- We have performed a scenario analysis of a typical seasoned U.K. RMBS transaction to examine the hypothetical effects of LIBOR replacement on our ratings.
- Our analysis demonstrates rating resilience when applying the most likely transition patterns and replacement terms, even for non-investment-grade rated tranches. For the revised transaction terms to cause a negative rating transition, they would need to materially exceed the current market expectations on the year-end sterling LIBOR rate, LIBOR to SONIA credit adjustment spread, or time to solicit the noteholders' consent to replace LIBOR. Junior notes are generally more at risk as break-even thresholds are lower than for higher ranking tranches.
- The scenario analysis results should be interpreted as indicative only. While we generally do not anticipate LIBOR replacement to trigger negative rating actions based on the outcome of our break-even analysis, the rating effect on the actual transactions may be different.
As the British pound sterling LIBOR approaches its scheduled phase-out deadline on Dec. 31, 2021, the U.K. RMBS transactions containing British pound sterling LIBOR exposures are set to execute the transition to the risk-free rates by the end of the year. S&P Global Ratings has performed a scenario analysis on a representative legacy U.K. RMBS structure to determine which transition patterns and amended terms could potentially trigger a negative rating action. We tested parameters such as the change in the interest rate vectors, the size of credit spread adjustments, and the timing mismatch between the changes on the assets and liabilities side.
LIBOR Transition: What's The Status?
While some issuers have requested rating confirmation while holding consultations with the noteholders and transaction parties, others have not. This situation creates uncertainty around the potential rating impact of LIBOR replacement once the transaction amendments have been executed. Table 1 below provides details on the transition status for our rated issues.
|S&P Global Ratings Rated U.K. RMBS Exposed To British Pound Sterling LIBOR: Transition Status|
|Number of issues|
|Rated U.K. RMBS Transactions with LIBOR-linked note coupon as of Dec. 31, 2020||102|
|Expected to redeem before year-end||13|
|Obtained noteholders' consent on SONIA rate||4|
|Outstanding with LIBOR-linked note coupon as of July 31, 2021||68|
|In consultation for rate replacement, RAC not requested*||15|
|In consultation for a clean-up call*||1|
|In consultation for rate replacement, RAC in progress||7|
|RAC provided, noteholders' consent solicitation to start shortly||15|
|To be confirmed||30|
|Of which the ultimate contractual fallback provision:|
|Fixed rate at last posted LIBOR†||16|
*Based on publicly available information, such as investor notices.
§Provisions contemplate polling banks for LIBOR quotes on the determination date. We view bank polling language as weaker because market quotes will no longer be guaranteed after the end of 2021, which makes this option somewhat impractical.
†Provision enabling the issuer to set the applicable rate at that posted at the last determination date, which effectively implies fixing the rate for the transaction's remaining life.
‡Model fallback provisions by the AFME containing replacement trigger events, an alternative benchmark rate, conditions, and form of noteholder solicitation.
LIBOR--London interbank offered rate. SONIA—Sterling overnight index average. RAC--Rating agency confirmation. AFME--Association for Financial Markets in Europe.
Chart 1 illustrates the U.K. RMBS transactions in our rated universe broken down by the contractual LIBOR fallback provisions at the start of 2021 and at the end of July 2021.
Our scenario analysis examines the break-even point for a negative rating transition for the notes. The results determine the minimum size of the tested parameter that would reduce the cash flow output for a given tranche by at least one notch compared to the base case.
Description of the sample transaction
We have used a sample seasoned U.K. RMBS transaction with the following features, which we deem typical for a legacy structure:
- The transaction has six tranches, each in a separate rating category ranging from 'AAA' to 'B', paying in sequential priority. For all classes of notes, our rating addresses timely payment of interest and ultimate payment of principal. There are no effective rating caps stemming from counterparty, operational, or legal risk considerations.
- The structure features a nonamortizing cash reserve (3.3% of the current balance) and a nonamortizing liquidity facility (6.7% of the current balance).
- Both assets and liabilities are linked to a three-month sterling LIBOR. There is no swap or interest rate cap.
- The weighted-average margin on the assets is 2.14%, converting to the weighted-average nominal interest rate of 2.18%. The weighted-average note coupon margin is 0.35%. Considering all senior costs including servicing fees, the starting level of excess spread is 1.2%.
Key assumptions and developed scenarios
When running LIBOR replacement scenarios, we made the following key assumptions:
- The note coupon rate switches from a three-month LIBOR to a daily compounded Sterling overnight index (SONIA) in arrears. In those scenarios where the credit spread is not a tested parameter, the fixed credit spread is set at 0.12%, an approximation of the 0.1193% Bloomberg spread adjustment for a three-month tenor published on March 5, 2021, which is also a recommended ISDA spread.
- The benchmark rate on the underlying mortgage contracts switches from LIBOR to Bank of England Base Rate (BBR). At the day of the switch, the individual credit margin is adjusted to equalize the starting nominal BBR-linked rate with the nominal LIBOR rate. This ensures that the monthly instalment amount payable by each borrower remains unaffected by the change in the benchmark at the transfer date, and thereafter follows a new index.
- We assumed a 0.15% three-month LIBOR as of Dec. 31, 2021, in line with the forward rate prevailing as of the publication date of this article.
- In scenarios where the note coupon switches to SONIA, we assumed the benchmark rate on the liquidity facility costs also switched to SONIA with 0.12% credit spread, with the applicable draw-down margin on top.
- We assumed £200,000 in legal and operational costs related to the benchmark rate transfer, paid once at the beginning of the model running. These are in addition to the regular stressed senior costs modelled in line with our global RMBS criteria.
Based on the observed transition progress among the rated transactions and contractual fallback provisions, we developed four scenarios, presented below.
|Scenario number||Scenario description||Note rate||Asset rate||Transfer fee||Tested parameter||Most stressful assumptions|
|1||Note coupon remains fixed for life at three-month LIBOR as of end-2021; asset rate switches to BBR on day 1||Fixed LIBOR plus contractual margin||BBR plus adjusted individual margin||£200,000||Three-month LIBOR at Dec. 31, 2021||
Interest rate: Down
Prepayment rate: Low
Default curve: Fast
|2||Note coupon switches to SONIA and asset rate to BBR simultaneously on day 1||SONIA plus credit spread plus contractual margin||BBR plus adjusted individual margin||£200,000||LIBOR to SONIA credit spread||
Interest rate: Up
Prepayment rate: Low
Default curve: Slow
|3||Note coupon stays fixed for a number of months and then follows SONIA; asset rate switches to BBR on day 1||(0.15% plus contractual margin) for X months; (SONIA plus 0.12% plus contractual margin) thereafter||BBR plus adjusted individual margin||£200,000||Number of months for which notes stay fixed||
Interest rate: Low
Prepayment rate: Up
Default curve: Slow
|4||Note coupon switches to SONIA on day 1; asset rate remains fixed for a number of months and then follows BBR||SONIA plus 0.12% plus contractual margin||(0.15% plus initial individual margin) for X months; (BBR plus adjusted individual margin) thereafter||£200,000||Number of months for which assets stay fixed||
Interest rate: Low
Prepayment rate: Up
Default curve: Fast
|LIBOR--London interbank offered rate. BBR--Bank of England base rate. SONIA--Sterling overnight index.|
Scenario 1 exemplifies when noteholders' consent on LIBOR replacement is not obtained, and the coupon rate remains fixed for life at the last determination date at the end of 2021. This is in line with the most common fallback option provided in most legacy U.K. RMBS transactions. This scenario also assumes that assets switch to BBR at the beginning of 2022. The tested parameter is the fixed LIBOR rate.
Our results show that, in order to cause a negative rating migration, the fixed LIBOR rate would have to significantly exceed the current level: at least 1.0% (compared to 0.12% today) to trigger a downgrade of a category 'B'-rated tranche. A higher LIBOR rate would affect mezzanine and senior classes of notes (see chart 2).
Scenario 2 addresses the simultaneous transfer of the note rate to SONIA and the assets rate to BBR on day 1. The tested parameter is the size of LIBOR to SONIA credit spread over a three-month tenor.
Based on our testing, applying the recommended ISDA spread adjustment of 0.12% is not likely to cause a negative rating transition, even for non-investment-grade classes of notes. In our model, the critical size of the credit spread starts from 0.55% (see chart 2).
We also ran a scenario assuming both the notes and the assets simultaneously transfer rates to SONIA with the same 0.12% credit spread. The tested structure has demonstrated rating resiliency under these assumptions.
Scenario 3 assumes that soliciting noteholders' consent on transferring to SONIA takes additional time beyond the end of 2021, and in the interim period the coupon rate stays fixed at the last available LIBOR rate as of Dec. 31, 2021. Meanwhile, the assets switch to BBR at the beginning of 2022 without any delay. The tested parameter is the number of months for the note coupon fixing.
Our findings show that if the timing gap takes less than 36 months, there wouldn't be a negative rating change for notes rated in the 'BB' up to 'AA' rating categories. For notes rated in the 'B' and 'AAA' categories, the break-even timing exceeds five years. The 36-month threshold is mainly driven by the start of the recessionary timing under the back-loaded default curve, which is the beginning of year four.
Scenario 4 is the opposite of the third scenario: it assumes the asset rate stays fixed at the LIBOR rate as of Dec. 31, 2021, for a few months before the individual clients' consent on the new benchmark is obtained, and then floats along with BBR. The note coupon switches to SONIA on day 1. The tested parameter is the number of months for the asset rate fixing.
This scenario proves more stressful, as a 12-month delay in the asset rate transfer causes a potential rating downgrade (see chart 3). The threshold timing for the 'AAA'-rated class exceeds 60 months.
In our opinion, this scenario is not likely to occur in practice if a synthetic LIBOR proves a working solution for transactions where the ability to change the initial mortgage terms is not certain. Financial authorities introduced the synthetic LIBOR concept to aid financial contracts classified as touch legacy where it is not feasible to amend rates tied to LIBOR. At this stage, however, the scope of its application remains an open question.
Impact of basis swap
The presence of a basis swap and amended swap rates in a LIBOR replacement would constitute an important cash flow consideration for the actual transactions. If the swap rate received by the issuer is reset to the same new benchmark and with the same credit adjustment spread as the note coupon rate (for example, daily compounded SONIA plus 0.12%), we would generally not expect a negative rating transition on the notes.
Negative Rating Migration Unlikely, With Some Caveats
The resilience of the initial ratings in the modelled transaction to the LIBOR replacement terms is in line with market expectations. Although this holds across the rating spectrum--for both investment- and non-investment-grade tranches--the break-even point for junior tranches is generally lower.
That said, should an actual transaction have less credit support than in the tested structure and/or incur higher replacement costs, rating deterioration would be more likely, with junior tranches more at risk. Additionally, we did not address any potential litigation related to changes in the mortgage contracts, which may prevent benchmark replacement or induce heavy legal costs.
The rating resilience demonstrated in the scenario analysis does not imply that the individual transactions are immune to negative rating actions. In the absence of a rating agency confirmation (RAC) request, we address the revised transaction terms in the course of surveillance when transaction-specific details are embedded in the ultimate rating decision.
Finally, our scenario analysis does not imply a deemed RAC on any amendments, including on the real-life structures having similar characteristics to the base case.
We will continue to closely monitor the changes in the terms of each affected transaction to assess the effect on our outstanding U.K. RMBS ratings.
- European RMBS Market Update Q2 2021, Aug. 16, 2021
- European Structured Finance Market Accelerates Transition From LIBOR, Feb. 9, 2021
- Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested, Jan. 13, 2021
This report does not constitute a rating action.
|Primary Credit Analyst:||Irina A Penkina, Moscow + 7 49 5783 4070;|
|Secondary Contacts:||John A Detweiler, CFA, New York + 1 (212) 438 7319;|
|Alastair Bigley, London + 44 20 7176 3245;|
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