The following article, written by J. Benjamin Earthman and Evan Wilkoff, originally appeared in the October 2009 issue of Law Journal Newsletter’s Equipment Leasing Newsletter.
It is reprinted here in its entirety:
It is without question that, over the last decade, securitization has played a pivotal role in the availability of credit to companies in the equipment leasing and finance sector. As investors shunned the structured product markets in 2008, liquidity disappeared and new ABS issuance dried up. This phenomenon was due to, among other things, re-pricing of risk, credit quality concerns related to the underlying exposures, questioned viability of originators/servicers, and the negative public perception (be it correct or incorrect) of any association with “structured” products. Finance companies became unable to access a traditionally inexpensive and ample source of funds which, in turn, constricted their ability not only to meet the capital needs of their existing customers, but also to grow their customer base. As a result, it became increasingly necessary for those companies to curtail financing activities and utilize other sources of available funding, such as working capital lines, revolving credit facilities, non-term securitization facilities and “one-off” partial or non-recourse transactions at a time when those same credit providers were under balance sheet pressures and seeking to reduce or eliminate exposures — particularly to middle-market credits.
It is this disruption in the ultimate availability of liquidity to customers of specialty finance companies that the Federal Reserve sought to remedy with its announcement and subsequent implementation of the Term Asset- Backed Securities Loan Facility (“TALF” or the “Facility”) and the inclusion of certain equipment ABS as eligible collateral thereunder. Without doubt, the initial availability, through TALF, of quality levered returns with substantially limited downside has played a role in resuscitating the ABS market. Up to and including September 2009, more than 60 TALF-eligible transactions have come to market. Although these are certainly encouraging statistics, significant hurdles still remain for many equipment lessors seeking to access the term ABS markets. Although the investor base for the AAA classes of TALF-eligible ABS and ABS generally continues to expand from a handful of traditional buyers, such as large money managers and a number of bespoke TALF-specific investment funds, investor demand for subordinate tranches remains soft. As few prospective issuers in the equipment sector have been able to achieve the required AAA rating on their senior bonds, the term ABS market remains effectively closed to all but a handful of these issuers.
This article: 1) as a matter of background, discusses the basic economics of a TALF loan backed by equipment ABS and provides a general overview of the collateral eligibility requirements of TALF relating to equipment ABS, and 2) discusses the key hurdle highlighted above (i.e., achieving a AAA rating) prospective issuers have encountered, and will likely continue to encounter in the near term under the existing paradigm, in their attempts to structure and execute equipment ABS in the current market.
The TALF Program
TALF provides an enticing, and indeed some critics say unnecessarily enticing, incentive for investors to re-enter the equipment ABS market: The ability to leverage their purchase of AAA-rated bonds and achieve attractive levered annualized returns (which, at the outset of the program approached 25%, but are now considerably tighter — in the 3% to 20% range) with substantial protections against market risk. Through the Facility, qualified investors are able to utilize term financing provided by the Federal Reserve to lever their purchase of eligible equipment ABS on a non-recourse and non-margining basis in an amount equal to: 1) the lesser of the par or market value (subject to a limit of 110% of par) of the related bond less 2) a haircut, ranging from 5% to 9% depending on the average life of such bond, which represents the maximum amount for which the investor is at risk. (For example, to purchase a $100 million AAA-rated fixed-rate tranche of equipment paper with an average life of 3.0 years, the investor would only be required to put up $7 million, reflecting the 7% haircut, and the remaining $93 million would be funded through the Facility at an interest rate of 100 basis points over the three-year LIBOR swap rate). All principal payments on the underlying bond will be passed through to the Federal Reserve and the investor pro rata in proportion to the haircut. This is the case notwithstanding the fact that the Federal Reserve has put up the lion’s share of the purchase price and, by virtue of the non recourse nature of the facility, the investor’s downside risk at the end of the term or in the event the bond incurs a principal loss during the term of the TALF loan, is limited to its equity less principal payments received (i.e., the haircut put up initially by the investor less the pro- rata share of principal received on the bond).
The eligibility criteria for equipment ABS under TALF focuses on two areas: 1) the terms of the bond itself, and 2) the credit exposures underlying the bond. As collateral eligibility for the bond is determined solely by the settlement date for the related TALF loan, there is no impact to the investor vis-à-vis the Facility if subsequent events, such as a ratings downgrade of the bond, occur after such date.
First, with respect to the terms of the bond itself, it must be U.S. dollar denominated, cash (i.e., not synthetic) ABS issued on or after Jan. 1, 2009. In addition, the bond must be rated in the highest investment-grade rating category by at least two of the three eligible rating agencies (currently Fitch, Moody’s, and S&P) and not have a credit rating below the highest investment-grade rating category from the third such rating agency. Although TALF-loans backed by equipment ABS are due and payable in three years, there is no requirement that the remaining term to maturity of the related bond be three years or less. It should be noted, however, that such a mismatch creates refinancing risk to the investor if the relevant TALF loan matures at the three-year mark and the related bond remains outstanding.
Second, with respect to the credit exposures underlying the bond, such credit exposures must be related to equipment receivables, which are broadly defined to include loans and leases relating to business, industrial and farm equipment, as well as other equipment types (other than aircraft) that have been the subject of prior equipment ABS transactions. In addition, there are certain concentration criteria that must be satisfied with respect to the underlying exposures — 95% must be comprised of U.S. domiciled obligors and originated by U.S. entities and 85% must have been originated on or after Oct. 1, 2007. Also, eligible collateral for a particular investor may not be backed by credit exposures that such investor has, either itself or through an affiliate, originated or securitized.
Getting To AAA: The Primary Hurdle To Equipment ABS Issuance
As highlighted above, a gating item for prospective issuers seeking access to the term equipment ABS market is the ability to achieve a AAA rating on their issuances, and primarily due to capitalization and tenure, only a few issuers have been successful in this regard. Although the rating agencies assert that their ratings process has not changed materially (and experience proves this to be true), their historical approach of using long-term performance data on the underlying exposures as a proxy for future performance has become increasingly tilted toward a focus on more recent collateral history. This is a practical approach, especially given the current general economic climate, but an approach that will often increase required credit enhancement to unprecedented levels. For a well-capitalized and liquid issuer, the increased credit enhancement level may manifest itself merely in reduced profitability as leverage drops. However, for many other originators, it is an insurmountable hurdle, as their constrained liquidity and capital position will not enable them to issue at such a low leverage multiple. This reality, coupled with reduced demand for subordinate bonds, which has resulted in historically high spreads for those tranches, is a major factor contributing to the inability of many potential issuers to execute in the term ABS market at present.
Another differentiating item that investors and rating agencies have recently elevated in priority when evaluating investments and ratings, respectively, is servicer viability. Again, credit and liquidity constrained issuers may not be able to realistically project long-term viability as a servicer. This issue has contributed significantly to the have/ have-not dichotomy in the marketplace — separating those issuers that can receive a AAA rating on their bonds from those that cannot.
It remains to be seen whether TALF, with its current expiration date of March 31, 2010 for ABS, will prove to be the panacea for the ills that have befallen the ABS market and the resulting headaches for businesses and consumers seeking access to credit. However, it is our view that TALF has proven itself as a viable and well-executed program and has been generally effective in resuscitating the term ABS market for 2009 notwithstanding that significant barriers to entry remain in existence for many equipment lessors. As investor demand for TALF-eligible bonds has continued to increase in the second and third quarters of 2009, spreads have compressed and, consequently, the ratio of investors utilizing TALF to cash investors has fallen significantly and is now less than 1:2. Obviously, the extension (or not) of TALF beyond March 31, 2010, potential modifications of the Facility (e.g., a change to the Facility allowing for certain highly rated tranches below the AAA level to be eligible collateral would greatly improve term execution potential for equipment ABS issuers), general economic conditions, and ultimate investor appetite for structured credit products will help determine the future of the term ABS market.
In the interim, however, because there is limited investor demand for non-AAA bonds, the marketplace for such issuances is not particularly liquid (especially for one-off or occasional issuers) and interest costs are high. Because of the have/have- not dichotomy that has developed in the marketplace between those companies able to execute TALF-eligible issuances and those that cannot, market participants in the equipment sector should expect smaller, single-investor deals from issuers currently relegated to the sidelines to become more prevalent over time. As was common before the late-1990s, when the equipment ABS marketplace opened up to a wide issuer audience, these deals will be challenging and cumbersome to close, but an experienced structurer/ underwriter/placement agent and legal team will enable many issuers to tap this private source of liquidity in an efficient manner.
About Evan Wilkoff
Evan Wilkoff is currently a Strategic Consultant for Hembstead Capital, LLC. Evan Wilkoff focuses his consulting practice on providing capital markets and financing expertise to the Specialty Finance industry.