus a collateral haircut. Collateral haircuts, established by the FRB-NY, will be applied to each type of eligible collateral based on the risk associated with, and the expected lives of, the eligible ABS securing each TALF loan. The TALF loans will have three-year terms. Any principal payments received will be allocable between the borrower and the FRB-NY based on the original TALF loan-to-value ratio. Interest on TALF loans will be payable monthly. Borrowers may pick fixed or floating interest rate TALF loans, although fixed and variable rate ABS must be pledged against fixed and variable rate TALF loans, respectively. The interest rate on TALF loans secured by ABS backed by federally guaranteed student loans will be 50 basis points over one-month LIBOR. The interest rate on TALF loans secured by SBA Pool Certificates will be the federal funds target rate plus 75 basis points. The interest rate on TALF loans secured by SBA Development Company Participation Certificates will be 50 basis points over the threeyear LIBOR swap rate. For TALF loans secured by other eligible fixed-rate ABS, the interest rate will be 100 basis points over the three-year LIBOR swap rate. For TALF loans secured by other eligible floating-rate ABS, the interest rate will be 100 basis points over one-month LIBOR. TALF loans may be prepaid without penalty, in whole or in part, at the option of the borrower. Generally, collateral may not be substituted during the term of a TALF loan. If any collateral becomes ineligible, eligible collateral must be used immediately to reduce the principal amount of the TALF loan in proportion to the loan s original loan-to-value ratio. If the ABS collateralizing a TALF loan mature before the TALF loan s scheduled maturity, the TALF loan will be due and payable upon the maturity of the related ABS. TALF loans may be assigned to other TALF eligible borrowers at any time new TALF loans are being made, subject to FRB-NY approval. The FRB-NY began accepting TALF loan subscriptions from eligible borrowers on March 17, 2009, and the first funding occurred on March 25, The FRB-NY will award the 2

3 loans to eligible borrowers based on a monthly competitive sealed-bid process. The next application date for TALF loan subscriptions is April 7, 2009, and the funding for such subscriptions is scheduled for April 14, On each loan subscription date, bidding borrowers may request one floating-rate and one fixed-rate TALF loan by indicating for each loan (i) the eligible collateral they expect to pledge, (ii) the desired loan amount, and (iii) the desired interest rate format (fixed or floating). The FRB-NY may declare any bid ineligible at its discretion. Eligible Collateral Eligible collateral for TALF loans must meet the following criteria: U.S. dollar-denominated cash ABS with a long-term credit rating of AAA from two or more of S&P, Moody s, or Fitch, with no rating less than AAA from any of these rating agencies.; The ABS must be issued on or after January 1, 2009 (excluding SBA Pool Certificates or Development Company Participation Certificates, which must have been issued after January 1, 2008). The ABS must include any of the following collateral, where at least 85 percent of the dollar amount of the receivables in the ABS were originated consistent with the dates specified below: credit card receivables (consumer and commercial) and certain small business loans (guaranteed by the Small Business Administration) originated on or after January 1, 2008 (eligible credit card ABS must refinance existing credit card ABS that mature in 2009). auto loans (cars, light trucks, motorcycles, and recreational vehicles, as well as commercial, governmental, and rental fleets) originated on or after October 1, 2007, with an expected life of no more than five years (eligible auto ABS must refinance existing auto ABS that mature in 2009). floorplan loans to finance dealer inventories originated on or after January 1, 2009, with an expected life of no more than five years (eligible floorplan ABS must refinance existing floorplan ABS that mature in 2009). leases of vehicle fleets. equipment loans (including retail loans and leases relating to business equipment) originated on or after October 1, 2007, with an expected life of no more than five years. student loans (federally guaranteed and private) with a first disbursement date on or after May 1, residential servicing advance receivables originated on or after January 1, 2007, with an expected life of no more than five years. Four of these ABS classes were added on March 19, 2009, and a number of other asset classes are being reviewed by the FRB-NY. ABS eligible for TALF loans must be cleared through The Depository Trust Company. In addition, 95 percent or more of the credit exposures underlying eligible ABS must be exposures to U.S.-domiciled obligors. Resecuritizations, synthetic ABS, and CDOs are not eligible TALF collateral. Eligible collateral will not include ABS where the credit rating is based on the benefit of a third-party guarantee or ABS that have been placed on review or watch for a downgrade by a nationally recognized rating agency. Eligible collateral pledged in exchange for a TALF loan may not be replaced or substituted at a later time by additional or different eligible collateral. Collateral Haircuts Preliminary collateral haircuts are based on the riskiness and the expected lives of the ABS. They range from 12 percent to 16 percent for auto floorplan loans, auto rental fleets, and residential mortgage servicing advances to 5 percent to 6 percent for SBA loans and government guaranteed student loans. For ABS benefiting from a government guarantee with average lives beyond five years, haircuts will increase by one percentage point for every two additional years of average expected life beyond five years. For all other ABS with average lives beyond five years, these haircuts will increase by one percentage point for each additional year of average life beyond five years. FRB-NY Funding The FRB-NY has been granted the authority under Section 13(3) of the Federal Reserve Act to lend up to $200 billion under TALF. A special purpose vehicle ( SPV ) has been or 3

4 will be formed, and it will purchase and manage any assets received by the FRB-NY in connection with defaults or otherwise under any TALF loan. The SPV will purchase such assets at a price equal to the TALF loan amount plus any accrued but unpaid interest. The United States Department of the Treasury (the Treasury ), using Troubled Assets Relief Program ( TARP ) funds, will purchase subordinated debt issued by the SPV to finance the first $20 billion of asset purchases. If more than $20 billion in assets are purchased by the SPV, the FRB-NY will lend additional funds to the SPV to finance such additional purchases. The FRB-NY s loan to the SPV will be senior to the SPV s TARP subordinated debt and will be secured by all the assets of the SPV. Even though TARP funding is being used indirectly and contingently for TALF, the FRB NY has stated that the executive compensation restrictions applicable to TARP recipients will not apply to TALF sponsors, underwriters, and borrowers solely as a result of their TALF participation. The aggregate size of the TALF appears driven by the amount of TARP funds committed to the SPV, with a 10-to-1 leverage of such funds. Randall, U.S. Treasury: $134.5 Billion Left in TARP, The Wall Street Journal (March 28, 2009), reported that the Treasury has indicated that it would invest $95 billion in TALF, thereby limiting TALF to a total program of $950 billion. Of this, $25 billion may be allocated to support TALF loans to participants in the Treasury s Public-Private Investment Program s ( PPIP ) Legacy Securities Program. Proposals by the Financial Accounting Standards Board ( FASB ) to amend Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, as amended ( FAS 140 ), and FASB Interpretation No. 46R, Consolidation of Variable Interest Entities ( FIN 46R ) are pending. The amendment to FAS 140 would remove special accounting rules for Qualifying Special Purpose Entities, or QSPEs, which may result in financial institutions being required to move hundreds of billions of dollars of securitized assets back onto their balance sheets. With respect to the proposed amendment to FIN 46R, the FASB would require financial institutions to perform additional assessments to determine whether assets and liabilities of certain special purpose entities should be included on their financial statements. The proposed changes to FAS 140 and FIN 46R are scheduled to be effective for fiscal years beginning after November 15, These amendments may make it more difficult for financial institutions to maintain or establish sales accounting treatment in connection with transfers of financial assets in securitization transactions. This would have significant adverse effects on the financial statements and capital needs of such financial institutions, since securitized receivables would be consolidated on their balance sheets as assets and the related debt issued to third-party investors would be added to their liabilities. See, for example, Saha- Bubna, Accounting Rule May Block Capital for Credit Card Issuers, The Wall Street Journal (March 27, 2009). How Long Will New TALF Loans be Made? The TALF will make loans available to eligible borrowers until December 31, 2009, subject to extension by the Federal Reserve. Securitization Issues Key advantages to securitizations are removing assets from the originator s balance sheet and freeing capital and cash to originate new loans. These aspects are also critical to the TALF achieving its goals of making credit more available to consumers and businesses. Issues for TALF Participants The following issues should be considered: ABS issuers and underwriters will want to structure and document ABS to meet TALF requirements, and they must obtain by PCAOB registered accountants certifications to meet TALF eligibility rules. Investors should evaluate the TALF MLSA and compare the terms and cost of any TALF borrowings with the pricing of the ABS they intend to purchase, and other financing alternatives. Investors need to work closely with their Primary Dealers to become precertified TALF borrowers so that they can access TALF quickly. 4

5 TALF facilitates the issuance of new ABS but does not address existing ABS. The Legacy Securities Program announced by the Treasury on March 23, 2009, as part of the PPIP initiative, is expected to provide alternative financing for eligible nonagency residential and commercial mortgage-backed securities issued prior to 2009 and that originally had a AAA rating from two or more national ratings agencies. The interaction of TALF and the Legacy Securities Program is to be determined. The FRB-NY has the right to conduct on-site inspections of TALF borrowers. Primary Dealers must apply their internal customer identification and due diligence procedures to each prospective TALF borrower and have substantial compliance obligations under TALF. Where the Primary Dealer is an underwriter of ABS, the MLSA seeks to hold the Primary Dealer responsible to the FRB-NY for the material accuracy and completeness of the ABS offering materials. Primary Dealers and their affiliates may not enter any transaction that hedges against loss specific to securities financed by TALF, including credit default swaps and correlative hedges, such as short sales of the ABX index. Issuers and sponsors of ABS cannot enter into transactions designed to hedge investors risks on ABS purchased with TALF financing. Broad portfolio hedges are permitted, however. Conclusions TALF seeks to make more credit available to consumers and businesses by reducing the financing costs of investors in TALF-eligible ABS, thereby stimulating investor demand for eligible ABS. Therefore, TALF focuses on newly issued ABS. TALF is available to a broad range of investors with respect to eligible ABS, regardless of the originator or sponsor. In contrast, the PPIP s Legacy Securities Program will finance older ABS currently held by financial institutions, as defined by Section 3(5) of the Emergency Economic Stabilization Act of 2008 ( EESA ). TALF will have a role in the PPIP, but the PPIP will have various other terms, costs, and oversight not applicable to borrowers participating in just the TALF. Issuers of ABS will need to carefully construct their ABS and document these to be TALF eligible and to provide investors, Primary Dealers, and the FRB-NY information needed for TALF borrowings. Primary Dealers have a special role and duties in acting as intermediaries between buyers of ABS seeking TALF financing and the FRB-NY. Potential borrowers will need to carefully consider the TALF process and terms, and consider the terms of the TALF Certification of Eligibility and the TALF MLSA. Investors will also want to carefully evaluate the ABS offering documents to determine the credit quality of the underlying loans and the expected lives and prepayment assumptions of the ABS, since these will affect the collateral haircuts under TALF. The interest rate spreads on TALF loans will be set for each monthly funding. TALF was first announced on November 25, 2008, and the first transaction closed four months later on March 25, The first TALF loans totaled $4.7 billion, comprising $2.8 billion of loans on credit card ABS, with $1.9 billion of loans on auto ABS. The TALF will continue to evolve. The TALF s major advantages over other government programs are its openness to a broad class of investors and a widening array of assets. As a Federal Reserve lending program seeking to promote new economic growth rather than to resolve existing problem assets, it may be less likely to be saddled with compensation and other restrictions imposed by Congress or financial institution regulators. Lastly, the TALF s terms and rates, and the fees payable to the FRB-NY, appear market driven and therefore more amenable to market participants than many other government programs and proposals. 5

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