(Editor's Note: This article was originally published on March 16, 2021. On March 19, 2021, we revised the wording in our answer to "What events did the FCA announcement trigger?" for clarification purposes.)
On March 5, the Financial Conduct Authority (FCA) officially confirmed the dates for the future cessation or loss of representativeness of global London Interbank Offered Rate (LIBOR) benchmarks. This will be effective after December 2021 for sterling, euro, yen and Swiss franc LIBOR settings and, after June 2023, for most U.S. dollar settings. This follows a consultation on the discontinuation of LIBOR launched on Nov. 30, 2020, by ICE Benchmark Administration, the administrator of the LIBOR rate. This official statement was widely anticipated given prior market guidance.
Below, we answer some frequently asked questions concerning this announcement and its ramifications.
Frequently Asked Questions
Will this announcement affect ratings on structured finance transactions for which coupons and/or assets are linked to LIBOR?
There is no immediate rating impact on structured finance transactions following this announcement. However, there remain many unknowns that we are monitoring that might eventually have a rating impact.
There is no immediate impact because structured finance transactions issued during the past several years with coupons linked to LIBOR have largely incorporated robust fallback language into the liability documents. Underlying collateral or loans linked to LIBOR generally are less likely than securitization documents to contain detailed fallbacks, but, in many cases, can switch rates more easily, usually at the lender's discretion. There is no expected change to transaction interest rates or cash flows now due to the FCA announcement--that will take place in the future.
Improved fallbacks have been recommended by working groups convened by central banks for each LIBOR currency. These include the Alternative Reference Rates Committee (ARRC) in the U.S., the Working Group on Reference Rates in the U.K., and the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks. Under ARRC recommendations, these improved fallbacks generally contain three provisions:
- Trigger events,
- A waterfall of alternate interest rates, and
- A mechanism to set spread adjustments for risk-free rates.
Taken together, these three components provide an objective way to transition rates away from LIBOR while minimizing any potential value transfer between borrower and lender.
Many older, legacy transactions, however, face significant challenges because their governing documents did not contemplate permanent LIBOR cessation and typically do not contain triggers tied to LIBOR termination, and amendments may prove difficult. Accordingly, remediation efforts are underway, including proposed New York, U.S. Federal, and U.K. legislation to attempt to transition those transactions to new interest rates in an orderly fashion.
Some of the uncertainties that we are monitoring, which could result in a ratings impact down the road, include the following:
- What the replacement rate and spread will be for assets and liabilities,
- If any disputes emerge,
- If "synthetic LIBOR" can help tough legacy contracts in some regions, and
- To what extent legislation will be able to assist LIBOR-based securitizations to transition in an orderly fashion.
Does this announcement signal any additional information needs for structured finance ratings with LIBOR exposure?
Yes. For key transaction parties (such as servicers, collateral managers, or trustees) setting the new rate (including a spread adjustment), early communication with S&P Global Ratings regarding their choices is desirable as we seek to catalog this information to inform our risk assessments of LIBOR-linked securities. The more time-sensitive scenarios involve sterling and yen LIBOR, which are now officially scheduled to cease after December 2021. Although the time horizon for the most widely used U.S. dollar LIBOR settings is longer (mid-2023), there are many more transactions for which fallback terms include benchmark transition event triggers.
In limited cases, notably in the U.S. corporate loan market, some newer corporate credit agreements already contain early opt-in interest rate conversion language that ties to a permanent cessation statement as made by the FCA. But other factors, such as judging the five-year historical spread adjustment versus the current LIBOR-Secured Overnight Financing Rate (SOFR) difference are relevant and may not automatically encourage early adoption of new rates.
What events did the FCA announcement trigger?
For most recent transactions containing ARRC recommended liability fallbacks, this announcement generally constitutes a benchmark transition event. Shortly after the announcement, ARRC indicated publicly that a benchmark transition event has occurred with respect to all U.S. dollar LIBOR settings. Accordingly, the relevant transaction party, such as a collateral manager, would send notice of the event to the trustee. While fallback language can vary somewhat, the benchmark transition event contemplates replacement of LIBOR on the date when it is no longer available (e.g., after December 2021 for sterling and yen LIBOR, after June 2023 for most U.S. dollar LIBOR settings).
Another impact is that the spread adjustment becomes fixed for use at a later date when interest rates shift to the new benchmark rate from LIBOR. Since new risk-free rates do not contain bank credit risk, a spread adjustment is needed to help minimize any value transfer between borrower and lender during the transition away from LIBOR. In the U.S. market, many recently issued (2020-21) structured finance transactions with LIBOR-linked liabilities utilize fallback provisions that were based on language developed by the Alternative Reference Rates Committee (ARRC). Spread adjustments are typically aligned with the recommendations of the International Swaps and Derivatives Association (ISDA) around a trailing-five-year median spread between LIBOR and the risk-free rates (SOFR for U.S. dollar, Sterling Overnight Index Average [SONIA] for pounds sterling, Tokyo Overnight Average [TONA] for yen).
Is this spread adjustment related to basis risk in securitizations?
We expect a number of U.S. servicers and collateral managers to freeze the spread adjustment on the liabilities following this announcement (as of March 5, 2021) for use when interest rates shift to a new benchmark rate. While the deadline for the LIBOR phaseout is approaching for sterling and yen (both after December 2021), the additional servicer or manager discretion for rate and spread selection in transaction documents in those markets may not result in the same lock-in of the spread adjustments as in the U.S. securitization market. We do not foresee any rating actions linked to the freezing of a liability spread adjustment at this time in any of these markets.
We will continue to monitor the transactions that fix their liability spreads over risk-free rates now (mostly U.S. transactions using ARRC fallbacks) given that floating-rate assets will transition away from LIBOR in the future and those rates may also have a spread adjustment. To the extent that asset/liability spreads differ, we could see basis risk introduced. Additional analysis may be needed to determine any potential rating impact; in general, this exposure is greater for non-investment-grade structured finance ratings. This is because excess spread typically makes up a larger portion of credit enhancement for these ratings compared to more senior tranche ratings.
How might a "synthetic LIBOR" rate affect structured finance securities?
If a synthetic LIBOR rate is developed for legacy securities and is not subject to disputes, it could help some structured finance securities achieve a more orderly transition.
The FCA announcement discusses the possibility of developing and implementing a synthetic LIBOR methodology in different currencies for some legacy securities with LIBOR exposures. This would mean publishing a LIBOR rate with a new methodology, most likely tied to a compounded risk-free rate like SONIA (sterling) or TONA (yen), plus a spread adjustment. It appears that it may apply to only limited maturities of sterling and yen, such as one-month, three-month, and six-month, and possibly U.S. dollar exposures as well. FCA has also indicated that if synthetic LIBOR were developed, it would only be available for legacy securities and would not be eligible for use in new transactions. We will monitor these developments, particularly in the U.S. market where the most outstanding LIBOR-based securitizations exist.
How does the announcement affect securitizations that utilize hedge agreements?
Hedging used in securitizations can introduce another layer of basis risk, as most fixed-floating hedge agreements typically contain a LIBOR-linked floating payment. This is in addition to asset and/or liability rates tied to LIBOR. If these three rates and their spreads are changed at different times and by different amounts, then it could give rise to incremental basis risk. While hedge agreements are rarely used in U.S. LIBOR-linked securitizations, they are more prevalent in Europe and, to a lesser degree, in Japan. Depending on the order of magnitude of potential basis risk, additional sensitivity testing using a cash flow model may be necessary.
Any special purpose vehicle (SPV) and related counterparty that both adhere to the January 2021 ISDA protocol will automatically benefit from updated robust fallbacks, including spread adjustment methodologies. That alignment would limit the potential basis risk introduced by the presence of hedges. While the five-year historical median is the recommended spread adjustment under the ARRC/ISDA methodology, the actual spread selected will need to be confirmed by the key transaction party.
Would most hedged transactions benefit from new ISDA protocol that contain robust fallbacks?
Based on our initial discussions with market participants, we do not expect SPVs and financial institutions that are counterparties on structured finance transactions to both join the new ISDA protocol that went live on Jan. 25, 2021, in most cases. Both counterparties to a given hedge agreement must join in order for the new robust fallbacks to be operative. Even if both counterparties do not adhere to the protocol, however, a hedge agreement could be amended, and we would expect the transaction sponsor to often enable such changes to incorporate more robust fallbacks prior to LIBOR cessation. For some U.S. legacy RMBS transactions in which sponsors are no longer in business, this could prove more challenging.
- Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested, Jan. 13, 2021
- SOFR Emerging As Alternative To LIBOR In U.S. Debt Markets, Dec. 4, 2020
- As The Deadline For The Transition From LIBOR Approaches, Work Remains For U.S. Structured Finance, Oct. 6, 2020
- Credit FAQ: How To Say Goodbye To LIBOR Without Creating Market Chaos, Sept. 23, 2019
- Credit FAQ: SONIA As An Alternative To LIBOR IN U.K. Structured Finance Transactions, Feb. 6, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||John A Detweiler, CFA, New York + 1 (212) 438 7319;|
|Irina A Penkina, Moscow + 7 49 5783 4070;|
|Yuji Hashimoto, Tokyo + 81 3 4550 8275;|
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