Slow Start Seen for Legacy TALF Program

The window has opened for TALF financing of "legacy" commercial MBS, but the program is expected to get off to a slow start.

Trading volume is likely to be suppressed at first by uncertainty about which super-senior bonds will qualify for financing and how those bonds should be valued, market pros said. Bond buyers also expressed concern because they would have to line up bridge financing for the period between settlement and the release of TALF money.

The Federal Reserve announced details late last week about how the TALF program would kick off for legacy, or seasoned, CMBS. Investors who buy eligible bonds between July 3 and July 16 can apply for a TALF loan on July 16. Subsequent loan "subscription" dates will occur monthly.

The TALF program, formally called the Term Asset-Backed Securities Loan Facility, is aimed at jumpstarting dormant securitization markets by providing low-cost financing to buyers of senior bonds. In the CMBS sector, the program has two components - one for seasoned bonds and the other for new-issue paper. The first funding period for new offerings occurred last month, although no deals were floated.

In the market for legacy bonds, a pricing disconnect has emerged between potential buyers and sellers of TALF-eligible CMBS, traders said. Super-senior bonds currently trade at about 700 bp over swaps. With TALF financing, buyers think eligible super-senior bonds will tighten to about 500 bp over swaps. But sellers point to the fact that the TALF program has driven down yields on triple-A asset-backed bonds to 8-9%, or about 350 bp over swaps.

"We think it takes some time to find the new ballpark levels that will unite buyers and sellers," said one trader in a note that was e-mailed to investors. "And that may be after the [July 16] loan subscription date for most."

One investor at a debt fund said that a spread of 350 bp would be too rich for many buyers. "If the price is still too high, the low-cost financing does not help," he said.

Under the first subscription schedule, approved TALF loans won't be funded until July 24 - at least eight days after bond purchases. That means that investors initially will have to pay cash for bonds or find bridge financing. Some trading desks are offering bridge loans to established clients, but other investors will have to fend for themselves in a historically tight credit market. And even for established clients, traders added, the cost of bridge financing is significantly higher than the cost of TALF loans, which are pegged to 100 bp over either three- or five-year swaps, depending on the term.

Meanwhile, the issue of which bonds will be eligible for TALF money remains unsettled. The Fed will consider only super-senior bonds with a current triple-A rating that aren't under review for downgrade. However, it reserves the right to disqualify even bonds in that category for perceived credit risks. Yet it has neither specified which bonds will be disqualified nor outlined specific criteria it will use to determine if bonds should be excluded.

That's a problem for investors, who have to buy bonds and apply for TALF financing without knowing for sure that the bonds are eligible. In this month's subscription, for example, investors have to apply for TALF loans on July 16, but won't be told whether their loans are approved until three days later.

The uncertainty has set off a guessing game among investors, who are expected to consider bonds only from the best-performing transactions. Citigroup's Darrell Wheeler estimated as few as 35 of the 215 fixed-rate, pooled CMBS deals floated in the U.S. since 2005 might end up being eligible.

"The Fed could 'ding' your deal and you might not see it coming," said one trader. As an example, he cited a $7.9 billion transaction (Wachovia Bank Commercial Mortgage Trust, 2007-C30) whose collateral pool includes a portion of a troubled loan on the Stuyvesant Town and Peter Cooper Village apartment complexes in Manhattan. "Everybody thinks there is a 50-50 chance right now that they could ding Wachovia C-30," he said. "If you gamble and buy it in the belief that it's 'TALF-able,' you could be in a bad position after the Fed dings it, because it will trade for less after that."

The question of how the market will learn about disqualified deals is also looming large. It appears the information will be disseminated by word of mouth, rather than by the official release of a list.

"Seems to us that if the government was trying to create a market benchmark to encourage new mortgage originations, they should publish a transparent list of the qualified bonds based on some credit criteria," Wheeler said in a report this week.

Several debt-fund managers - potential users of the TALF loans - said they were loath to be the first ones out of the gate in tapping the Fed's line. They all said they would prefer to see other parties execute a few trades first to gauge how well the program works.

In its latest announcement, the Fed dashed industry hopes that it would loosen its eligibility criteria for TALF loans. Many players had hoped the Fed would include super-senior bonds that are under review for downgrade, but it made no change. As a result, a slew of CMBS transactions that S&P put under review for downgrade two weeks ago are ineligible.

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