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Risks for legacy securitizations in the LIBOR transition

| September 27, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The global effort to move away from LIBOR after 2021 has probably moved faster and further than many suspected when the UK’s Financial Conduct Authority first announced it. But the process may be saving the hardest part for last. The effort has largely focused so far on replacing LIBOR in new transactions, but no market arguably has a bigger challenge with existing transactions than securitization. A sizable share of LIBOR-indexed securitizations last beyond 2021, and the mechanisms for replacing the index are variable and rigid.

No market, beyond some categories of consumer loans, has a longer tail of LIBOR exposure beyond 2021 than securitization (Exhibit 1). MBS, ABS and CDOs each show 40% to 50% of recent exposures lasting beyond 2021, with CLOs showing nearly 75%. Other major markets have exposure of 35% or less.

Exhibit 1: Securitization has substantial exposure to LIBOR beyond 2021

Note: Data shows percent of gross notional exposures as of year-end 2016 that last beyond 2021. Based on The Alternative Reference Rates Committee, Second Report, March 2018, Table 1, available here.

Most securitizations never anticipated a permanent end to LIBOR. Although the language governing LIBOR settings varies across securitizations, may follow a common waterfall: set the index off of the British Bankers Association official LIBOR mark, set the index off readings from major UK or European banks, set the index off readings from New York banks and, if all else fails, revert to the last LIBOR setting. Reverting to the last LIBOR setting would obviously convert many securitizations from floating- to fixed-rate. The potential change in asset value and interest rate risk, and the potential for conflict of interest between different classes of a securitization, are clear. It would not be pretty.

The mechanisms in most securitizations for negotiating changes also vary across deals. For most MBS and ABS, any change that would affect deal cash flows must be approved by all investors. The rules across CLOs vary widely. An informal and unsystematic shows some CLO documents requiring unanimous consent from all investors, some a majority of interests in each deal class, some a majority of interests in a controlling class and some a majority of interests in the ‘AAA’ class.

Possibly more problematic than differences in the amendment process is the rigid process for communicating among interested investors. Most securitizations rely on DTCC for that, and only a deal trustee has authority to communicate to investors through DTCC. DTCC, in turn, sends communications to a range of securities custodians who then pass it on to investors. Assuming the communication reaches a decision maker, an investor that objects to a proposed change in the index has no way to communicate back through DTCC directly to other investors. The investor would have to contact the trustee and persuade the trustee to relay any objections or suggests. Negotiation becomes a process of iterating through DTCC, which could require a long timeline.

Investors in existing securitizations would have to negotiate a potentially wide range of details even if SOFR were the preferred LIBOR substitute. If no forward market existed after 2021 in term SOFR, investors may have to agree on a backward looking window. A backward window would involve decisions about opening and closing conventions for the window before resetting the coupon, handling the rate over weekends, using a simple average of SOFR in the window, a compound average or a median. If a forward market existed after 2021 in term SOFR, investors would still have to agree on the fair spread. Iterations on these details could be extensive.

Based on the number of speaker panels at the recent ABS East conference in Miami that directly or indirectly addressed the LIBOR transition and based on the conversations in the hallways, the securitization market is starting to recognize the complexity of the process. If there is an easy path, it is not clear.

At some point, investors in securitization will need to consider the risk in legacy LIBOR exposure. It is conceivable that other markets will move ahead. Derivatives counterparties often will negotiate the transition in the context of an ongoing trading relationship that could smooth the process. Borrowers and lenders in the loan market also will likely negotiate as part of a continuing relationship. Between different investors in a securitization, the relationship is largely transactional. Progress could be slow. Securitization could find itself approaching the end of 2021 without enough time to find a good solution.

* * *

The view in rates

The FOMC clearly believes another cut or two in fed funds should be enough to help growth and eventually tip inflation back towards its 2% target. The market still thinks the Fed eventually will go further. The rates of inflation and growth implied by 10-year notes and TIPS remain relatively low, and the curve remains relatively flat. Fundamentals suggest much better growth, and the Fed still has fed funds, forward guidance and QE left to fight low inflation. Trade has become the favored bogey for explaining the gap between Fed and markets, and trade is an influence difficult to predict. The best position: neutral on rates.

The view in spreads

The market has done a far better job of pricing a Fed inclined to create easy financial conditions, and most credit spreads have tightened. MBS has lagged credit. Financial conditions have eased since early August, according to most benchmarks, with lower rates and recent stock market gains contributing. The market sees another cut in fed funds by December. Low rates should help cash flows on corporate and consumer balance sheets.

The view in credit

The credit markets also have struggled to price risks to growth, but rather than price average growth the way rates markets might, credit has had to price for the tail event—recession. Recession seems unlikely in large part due to the readiness of the Fed, the ECB and other central banks to backstop growth. The Fed’s linking of policy to trade risk is among the more explicit examples. The drop in rates broadly and the likely continuing drop in short rates have helped. Fundamental corporate credit is soft with debt-to-EBITDA elevated and EBITDA-to-interest-expense below average. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

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