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Joy Zhang

Joy Zhang
Executive Director, MSCI Research

Yihai Yu

Yihai Yu
Executive Director, MSCI Research

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Are Securitized Products Ready for the LIBOR-SOFR Transition?

  • 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.

Will the securitization industry be ready for the transition from LIBOR to the secured overnight financing rate (SOFR), as LIBOR can no longer be guaranteed beyond the end of 2021? Among the estimated USD 200 trillion of financial contracts referencing USD LIBOR, approximately USD 8.3 trillion are potentially related to securitizations.1  As the securitization industry is mobilized for this project, much progress has been made. Significant challenges remain for the LIBOR/SOFR transition in securitized products, however.

 

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

Among these, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have made the most strides in the LIBOR-SOFR transition planning.

The GSEs announced the timelines for offering SOFR products and ceasing to offer LIBOR as the index for single-family and multifamily ARM loans and MBS securities.6 They also adopted and endorsed the ARRC’s recommended fallback language for reference-index selection and spread adjustment for their new securities. The plan for their legacy LIBOR securities has not yet been announced.

For the USD 1.2 trillion leveraged-loan market, the ARRC has updated recommendations regarding more robust fallback language for new originations of LIBOR syndicated loans. This recommended fallback language will begin to appear in loans originated after Sept. 30, 2020, and for LIBOR’s removal for loans originated after June 30, 2021.

For the USD 800 billion CLO/CDO market, the ARRC recommended incorporation of the fallback language by June 30, 2020. Technology and operation vendors should be prepared by the end of 2020, and CLOs should target for cessation of new issues' use of USD LIBOR by Sept. 30, 2021.

 

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.

 

 

Quarles, R. “Introductory Remarks.” Federal Reserve Board, July 19, 2018.

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.

“Transition from LIBOR.” ARRC.

4 “Summary of ARRC’s LIBOR Fallback Language.” ARRC, November 2019.

“SOFR Primer: The transition away from LIBOR.” SIFMA, July 15, 2019.

“LIBOR Transition Playbook.” Fannie Mae and Freddie Mac, August 2020.

“ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans.” ARRC, June 30, 2020.

“Supervisory issues associated with benchmark transition.” Financial Stability Board and Basel Committee on Banking Supervision, July 9, 2020.

“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.

 

 

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