Securitized Products’ LIBOR Transition Picking Up Pace
- In 2021, significant progress has been made in securitized products' transition from LIBOR, including the cessation of LIBOR indexes and fixing of fallback spreads.
- The key remaining issue is fallback language for "tough legacy" products — i.e., those that will not be converted or amended before LIBOR cessation — with New York state's newly enacted law and a federal law under consideration to address this issue.
- Securitized products' LIBOR-transition analytics include application of the SOFR index and SOFR benchmark curve, as well as fallback options. The valuation of many legacy LIBOR securities is generally converging among many transition options.
Recent Key Milestones in the LIBOR-SOFR Transition
The Financial Conduct Authority and ICE Benchmark Administration on March 5 announced LIBOR's cessation, with USD overnight and 1-, 3-, 6- and 12-month LIBOR tenors scheduled to cease after June 30, 2023.1 All other LIBOR settings will cease after Dec. 31, 2021. The Alternative Reference Rates Committee (ARRC) has recommended that after June 30, 2021, there should be no floating-rate securitizations indexed to USD LIBOR.
As a result of these announcements, the International Swaps and Derivatives Association's (ISDA) fallback spreads are now fixed for all LIBOR settings. Listed below are sample USD-LIBOR spreads calculated using the fallback formula suggested in a recent white paper from the ARRC.2
Calculating Fallback Spreads
LIBOR Term | Fallback-Spread Adjustment |
Overnight | 0.00644 |
1 Month | 0.11448 |
2 Months | 0.18456 |
3 Months | 0.26161 |
6 Months | 0.42826 |
12 Months | 0.71513 |
Source: ARRC, MSCI
The ARRC's white paper outlines a model for using SOFR in asset-backed securities (ABS), mortgage-backed securities (MBS) and related products. Its recommendation is to use 30-day average SOFR with monthly reset (with flexibility to select 90-day and 180-day), set one to two business days in advance of the interest-accrual period.
On April 7, the governor of New York signed into law a bill, recommended by the ARRC, that addresses some difficult situations arising from the variety of fallback clauses.3 The legislation will override any references to a LIBOR-based rate and nullify any polling for interbank funding rates, as well as establish recommended benchmarks for contracts with no fallback language. The law also establishes the recommended SOFR-based benchmark replacement as a commercially reasonable and substantial equivalent for LIBOR and provides a legal safe harbor for parties if they follow the recommended practices. Similar federal legislation is also under consideration.4
The Challenges Ahead for Investors
As we discussed in our previous blog post on this topic, creating broad fallback provisions for legacy LIBOR securitized products is difficult. As shown below, about one-third of total current LIBOR exposures will mature after the announced timetable for LIBOR cessation, including most of the securitized-product segments. These "tough legacy" exposures remain a difficult challenge of the LIBOR transition.
Exposure to 'Tough Legacy' LIBOR Products
None | Outstanding Balance with LIBOR (in USD Trillions) | Maturing after June 2023 (in USD Trillions) |
OTC Interest-Rate Swaps | 81 | 46 |
OTC Interest-Rate Options | 20 | 12 |
Business Loans | 4.8 | 2.3 |
Consumer Loans | 1.3 | 0.8 |
Retail Mortgages | 0.1 | 0.1 |
MBS | 0.8 | 0.8 |
CLOs | 0.5 | 0.5 |
ABS | 0.2 | 0.2 |
Exposure to legacy LIBOR products maturing after the index cessation. Source: Federal Reserve, MSCI
The LIBOR transition's impact on securitized-product analytics generally falls into three categories.
- SOFR and other new indexes: With SOFR-linked securitization having ramped up significantly over the past two quarters, analytics providers will need to add and properly model SOFR and other replacement indexes (for example, the sterling overnight interbank average, or SONIA). In the table below, we used the MSCI Agency MBS Prepayment Model and MSCI Two-Factor Interest Rate Model to show the analytics for a SOFR-indexed collateralized mortgage obligation, FH 5062C BF. Valuation Examples for SOFR Index and Benchmark-Curve Changes
Security | Price | Avg Life | Yield | LIBOR OAS | Treasury OAS | SOFR OAS |
FNCL 2.5 | 103.53 | 5.61 | 1.78 | -3.09 | -12.18 | 17.14 |
FNCL 3.0 | 104.44 | 3.40 | 1.54 | 11.97 | 4.46 | 31.63 |
FH 5062C BF | 97.00 | 7.21 | 0.64 | 52.02 | 41.60 | 72.80 |
Security | Price | Avg Life | Yield | LIBOR OAS | Treasury OAS | SOFR OAS |
FH 5028B F | 99 | 3.01 | 0.63 | 62.00 | 65.65 | 79.54 |
FH 5028B F (fallback) | 99 | 3.02 | 0.63 | 62.45 | 66.08 | 80.01 |
Altogether, the developments of the first half of 2021 have provided much more clarity in how the LIBOR transition will be handled in most securitized products.
Further Reading
1“Announcements on the end of LIBOR.” Financial Conduct Authority, March 5, 2021.2LIBOR-tied contracts with maturities that extend beyond the LIBOR-cessation date will need to “fall back” on a replacement rate. For more information on the fallback-spread calculation, see: “Options for Using SOFR in New ABS, MBS, and CMBS Products.” Alternative Reference Rates Committee, March 29, 2021.3“ARRC Endorses Decision to Sign New York State LIBOR Legislation into Law.” Alternative Reference Rates Committee, April 7, 2021.4“Adjustable Interest Rate (LIBOR) Act of 2021.” 117th Congress 1st Session, April 12, 2021.
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