Andrew Smith, founder and president, and Bruce Lohman, md at Houlihan Smith & Co, discuss the valuation challenges posed by the end of TALF

In December 2009, the Fed reiterated its anticipated expiration dates of the Term Asset-Backed Loan Facility (TALF): June 30 of this year for loans backed by new-issue CMBS and March 31 for loans backed by all other approved types of collateral. The original anticipated date having been 31 December 2009, there is certainly no guarantee that the new dates won't be extended as well.

However, in the fourth quarter of 2009, non-CMBS TALF participation waned as more investors began circumventing the programme and making deals on their own terms. This independent private-sector activity is a strong signal that the Fed has made progress in restoring confidence in an ABS market that was all but frozen in the autumn of 2008.

The purpose of the TALF programme was to increase credit availability and support economic activity by promoting renewed issuance of consumer and business ABS at historically normal spread levels. Fundamentally, the TALF provides balance sheet capacity to the financial system that the private firms have been unable or unwilling to provide in the past year.

Against these goals, the TALF must be considered a measured success. Beginning with consumer ABS in March and with successful auctions each month thereafter, the TALF programme moved onto legacy CMBS in July. While TALF loans for legacy CMBS have been steadily granted, new CMBS issuance has been dormant, aside from US$72m in November. In addition, due to an overall higher demand, spreads on consumer ABS are also down substantially since peaking late in 2008.

The TALF has resulted in increased levels of new issuance for its approved ABS categories. Eligible collateral for non-CMBS TALF loans includes packaged debt within the following sectors: auto, credit card, equipment, floorplan, premium finance, servicing advances, small business and student loans. TALF loans for investment in CMBS weren't introduced until July, three months after the non-CMBS loans.

Although at times overshadowed by the Fed's balance sheet expansion plan and the March PPIP announcement, the TALF serves as an important complement to other measures introduced by various government entities during the crisis.

Many people underestimated the difficulties of establishing TALF funds, as the bureaucracy and reporting requirements are onerous. In fact, these hurdles have encouraged a revival of ABS deals apart from the TALF. Non-CMBS TALF loan requests have been declining steadily since peaking at over US$11bn in June 2009.

The TALF issued but one loan to eligible investors in January, while investors have purchased every ABS from the auto sector in the past two months without TALF assistance. This mixture of investors' new confidence and their aversion to burdensome TALF procedure has precipitated what appears to be a recovering non-CMBS ABS market.

However, comparably encouraging evidence has not been as easily found in support of the CMBS market until recently. Borrowing through the TALF for legacy CMBS has not tapered as much as borrowing for non-CMBS; this indicates that many investors are still not ready to enter the market without the Fed's low rates and non-recourse financing. This tentative behaviour is likely due to disheartening data from the sector.

In December 2009, delinquency rates for loans underlying CMBS exceeded 6% for the first time ever (see SCI issue 167). Jefferies & Co analysts say that rate could climb to between 9% and 14% by the end of 2011.

To add to the stress, US$40bn of CMBS is due to mature this year. That's more than twice the value of new CMBS that Barclays Capital expects to be sold over the same period.

The good news for CMBS is that after 18 months of dormancy, new deals are finally happening. Recently, Goldman Sachs and Developers Diversified Realty Corp arranged a US$400m deal with some TALF assistance. Two fully private CMBS deals have also been executed: JPMorgan-Inland Western Real Estate Trust Inc executed one worth US$500m, and Bank of America and Fortress Investment Group teamed up for a US$460m issuance (SCI passim). It's also been reported that RBS and Deutsche Bank are planning to get into the market.

Structural features impact valuation analysis
As we approach the anticipated date of TALF's termination, the managers of TALF funds are entering a new phase of financial reporting requirements and analysis. While the basic requirements for TALF funds reporting are reasonably straightforward, the programme's terms and conditions present some interesting questions going forward. As with many investment funds, the accounting literature applicable includes recently amended Topic 820, 'Fair Value Measurements and Disclosures'; FAS 157, 'Fair Value Measurements'; and FAS 159, 'The Fair Value Option for Financial Assets and Financial Liabilities'.

The TALF programme provides three essential attributes that the private financing markets have been unable to provide during this period of credit and liquidity stress. First, the TALF programme provides leverage for purchases of highly rated assets in a period of rapid deleveraging. It can provide six- to 20-times leverage, depending on the type of collateral provided.

Second, the TALF programme provides term financing, which allows investors to avoid rollover risk on various asset categories. Lastly, the TALF programme provides protection against negative economic outcomes, making the US federal government the ultimate obligor.

This last important feature of a TALF loan is an implied put option to the Federal Reserve Bank of New York (FRBNY). Under the programme, the FRBNY will provide non-recourse financing to any eligible borrower owning eligible collateral.

If the borrower is unable to repay the TALF loan, the FRBNY will enforce its rights to seize the underlying collateral. In essence, with some minor clarifications for violations of representations and warranties, any TALF fund cannot lose more than its initial collateral posting (i.e., its equity contribution) and administrative fees. The FRBNY does not at any point call for additional collateral or margin posting.

The application of Topic 820 and FAS 159 standards as it applies to assets appears to be relatively straightforward compared to the liabilities evaluation. From a liability perspective, if FAS 159 is elected, the fund may choose to value the debt payable to the FRBNY at fair value.

TALF funds likely will work with outside valuation firms and auditing firms to develop internal models to value debt facilities with little observable market data and substantial restrictions on transferability. As FASB continues to develop guidance on how fair value models apply to liabilities, accountants and financial advisors will need to develop appropriate models to maintain consistency with ever-evolving practice. One possible outcome is the development of methods to limit the reporting of negative equity model solutions, given the inconsistency of such presentation with the non-recourse nature of the FRBNY debt facility.

The TALF expiration dates present unique questions about the valuation of the balance sheet of any TALF fund. While operational, the market reference for TALF liabilities is other TALF fundings. Each month, the programme effectively validates the existing funding level as market-appropriate.

At expiration, however, it is not currently anticipated that privately available funding sources will match the TALF's generous terms, conditions and spread levels. Market reference spreads therefore may be substantially wider, implying that the liability structure may have experienced an implied gain. Again, as the FRBNY develops a withdrawal or programme termination strategy, valuation professionals must be prepared to work with clients on modifications to valuation models to reflect past market inputs.

Conclusion
The TALF programme has been a success to date, as measured against the programme goals of reviving the securitisation markets. However, the extent to which TALF is simply a leveraged bandage in a world of nuclear deleveraging is unclear. As evidenced in the first 11 months of the TALF programme, we anticipate the FRBNY to continue to revise the terms and conditions in order to align incentives that will be necessary to implement an orderly withdrawal from being the world's largest repo desk.