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Libor transition language in an agency CRE securitization

| October 10, 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.

Loan originators, underwriters, issuers and investors are stepping up efforts to prepare for the transition away from LIBOR that is expected to occur no later than year-end 2021. Fannie Mae and Freddie Mac, as underwriters and issuers, are on the forefront of developing robust yet flexible contract language in both residential and commercial mortgage loans and securitizations. A review of the LIBOR transition language in a new commercial real estate (CRE) deal from Freddie Mac provides an informative overview of how that contract language is developing.

Preparing for a LIBOR transition

The following summary points are based on excerpts from the Offering Circular Supplement for Freddie Mac’s K-F68 deal pertaining to LIBOR and a conversion to an alternate index in the underlying mortgage loans and in the certificates. All of the loans are underwritten by Freddie Mac and the securitization is new, giving Freddie Mac extensive control over the loan documentation and the Libor transition process for both the loans and securities.

All of the underlying mortgage loans in the K-F68 deal are floating rate, multifamily mortgages whose interest rates are based on 1-month Libor plus a specified spread. The pass through certificates: FHMS KF68 A, FREMF 2019-KF68 B and C, are floating rate certificates with coupon payments based on 1-month Libor plus a specified margin. The weighted average life of the pass through certificates at deal announcement on 10/1/2019 was 6.5 years.

The contract language is designed to provide Freddie Mac with the greatest amount of control over the basis risk – so that the transition from LIBOR to an alternate index in the underlying mortgage loans triggers a transition in the securities.

Executive summary

Below is a condensed version of the excerpts covering the LIBOR transition contract language. All mistakes, omissions and misrepresentations are due to the editor. Please consult the offering circular for complete and detailed information.

  • The loan documents for all of the underlying mortgage loans provide that such underlying mortgage loans will convert from an interest rate based on LIBOR to an interest rate based on an Alternate Index if a Loan Index Conversion Event occurs.
  • For all of the underlying mortgage loans, in the event of a conversion to an Alternate Index, the selection of the Alternate Index will be made by Freddie Mac at their sole discretion.
  • A Loan Index Conversion Event refers to any of the following events:

(i) the publication of the then-current Index has been permanently or indefinitely suspended;

(ii) regardless of the continued existence of the then-current Index, the use of an alternate, substitute or successor index is required by a regulator or government entity with authority to direct the actions of Freddie Mac, or by applicable law;

(iii) Freddie Mac has determined, in its sole discretion, that the then-current Index must be replaced with an Alternate Index as a result of the occurrence of one or more of the following event(s):

(a) The supervisor of the administrator of the then-current Index has announced in a public statement that (1) the publication of the then-current Index will be either permanently or indefinitely suspended, (2) there has been or will be a material change in the methodology of calculating the Index, or (3) it no longer recommends the use of the Index as an Index.

(b) Freddie Mac has determined that the use of an alternate, substitute or successor index to the then current Index has become a generally acceptable market practice in the commercial real estate finance industry regardless of the continued existence of the then-current Index.

(c) ISDA has announced that it will use an alternate, substitute or successor index to the then-current Index regardless of the continued existence of the then-current Index.

(d) Any regulator or governmental entity with authority to direct the actions of Freddie Mac recommends the use of an alternate, substitute or successor index to the then-current Index in mortgage loans purchased and/or guaranteed by Freddie Mac regardless of the continued existence of the then-current Index.

  • Upon conversion of the underlying mortgage loans to an Alternate Index, the Index used in calculating the pass-through rates for the class A, B and C certificates will also convert to an Alternate Index.
  • In the event the Alternate Index with respect to any Interest Accrual Period is less than zero, the Alternate Index for such Interest Accrual Period will be deemed to be zero.
  • The Alternate Index with respect to any underlying mortgage loan or certificate may be adjusted by Freddie Mac in its sole discretion using an Adjustment Factor to reflect a value comparable to the index being replaced, taking into consideration standards or recommendations from the commercial real estate finance industry and ISDA.
  • In determining the Adjustment Factor, Freddie Mac will take into consideration the methods generally accepted by the commercial real estate finance industry or ISDA for calculating an adjustment factor. The Adjustment Factor may be positive, negative or zero.
  • The Adjustment Factor will not be re-determined or re-designated unless another Loan Index Conversion Event or Certificate Index Conversion Event subsequently occurs.
  • The strike rate in all Interest Rate Cap Agreements will be based on LIBOR until the IBA ceases to set or publish a rate for LIBOR. Note: the LIBOR transition for derivative contracts is governed by ISDA. There are separate risk factors which cover those issues that appear in the circular but are not excerpted here.

Remarks

The Alternative Reference Rates Committee (ARRC) has made recommendations and drafted fallback contract language that can voluntarily be incorporated into new loan and securitization contracts that reference USD LIBOR. ARRC’s recommended contract language by product is available here, and includes adjustable rate mortgages, bilateral business loans, floating rate notes, securitizations and syndicated loans.

Interestingly, in some broad respects the language currently being incorporated by Freddie Mac deviates from ARRC’s recommendations, though this appears to be done in order to maximize flexibility in the definition and transition to a new benchmark interest rate. Notably there is no mention of the secured overnight financing rate (SOFR), the waterfall methodology for benchmark replacement, the choice of compounded versus average SOFR, or a replacing a forward-looking 1-month term index with a daily spot index.

The contract language will no doubt evolve over time. In its present form it seems designed to allow Freddie Mac the greatest flexibility over the choice of index, calculation of an adjustment factor from one index to another, and to some extent the timing of the transition. This seems a reasonable and conservative choice given the still outstanding questions regarding SOFR, LIBOR and the transition between the two.

Appendix A: Extensive excerpts from the offering circular

  • These excerpts are not contiguous and not necessarily quoted in their entirety. Some have been formatted for clarity and edited for brevity.
  • All bold text is from the original document. All yellow highlighting has been added for emphasis.

Apologies for the length.

Description of the mortgagesfrom page 10 of 355, page S-9 (as numbered)

The Mortgages consist of 29 LIBOR-based floating-rate mortgage loans, secured by 30 multifamily properties, including 5 manufactured housing community properties. The loan documents for all of the Mortgages provide that such Mortgages will convert from an interest rate based on LIBOR to an interest rate based on an Alternate Index if a Loan Index Conversion Event occurs. The Mortgages have an initial mortgage pool balance of approximately $795,269,498 as of October 1, 2019. All of the Mortgages are Balloon Loans.

Description of the pass-through certificatesbeginning page 27 of 355, page 7 (as numbered)

Each class of certificates identified in the table as having a pass-through rate of LIBOR plus a specified margin has a per annum pass-through rate equal to the lesser of—

(i) LIBOR (or Alternate Index) plus the specified margin for that class set forth in that table; and

(ii) (a) with respect to the class A certificates, the Weighted Average Net Mortgage Pass-Through Rate for the related distribution date minus the Guarantee Fee Rate and (b) with respect to the class B and C certificates, the Weighted Average Net Mortgage Pass-Through Rate for the related distribution date; provided that in no event will the class A pass-through rate, the class B pass-through rate or the class C pass-through rate be less than zero.

Conversion to an alternate index, from page 27 of 355, page 7 (as numbered)

Upon conversion of the underlying mortgage loans to an Alternate Index, the Index used in calculating the pass-through rates for the class A, B and C certificates will also convert to an Alternate Index. In addition, if Freddie Mac determines, in its sole discretion, that (a) applicable law requires or (b) any regulator of Freddie Mac or any governmental entity with authority to direct the actions of Freddie Mac recommends the use of an alternate, substitute or successor index to the then-current Index in mortgage loans purchased and/or guaranteed by Freddie Mac, regardless of the continued existence of the then-current Index, then Freddie Mac may in its sole discretion elect that the Index used in calculating the pass-through rates for the class A, B and C certificates will also convert to an Alternate Index.

Risk Factors, beginning page 80 of 355, page 60 (as numbered)

Changes to, or Elimination of, LIBOR Could Adversely Affect Your Investment in the Certificates.

Regulators and law-enforcement agencies from a number of governments, including entities in the United States, Japan, Canada and the United Kingdom, have been conducting civil and criminal investigations into whether the banks that contributed to the British Bankers’ Association (the “BBA”) in connection with the calculation of daily LIBOR may have underreported or otherwise manipulated or attempted to manipulate LIBOR.

Based on a review conducted by the Financial Conduct Authority of the United Kingdom (the “FCA”) and a consultation conducted by the European Commission, proposals have been made for governance and institutional reform, regulation, technical changes and contingency planning. In particular: (a) new legislation has been enacted in the United Kingdom pursuant to which LIBOR submissions and administration are now “regulated activities” and manipulation of LIBOR has been brought within the scope of the market abuse regime; (b) legislation has been proposed which if implemented would, among other things, alter the manner in which LIBOR is determined, compel more banks to provide LIBOR submissions, and require these submissions to be based on actual transaction data; and (c) LIBOR rates for certain currencies and maturities are no longer published daily. In addition, pursuant to authorization from the FCA, the ICE Benchmark Administration Limited (the “IBA”) took over the administration of LIBOR from the BBA on February 1, 2014.

In a speech on July 27, 2017, Andrew Bailey, the Chief Executive of the FCA, announced the FCA’s intention to cease sustaining LIBOR after 2021. The FCA has statutory powers to require panel banks to contribute to LIBOR where necessary. The FCA has decided not to ask, or to require, that panel banks continue to submit contributions to LIBOR beyond the end of 2021. The FCA has indicated that it expects that the current panel banks will voluntarily sustain LIBOR until the end of 2021. The FCA’s intention is that after 2021, it will no longer be necessary for the FCA to ask, or to require, banks to submit contributions to LIBOR. The FCA does not intend to sustain LIBOR through using its influence or legal powers beyond that date. It is possible that the IBA and the panel banks could continue to produce LIBOR on the current basis after 2021, if they are willing and able to do so, but we cannot assure you that LIBOR will survive in its current form, or at all.

LIBOR will be based on the IBA’s one-month London interbank offered rate for United States Dollar deposits as displayed on the LIBOR Index Page, or another rate as set forth in the definition of LIBOR. The loan documents for all of the underlying mortgage loans provide that such underlying mortgage loans will convert from an interest rate based on LIBOR to an interest rate based on an Alternate Index if a Loan Index Conversion Event occurs. For all of the underlying mortgage loans, in the event of a conversion to an Alternate Index, the selection of the Alternate Index will be made by Freddie Mac in its sole discretion in accordance with the terms of the related underlying mortgage loan.

Depending on the language in the applicable loan documents, it is possible that certain of the underlying mortgage loans may convert to a different Alternate Index than other underlying mortgage loans. The Alternate Index as to any underlying mortgage loan and the certificates may not move in tandem with LIBOR. We cannot assure you that the occurrence of a Loan Index Conversion Event or Certificate Index Conversion Event will not result in the pass-through rate for the class A, B and C certificates being capped at the Weighted Average Net Mortgage Pass-Through Rate minus, if applicable, the Guarantee Fee Rate. The yield to maturity on the class XI certificates will also be adversely affected to the extent interest otherwise payable to the class XI certificates is required to be distributed on the class B or C certificates as Additional Interest Accrual Amounts or paid to the Guarantor.

In addition, the strike rate in all Interest Rate Cap Agreements will be based on LIBOR until the IBA ceases to set or publish a rate for LIBOR. A rise in the level of the Alternate Index without a corresponding rise in the level of LIBOR could result in the inability of a borrower to pay its required debt service on an underlying mortgage loan.

In the event LIBOR is no longer available, a borrower may not be able to extend or replace the interest rate cap agreement it may be required to maintain under the related loan documents with an interest rate cap agreement based upon the Alternate Index. As a result, the borrower would be in default under the related loan documents.

We cannot predict the effect of the FCA’s decision not to sustain LIBOR, or, if changes are ultimately made to LIBOR, the effect of those changes. In addition, we cannot predict what Alternate Index would be chosen, should this occur. If LIBOR in its current form does not survive or if an Alternate Index is chosen, the market value and/or liquidity of the certificates could be adversely affected.

Description of the Underlying Mortgage Loans, Beginning page 114 of 355, page 94 as numbered

Certain Terms and Conditions of the Underlying Mortgage Loans

 Due Dates. Subject, in some cases, to a next business day convention, monthly installments of principal and/or interest will be due on the first of the month with respect to each of the underlying mortgage loans.

Mortgage Interest Rates; Calculations of Interest.

General. Each of the underlying mortgage loans bears interest at a mortgage interest rate that, in the absence of default or modification, is a floating rate based on LIBOR plus a margin. On each LIBOR Determination Date, LIBOR on each underlying mortgage loan will be determined for the related Interest Accrual Period, and the mortgage interest rate for such underlying mortgage loan will be reset as of the beginning of such Interest Accrual Period to LIBOR determined on such LIBOR Determination Date plus the specified margin applicable to such underlying mortgage loan (provided that if LIBOR is determined to be below zero, the interest rates on the underlying mortgage loans will be equal to the margin), subject to rounding as set forth in the related loan documents.

LIBOR” means, for any Interest Accrual Period, the IBA’s one-month London interbank offered rate for United States Dollar deposits, as displayed on the LIBOR Index Page, as determined on the related LIBOR Determination Date; provided, however, that, for purposes of the certificates and the underlying mortgage loans, in the event LIBOR with respect to any Interest Accrual Period is less than zero, LIBOR for such Interest Accrual Period will be deemed to be zero. LIBOR will be [_____]% per annum for the Interest Accrual Period relating to (i) the first due date after the Cut-off Date for the underlying mortgage loans and (ii) the first distribution date for the Principal Balance Certificates. With respect to each LIBOR Determination Date, the value of LIBOR for the underlying mortgage loans will be determined by the master servicer and the value of LIBOR for the certificates will be determined by the Calculation Agent. In the event of a discrepancy between the value of LIBOR determined by the Calculation Agent and the value of LIBOR determined by the master servicer on any LIBOR Determination Date, LIBOR for the related Interest Accrual Period for the underlying mortgage loans and the related Interest Accrual Period for the certificates will equal the value of LIBOR determined by the master servicer.

LIBOR Index Page” means the Bloomberg L.P., page “BBAM,” or such other page for LIBOR as may replace page BBAM on that service, or at the option of the master servicer (with respect to the underlying mortgage loans) or the Calculation Agent (with respect to the certificates) (i) the applicable page for LIBOR on another service which electronically transmits or displays IBA LIBOR rates, or (ii) any publication of LIBOR rates available from the IBA.

LIBOR Determination Date” means, with respect to any Interest Accrual Period and (i) any underlying mortgage loan, the first day preceding the beginning of such Interest Accrual Period for which LIBOR has been released by the IBA or (ii) any principal balance certificate, the date on which the value of LIBOR for the underlying mortgage loans was determined in the month preceding the month in which the applicable Interest Accrual Period for the certificates commenced.

Calculation Agent” means, for so long as any of the certificates remain outstanding, an agent appointed to determine the value of LIBOR (or the Alternate Index) in respect of each Interest Accrual Period for the certificates. The certificate administrator will be the initial Calculation Agent for purposes of determining the value of LIBOR (or Alternate Index) for each Interest Accrual Period for the certificates.

Conversion to Alternate Index. The loan documents for all of the underlying mortgage loans provide that such underlying mortgage loans will convert from an interest rate based on LIBOR to an interest rate based on an Alternate Index if a Loan Index Conversion Event occurs.

Alternate Index” means

  • with respect to any underlying mortgage loan, an alternate, substitute or successor index to the then current Index selected by Freddie Mac in its sole discretion in accordance with the terms of the related underlying mortgage loan (which alternate, substitute or successor index may be adjusted by Freddie Mac in its sole discretion using an Adjustment Factor to reflect a value comparable to the Index being replaced), taking into consideration any alternate, substitute or successor index to the then-current Index that has been selected, endorsed or recommended by the commercial real estate finance industry or ISDA. In the event the Alternate Index for any underlying mortgage loan with respect to any Interest Accrual Period is less than zero, the Alternate Index for such underlying mortgage loan for such Interest Accrual Period will be deemed to be zero.
  • with respect to the certificates, an alternate, substitute or successor index to the then-current Index selected by Freddie Mac in its sole discretion (which alternate, substitute or successor index may be adjusted by Freddie Mac in its sole discretion using an Adjustment Factor to reflect a value comparable to the Index being replaced), taking into consideration (i) any alternate, substitute or successor index to the then-current Index that has been selected, endorsed or recommended by the commercial real estate finance industry or ISDA, (ii) the Alternate Index for each underlying mortgage loan and (iii) the degree of availability or obtainability of such Alternate Index. In the event the Alternate Index for the certificates with respect to any Interest Accrual Period is less than zero, the Alternate Index for the certificates for such Interest Accrual Period will be deemed to be zero.

Adjustment Factor” means, with respect to any underlying mortgage loan or a class of certificates, a value calculated by Freddie Mac upon the occurrence of a Loan Index Conversion Event or Certificate Index Conversion Event, as applicable, that Freddie Mac determines in its sole discretion will, when added to the value of the alternate, substitute or successor index to the then-current Index, cause the value of such alternate, substitute or successor index to the then-current Index to reflect a value comparable to the Index being replaced (determined as of the final index determination date for the Index being replaced on which adequate and reasonable means, as determined by Freddie Mac in its sole discretion, existed for ascertaining such Index) as a result of the Loan Index Conversion Event or Certificate Index Conversion Event. In determining the Adjustment Factor, Freddie Mac will take into consideration the methods generally accepted by the commercial real estate finance industry or ISDA for calculating an adjustment factor. The Adjustment Factor may be positive, negative or zero. For the avoidance of doubt, the Adjustment Factor will not be re-determined or re-designated unless another Loan Index Conversion Event or Certificate Index Conversion Event subsequently occurs.

Loan Index Conversion Event” means, with respect to any underlying mortgage loan, any of the following events:

(i) the publication of the then-current Index has been either permanently or indefinitely suspended,

(ii) regardless of the continued existence of the then-current Index, the use of an alternate, substitute or successor index to the then-current Index in mortgage loans purchased or guaranteed by Freddie Mac is required by

(a) any regulator of Freddie Mac,

(b) any governmental entity with authority to direct the actions of Freddie Mac, or

(c) applicable law, or

(iii) Freddie Mac has determined, in its sole discretion, that the then-current Index must be replaced with an Alternate Index as a result of the occurrence of one or more of the following event(s):

(a) The supervisor of the administrator of the then-current Index has announced in a public statement that

(1) the publication of the then-current Index will be either permanently or indefinitely suspended,

(2) there has been or will be a material change in the methodology of calculating the Index, or

(3) it no longer recommends the use of the Index as an Index.

(b) Freddie Mac has determined that the use of an alternate, substitute or successor index to the then current Index has become a generally acceptable market practice in the commercial real estate finance industry regardless of the continued existence of the then-current Index.

(c) ISDA has announced that it will use an alternate, substitute or successor index to the then-current Index regardless of the continued existence of the then-current Index.

(d) Any (1) regulator of Freddie Mac or (2) governmental entity with authority to direct the actions of Freddie Mac recommends the use of an alternate, substitute or successor index to the then-current Index in mortgage loans purchased and/or guaranteed by Freddie Mac regardless of the continued existence of the then-current Index.

Index” means, (i) with respect to any underlying mortgage loan, as of the Closing Date, LIBOR; thereafter, upon the occurrence of a Loan Index Conversion Event, any successor Alternate Index, and (ii) with respect to the certificates, as of the Closing Date, LIBOR; thereafter, upon the occurrence of a Certificate Index Conversion Event, any successor Alternate Index.

Freddie Mac will not re-determine or re-designate another Alternate Index unless another Loan Index Conversion Event or Certificate Index Conversion Event subsequently occurs.

Note: There is additional language covering the interest rate cap agreements in the underlying mortgage loans. That language begins on page 116 of 355, or page 96 (as numbered). Omitting that language here.

Description of the Certificates, beginning page 150 of 355, page 130 (as numbered)

Calculation of Pass-Through Rates. Each class identified in the table on page 6 as having a pass-through rate of LIBOR plus a specified margin has a per annum pass-through rate equal to the lesser of—

(i) LIBOR (or Alternate Index) plus the specified margin for that class set forth in that table; and

(ii) (a) with respect to the class A certificates, the Weighted Average Net Mortgage Pass-Through Rate for the related distribution date minus the Guarantee Fee Rate and (b) with respect to the class B and C certificates, the Weighted Average Net Mortgage Pass-Through Rate for the related distribution date;

provided that in no event will the class A pass-through rate, the class B pass-through rate or the class C pass-through rate be less than zero.

The pass-through rate for each such class is a floating rate based on LIBOR. LIBOR for the certificates is determined in the same manner and on the same date as LIBOR is determined for the underlying mortgage loans.

Upon conversion of the underlying mortgage loans to an Alternate Index, the Index used in calculating the passthrough rates for the class A, B and C certificates will also convert to an Alternate Index. In addition, if Freddie Mac determines, in its sole discretion, that (a) applicable law requires or (b) any regulator of Freddie Mac or any governmental entity with authority to direct the actions of Freddie Mac recommends the use of an alternate, substitute or successor index to the then-current Index in mortgage loans purchased and/or guaranteed by Freddie Mac, regardless of the continued existence of the then-current Index, then Freddie Mac may in its sole discretion elect that the Index used in calculating the pass-through rates for the class A, B and C certificates will also convert to an Alternate Index. In the case of any of the occurrences described above in this paragraph (each, a “Certificate Index Conversion Event”), Freddie Mac will be required to promptly determine, in its sole discretion, the Alternate Index for the certificates.

Freddie Mac will be required to notify the parties to the Pooling and Servicing Agreement, the directing certificateholder and the Calculation Agent of the occurrence of a Certificate Index Conversion Event or a Loan Index Conversion Event within 3 Business Days after the occurrence of such event (a “Certificate Index Conversion Notice” or a “Loan Index Conversion Notice,” as applicable). Freddie Mac will provide notice of the Alternate Index with respect to any applicable underlying mortgage loan and the certificates (each, an “Alternate Index Notice”) to the parties to the Pooling and Servicing Agreement, the directing certificateholder and the Calculation Agent within 3 Business Days after such determination. Following receipt of the Certificate Index Conversion Notice, Loan Index Conversion Notice or Alternate Index Notice from Freddie Mac, (i) the certificate administrator will be required to post a “special notice” of the occurrence of a Certificate Index Conversion Event or Loan Index Conversion Event, or the determination of the Alternate Index, as applicable, on the certificate administrator’s website within 3 Business Days and (ii) the master servicer will be required to notify the applicable borrowers of any Alternate Index with respect to any underlying mortgage loan within 5 Business Days. Beginning on the date specified in the Certificate Index Conversion Notice, the pass-through rates for the class A, B and C certificates will be calculated using the Alternate Index specified in the Alternate Index Notice. The parties to the Pooling and Servicing Agreement and the Calculation Agent will be entitled to conclusively rely on Freddie Mac’s determination that a Certificate Index Conversion Event or a Loan Index Conversion Event has occurred, Freddie Mac’s selection of the Alternate Index and Freddie Mac’s calculation of any Adjustment Factor.

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