A first cut at LIBOR transition and RMBS price

| November 6, 2020

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.

Investors across the legacy RMBS market are starting to evaluate the potential impact on bond value from a move away from LIBOR. The risk of floating-rate securities converting to fixed-rate does not appear uniform across the legacy market in part because transition language differs. Where the risk of converting is clearer, the likely price impact differs across deals. The differing exposure across deals and tranches within those deals should weigh on the legacy market given the uncertain and potentially contested transition.

Deal and tranche exposure to the transition away from LIBOR depends on number of factors. At the deal level, existing fallback language will in all likelihood determine a trust’s exposure to the potential for liabilities to convert to fixed-rate bonds in the absence of LIBOR. Deal structure and structural leverage in turn should drive a bond’s price sensitivity to fixing LIBOR at its last setting.

Looking at language discrepancies

The thousands of agreements that govern legacy RMBS are inconsistent in both conception and potential remedies for instances where a current LIBOR rate is no longer available. Governing agreements broadly fall into three camps:

  • Those that empower the trustee to select a suitable replacement index
  • Those that use alternative remedies including trustee polling of reference banks or the use of a “Reserve Interest Rate,” which may be provided by only a single bank on some documents, and
  • Those where the documents have no governing language

One example of a deal where the governing agreement would give the trustee authority to select an alternative index is SASC 2006-BC6, which states

If any such offered rate is not published for such LIBOR Determination Date, LIBOR for such date will be the most recently published offered rate on the Designated Telerate Page. In the event that the BBA no longer sets such offered rate, the Securities Administrator will designate an alternative index that has performed, or that the Securities Administrator expects to perform in a manner substantially similar to the BBA’s offered rate.

In this language, the risk to fixing LIBOR may not be zero as the agreement also says the administrator should use the most recently published offered rate in the instance where a LIBOR setting is not available on the determination date.

Other trusts, such as JPMAC 2007-CH1 do not make any clear reference to the responsibility or authority of the administrator to select an alternative index but rather requires the trustee to determine a “Reserve Interest Rate” by polling “Reserve Banks,” which meet certain criteria and are selected by the depositor. While these examples by no means capture the breadth of inconsistencies across the governing agreements in legacy trusts, they do demonstrate the incongruity in fallback language, which may leave some trusts more exposed to trust liabilities being pegged to the last LIBOR setting than others.

Impact on valuations

The potential price impact of letting trust liabilities get pegged to the last LIBOR setting looks easier to estimate than interpreting the language. Running the universe of legacy bonds at a fixed yield and holding 1-month LIBOR constant at its forward setting in December 2021 while letting all other floating rate indices float up along the forward curve should provide a reasonable proxy to the price impact associated with fixing coupons on trust liabilities while letting coupons on trust assets float higher.

The largest price upside on legacy securities comes in derivatives, such as IOs and inverse IOs, as well as lower dollar priced subprime mezzanine bonds. With the increase in price on these securities comes a significant reduction in the interest rate duration of these cash flows. Under normal circumstances, coupons or excess spread on derivative and mezzanine bonds will fall as rates rise. Given the levered nature of the cash flows, the spread compression and subsequent reduction in bond coupon or excess spread generates significant interest rate duration for these bonds. However, once certain bond coupons become fixed, especially on floating-rate senior certificates, certain derivative and mezzanine tranches will get the growing interest generated between loan and bond coupons either in the form of coupon income or excess spread (Exhibit 1). While fixing LIBOR on legacy RMBS trusts would increase duration for the majority of the affected universe, certain derivative and mezzanine bonds should see duration drop.

Exhibit 1: Estimating the impact of fixing LIBOR on legacy RMBS

Source, Intex, Bloomberg LP, APS   Assumes a fixed 4% yield to price with 1ML fixed as of December 2021

The analysis also illustrates the improvement in tranche-level expected losses as a result of the incremental excess spread generated by fixing LIBOR. The net effect of fixing LIBOR in subprime trusts looks to reduce expected losses across mezzanine bonds by roughly 10 points. And that write-up will have a much more pronounced price impact on lower dollar price mezzanine classes given a roughly similar amount of principal write-up to higher dollar price ones. This leads to an additional nuance to upside associated with fixing LIBOR in these trusts. In some cases, where there is sufficient excess spread allocated to lower classes of these deals, bonds that have been previously written off may begin to start to receive cash flow, potentially making the opportunity larger than the one presented here which admittedly is only a small portion of the legacy universe after accounting for the market value discount on par notional on affected derivatives and mezzanine bonds. And that is even before taking into account which of the impacted trusts may have language in their operative documents that potentially allow for bond coupons to remain fixed.

While likely not a zero-sum game, there are cash flows where prices should drop if a trust’s floating-rate liabilities get pegged to a last LIBOR setting. Unsurprisingly, prime and Alt-A senior floaters across multiple vintages as well as well enhanced Option ARM seniors and mezzanine bonds that are expected to receive their full principal balance would all be hurt to varying degrees where trust liabilities no longer float (Exhibit 2).

Exhibit 2: Floaters and no expected loss mezzanine bonds lose to flat LIBOR

Source: Intex, Bloomberg LP, APS Assumes 4% yield to price

The analysis illustrates that while the percentage price downside to these securities is not as pronounced as the percentage price upside to other bonds, the amount of securities potentially hurt outweighs those that are helped. Based on these assumptions, senior floaters and higher dollar mezzanine bonds that are not projected to take a principal loss would lose an estimated $520 million in market value if coupons were to fix on all these deals at the end of next year. That compares to an estimated $460 million gain on derivatives and more levered mezzanine profiles. While it appears that not all affected bonds would be susceptible to having their coupons fixed, this analysis does illustrate the both the magnitude and asymmetry of interest between senior and mezzanine and derivative noteholders.

john.killian@santander.us 1 (646) 776-7714

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