- The Alternative Reference Rates Committee recommended best practices for completing the cessation of USD LIBOR, set timelines for index-cessation events and recommended fallback language for the cash market.
- New issue of securitizations backed by the secured overnight financing rate (SOFR) has been lacking. The reasons include lack of SOFR term rates and liquidity and lack of credit sensitivity for SOFR.
- For legacy LIBOR securitized products, creating effective fallback provisions is the ongoing challenge.
USD 8.3 Trillion in Cash Instruments Tied to LIBOR
Source: SIFMA
Progress So Far
The Alternative Reference Rates Committee (ARRC),2 has published its 2020 objectives containing detailed timelines for, among other things, supporting SOFR use and liquidity; market infrastructure and operations; contractual fallbacks; and legal, tax, accounting and regulatory clarity.
The ARRC and International Swaps and Derivatives Association (ISDA) have also finalized their approach to LIBOR discontinuation, including "Index Cessation Event" and "Index Cessation Effective Date," and recommended best practices. The ARRC has identified SOFR as the best-practice replacement reference rate. To support the transition to SOFR, the ARRC developed the "Paced Transition Plan," with specific steps and timelines designed to encourage adoption of SOFR.3
For new contracts, the ARRC has finalized the recommended fallback language for the cash market, which is similar to that used by ISDA for derivatives, except that there is a broader "waterfall" of term and spread. For the waterfall-based approach, the ARRC recommends a static spread adjustment that would be fixed at a specified time at or before LIBOR's cessation and would reflect the historical median of the difference between LIBOR and SOFR over a five-year lookback period. The ARRC recommends the spread adjustment to occur instantaneously for floating-rate securities, including asset-backed securities (ABS) and corporate loans. For consumer loans and mortgages, the ARRC recommends a one-year transition period where the spread adjustment is linearly interpolated.4
The transition to SOFR from LIBOR affects an array of instruments,5 chiefly:
- Agency adjustable-rate-mortgage (ARM) MBS, collateralized mortgage obligations and credit-risk-transfer (CRT) and ARM mortgage loans
- Agency commercial MBS (multifamily ARMs and MBS)
- Collateralized loan obligations (CLOs) and leveraged loans
- ABS of floating student loans, credit cards and some auto loans
Major Challenges Ahead
To date, there have been very few issuances of new SOFR-indexed securitizations and related loans. A recent survey from the Financial Stability Board and Basel Committee on Banking Supervision cited many obstacles for the overall LIBOR-SOFR transition; the top two are lack of term rates and liquidity for SOFR. For example, the lack of credit sensitivity of SOFR versus LIBOR handicaps usage of the new reference rate for regional banks' asset/liability management. Instead, they are pursuing alternatives to SOFR, such as AMERIBOR or the ICE Bank Yield Index. The recent near-zero interest rates do not help either with development of SOFR derivatives, including term SOFR.
Creating fallback provisions for legacy securities and loans is also challenging. Many legacy securitized products and related loans do not have robust fallback language to effectively address discontinuation of LIBOR (some only address temporary LIBOR disruption), and it is very difficult to amend. Many details regarding fallback provisions for legacy securitizations and loans have not yet been unveiled, creating difficulties for transition preparation by analytics and technology operations.
For example, many student-loan securitizations fix the interest rate at the last LIBOR rate and some credit-card ABS make no provisions for permanent LIBOR discontinuation. Modifying ABS documentation to contend with potential LIBOR termination is difficult, as documents typically require the impractical 100% investor consent for interest-rate modifications. To this end, the ARRC on March 6 released a proposal for New York state legislation for USD LIBOR contracts. However, legal and regulatory issues at the federal and interstate level can be complex and fraught with difficulties.
Given these difficulties, the potential deadline at the end of 2021 for LIBOR transition presents tremendous challenges for securitization investors and analytics providers.
1 Quarles, R. "Introductory Remarks." Federal Reserve Board, July 19, 2018.
2 The ARRC is a group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York in cooperation with key federal agencies. See "ARRC Announces its Key Objectives for 2020." ARRC, April 17, 2020.
3 "Transition from LIBOR." ARRC.
5 "SOFR Primer: The transition away from LIBOR." SIFMA, July 15, 2019.
6 "LIBOR Transition Playbook." Fannie Mae and Freddie Mac, August 2020.
7 "ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans." ARRC, June 30, 2020.
8 "Supervisory issues associated with benchmark transition." Financial Stability Board and Basel Committee on Banking Supervision, July 9, 2020.
9 "Small banks tell Fed its Libor replacement doesn't work for them." American Banker, Feb. 27, 2020.
10 "ARRC Releases a Proposal for New York State Legislation for U.S. Dollar LIBOR Contracts." ARRC, March 6, 2020.
Further Reading
4 “Summary of ARRC’s LIBOR Fallback Language.” ARRC, November 2019.
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