- Japanese yen LIBOR announcements will be discontinued at the end of 2021; discussions on replacements among securitization transaction parties are accelerating in Japan.
- Of the transactions we rate in Japan, 12% have Libor-based benchmarks; all have fallback provisions, which typically address a temporary unavailability of the benchmark, rather than permanent discontinuation, in our view.
- We will assess the effects of replacement benchmarks on rated transactions as we learn about them.
Japanese securitizations could find losing LIBOR laborious.
The U.K.'s Financial Conduct Authority (FCA) officially announced on March 5, 2021, permanent cession of LIBOR publication at the end of 2021 for many currencies, including the Japanese yen.
In view of the permanent discontinuation of the publication of the Japanese yen London Interbank Offered Rate (LIBOR), parties to securitization transactions are intensifying discussions on benchmark replacements. Certain securitizations we rate in Japan use LIBOR as a benchmark for setting reference rates. The fallback provisions for such transactions vary.
In this report, S&P Global Ratings examines the potential impact of the loss of LIBOR on Japanese securitizations it rates.
Fallback Provisions Vary By Transaction
In Japan, about 12% of our rated tranches relate to securitizations that reference LIBOR on the asset side (underlying loans), the liability side (rated notes), or both sides (see Chart 1).
The fallback provisions on the liability side of the transactions are generally classified in one of three ways.
- Fixing the rate at the last LIBOR rate,
- Using bank polling, or
- Transaction party selects the rate.
Some fallback provisions may not work effectively upon permanent secession of LIBOR. We believe transaction contracts typically assume a temporary cessation of LIBOR, rather than a permanent one. Fixing a transaction's benchmark rate to the last LIBOR rate may not cause serious problems if the cessation is temporary. However, a permanent cessation of LIBOR will mean conversion to a fixed rate for the remaining life of a transaction, which noteholders likely did not anticipate. In such cases, transaction parties may look to amend the wording of their provisions. We will assess the impact of this on ratings.
The FCA is considering a mechanism to continue publishing synthetic LIBOR for one, three, and six months in Japanese yen after the end of 2021. This is to avoid market disruption for contracts that are difficult to migrate. This mechanism would likely to continue to be published until the end of 2022, if adopted. However, based on our discussions with some transaction parties, no securitization transactions we rate expect to use synthetic LIBOR at this point.
|LIBOR fallback language in liability documents for securitization transactions rate in Japan|
|Liability fallback language||Summary and comments|
|Fixing the rate at the last LIBOR rate||If LIBOR is unavailable, the liability reference rate will use the last available LIBOR. As this will convert interest payments to investors from floating to fixed rate, we expect transaction parties to pursue a new reference rate in most cases.|
|Bank polling||This provides for a replacement interest rate to be determined by polling banks for LIBOR quotes and taking the average of the quotes. We think it highly unlikely that banks will provide quotations after the permanent cessation of LIBOR. Additionally, it will likely be operationally challenging for banks to provide quotes regularly, such as monthly and quarterly.|
|Transaction party selects the rate||This allows a specified transaction entity, such as trustee, custodian, or other transaction party, to set a replacement rate.|
Transition Effects Will Diverge
If interest rate mismatch risk arises when securitization reference rates change, we will typically evaluate the impact of this through cash flow analysis. Such changes could include interest rates on the liability side converting from floating to fixed (the last published LIBOR) while the asset side remains linked to a floating rate. However, we think switching to fixed interest rates is generally unlikely to adversely affect transactions, provided the last published LIBOR is sufficiently low, reflecting the recent low interest rate environment.
Structural features of transactions--such as payment waterfalls--and spread and type of interest rates on the asset side, will likely lead to variations in the impact of the loss of LIBOR. Generally, asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) might be able to absorb increases in interest rate mismatches through factors including increased credit enhancement and excess spreads. Repackaged transactions, however, could face a more severe situation than other structured finance transactions because of a lack of factors that can mitigate interest rate mismatches, in our view.
We generally consider various scenarios, including those below, in light of the coming LIBOR sunset.
- Transactions referencing LIBOR on both the asset and liability side are currently unexposed to interest rate mismatch risk. Applying different replacement benchmarks on assets and liabilities could affect transactions' cash flows.
- Transactions facing interest rate mismatches could see them widen, depending on the replacement rates chosen. Temporary interest rate mismatches could occur because of a gap in the timing of a change in rates on the asset and liability sides.
- Investor approval is sometimes required to modify certain transaction documents, including those for spread adjustments, to avoid value transfer from applying an alternative rate. Investors could reject modifications, leading to the absence of benchmarks after the cessation of LIBOR. If this occurs on the liability side of a rated transaction, we may withdraw our ratings.
- For general repack transactions, there is risk that interest collection on the asset side falls short of payments on the liability side, including interest and other transaction costs, due to benchmark rate conversion.
Transition Will Likely Be Easier On Assets Than Liabilities
If LIBOR is unavailable, fallback language on the asset side typically allows lenders to pick a similar reference rate. Transition to replacement rates might lead to operational challenges if transactions are backed by diversified pools of assets with many borrowers involved. However, compared with transition to alternative rates on the liability side that would require investor approval, transition to alternative rates on the asset side would be easier if parties such as servicers can set replacement rates.
For transactions with LIBOR-based liabilities, we think it is likely that transaction parties can mitigate interest rate mismatch risk by coordinating the timing of rate conversion for assets and liabilities to the greatest extent possible. Similarly, for securitizations involving swap agreements, we expect reference rates on swaps to be, in general, changed simultaneously.
There Are Several Alternative Rates To Japanese Yen LIBOR
There are several alternative rates to Japanese yen LIBOR. There is therefore flexibility for choosing an alternative rate better suited to products and the preferences of transaction parties, including investors. The Cross-Industry Committee on JPY Interest Rate Benchmark, for which the Bank of Japan acts as the secretariat, has specified benchmarks. These include the uncollateralized overnight call rate (TONA), the JPY overnight index swap (TORF), Tokyo Interbank Offered Rates (TIBOR) and overnight call rate futures.
As we view fallback provisions as generally intended to cover a temporary unavailability of LIBOR, we believe transactions with relatively larger numbers of investors may face difficulties. There might be cases where it is challenging to achieve enough agreement among transaction participants to modify the wording of fallback provisions.
We anticipate the transition to benchmarks that replace LIBOR will accelerate in 2021. We expect key transaction parties responsible for selecting replacement rates for LIBOR to notify us of new rates, spreads, and related information well before the December 2021 phase out (see "Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested," published Jan. 13, 2021).
- Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition requested, Jan. 13, 2021
- European Structured Finance Market Accelerates Transition From LIBOR, Feb. 9, 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
Data used in this report include rating actions by S&P Global SF Japan Inc. (SPSF). SPSF is a registered credit rating agency under Japan's Financial Instruments and Exchange Act (FIEA) but is not registered as a Nationally Recognized Statistical Rating Organization (NRSRO) under U.S. Laws. Therefore, the credit ratings assigned by SPSF are Registered Credit Ratings under FIEA but are not Credit Ratings issued by an NRSRO under U.S. Laws.
This report does not constitute a rating action.
|Primary Credit Analyst:||Yuji Hashimoto, Tokyo + 81 3 4550 8275;|
|Secondary Contact:||Toshiaki Shimizu, Tokyo + 81 3 4550 8302;|
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