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.

Regulators, lawmakers and the securitized-product industry in 2021 have made significant progress in the transition from the LIBOR reference rate to its replacement, the secured overnight financing rate (SOFR). Meanwhile, investors in securitized products are grappling with the challenge of the LIBOR-SOFR transition and its impact on their analytics.

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

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

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

   

• Benchmark-curve changes: With the cessation of LIBOR indexes and curves, the new benchmark valuation curves need to be transitioned to new SOFR curves for the purpose of valuing securitized products. The examples above show a difference between a SOFR option-adjusted spread (OAS) and a LIBOR OAS of approximately 20 basis points, which is generally consistent between the current spread levels between the two curves (the difference in OAS is greater than the spread adjustment, due to the spread between the 1- and 3-month LIBOR curve).
• Fallback options: With the uncertainty associated with fallback options of securitized products, investors can test valuation and hedging differences arising from the various fallback options. The example below shows the valuation difference between two fallback assumptions. As the LIBOR curve generally reflects the upcoming LIBOR transition and ISDA fallback spreads, the valuation differences for these two assumptions are generally converging.

   

  Valuation Examples for LIBOR Fallback Scenarios

  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.

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.

Further Reading

Are Securitized Products Ready for the LIBOR-SOFR Transition?

A New COVID-19 Regime for MBS?

What Can Loan-Level Data Reveal About US Auto-Loan ABS?