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U.K. RMBS And ABS LIBOR Transition: Beware Of Early Success

Despite a successful transition away from LIBOR, U.K. residential mortgage-backed securities (RMBS) and asset-backed securities (ABS) transactions could face disruption risk if the Financial Conduct Authority (FCA) ceases publishing synthetic LIBOR by year-end. This could lead to negative rating actions. So far, S&P Global Ratings has placed its ratings in only one transaction on CreditWatch negative (Uropa Securities Series PLC series 2007-1B). We have since resolved the CreditWatch placements as the relevant transaction parties formally confirmed transition to Sterling Overnight Index Average (SONIA) where relevant, effective from the first interest determination date in 2023 (see "Uropa Securities Series 2007-1B U.K. RMBS Notes Ratings Affirmed," published on July 22, 2022). We expect servicers and/or trustees to work toward timely and smooth transitions to an alternative benchmark to avoid a transition frenzy in December.

The Transition Journey

After an early but slow start in 2017, the preparation performed by various parties for the transition of U.K. RMBS and ABS transactions away from LIBOR reached its climax at the end of 2021, the point at which the sterling LIBOR was discontinued. Sponsors and issuers--with the help of law firms, servicers, and custodians--facilitated the transition of these transactions to an alternative benchmark rate (e.g., daily compounded SONIA) or synthetic LIBOR when SONIA was not possible for technical or legal reasons. Our rated U.K. RMBS and ABS universe comprises 69 transactions with classes of notes referencing sterling LIBOR. Of these transactions, 71% have transitioned to daily compounded SONIA, with the remaining 29% to synthetic LIBOR (see chart 1).

Chart 1

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An FCA consultation (CP22/11) instigated on June 30, 2022 about the best timing to retire the one-, six-, and three-month synthetic LIBOR rates ran until Aug. 24, 2022. In particular, it requested feedback on ceasing the publication of one- and six-month sterling LIBOR settings at end-March 2023 instead of end-December 2022, as well as some indication about the timing of the withdrawal of the three-month sterling LIBOR. For the next 10 years, it will decide annually whether to continue publishing the index, with a hard stop in December 2031. The outcome could further accelerate the need to find an alternative benchmark to synthetic rates. The three-month synthetic LIBOR rate is widely used in U.K. RMBS, so discontinuing it could prove problematic and disruptive. The consultation also seeks views on the nature and size of remaining exposures to USD LIBOR and associated transition plans before the end of June 2023.

So far, market participants estimate a transition success rate of above 90% for the overall LIBOR-referencing notes universe, with the rest primarily pre-financial crisis or "tough legacy" transactions, with lenders, sponsors, or arrangers no longer around.

Synthetic LIBOR preferred for "tough legacy" transactions

Transition of the notes' benchmark interest rate shows a clear pattern: All those that transitioned to synthetic LIBOR were legacy transactions (2005 to 2007), while post-financial crisis originated transactions typically moved to daily compounded SONIA. Legacy transactions present a series of challenges: Sponsors, lenders, or arrangers may no longer be around, noteholders may be hard to identify, or the documentation may not contemplate a change in the notes' benchmark rate.

Noteholder consent solicitation proved difficult

For transactions closed before 2018, an interest benchmark transition via note consent solicitation was the preferred and easiest route. Regulators also somewhat encouraged this method of resolution. However, the process is long and includes an extraordinary resolution for all classes of notes, including identifying all investors and in some cases asking for help from custodians. It was also an iterative process due to inquorate meetings being adjourned and/or not all classes of notes voting in favor of a specific course of action.

For more recent transactions, a fallback mechanism laid out in the legal documentation facilitated the transition. It was simpler and, in some cases, by default the resolution was implemented unless a small percentage (e.g., 10%) of noteholders blocked the process.

Only seven transactions are exposed to U.S. dollar-denominated LIBOR

Historically, U.K. commercial banks' RMBS master trusts have been the main issuers of U.S. dollar-denominated tranches. Minimal tranches remain outstanding, given their recent low issuance volume due to originators' preference for cheap central bank funding. Only seven classes of notes reference USD LIBOR, among them a mix of RMBS, ABS, and corporate securitization. Three transitioned to the Secured Overnight Financing Rate (SOFR), while the other four still reference USD LIBOR and have until June 2023 to transition to an alternative benchmark.

Slightly less than half of U.K. RMBS and ABS sterling-LIBOR referencing assets have transitioned to synthetic LIBOR

While most of the focus has been on the liabilities' transition, assets referencing sterling LIBOR have also transitioned. Notably, these do not necessarily belong to the same transactions and basis risk may still materialize post-transition. Among our universe, 86 transactions had assets exposed to sterling LIBOR. Of these, 43% saw their assets' benchmark interest rate transition to synthetic LIBOR, with the balance split between the Bank of England base rate (BBR; 22%), mixed alternative rates whereby the transaction transitions to more than one alternative rate (21%), daily compounded SONIA (7%), and Term SONIA (7%) (see chart 2).

Chart 2

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Interestingly, the Term SONIA is used on the assets' side, but not yet contemplated on the notes' side. We understand the regulator favored the use of the Term SONIA for less sophisticated agents, such as retail customers. Additionally, we have sometimes seen several alternative benchmark rates used in the same transaction, reflecting different practices across servicers. Just over 20% of U.K. RMBS and ABS transactions that we rate due for transition represent mixed transitions where assets have moved to several alternative benchmark rates (in most of these cases assets have transitioned to synthetic LIBOR and BBR).

Finally, in line with the transition witnessed on the liability side, almost all assets in legacy transactions have transitioned to synthetic LIBOR, with very few exceptions transitioning to the BBR. In other words, the same disruption risk present on the notes' side is present here if the relevant synthetic rate is no longer published at the end of the year.

Comparing the assets' yield pre- and post-transition and assessing the credit impact is challenging because:

  • Not all assets within a given transaction necessarily reference LIBOR, meaning not all loans must transition. The effect of the transition can be distorted by the proportion of these other assets and the level of their benchmark and interest rates. This argument also holds true for mixed transitions described above.
  • Affected transactions transitioned over a period of two years and recent market volatility would have affected the yield due to the interest benchmark movements.
  • While a higher asset yield increases excess spread, it could ultimately be credit negative as borrowers may no longer be able to afford their mortgages. This holds particularly for nonconforming borrowers with an interest-only floating rate mortgage, in our view. That said, lenders need to treat all customers fairly, according to FCA regulations, and would not be able to charge an usury rate.
  • When interest rates were low, most borrowers initially took a passive approach following mortgage interest rate benchmark changes. But things have gradually changed and against the backdrop of the cost-of-living crisis, they may be wondering if the actual mortgage rate rise could be due to monetary policy tightening and/or the actual benchmark transition.
  • Finally, some transitions are temporary (for those having elected to reference synthetic LIBOR) so it may be too early to tell the end effect.

LIBOR transition has entailed associated annual fixed fees. However, we consider these to be non-material (approximately £250,000 based on our analysis of a large sample of transactions), and to have a minimal impact on the overall credit performance of transactions.

Rating Agency Confirmations And Basis Risk Stress Remain An Integral Part of Our Analysis

Over the last two years, numerous transaction parties have approached S&P Global Ratings for a rating action confirmation (RAC) to assess the impact of a change in the LIBOR benchmark rate on the asset and/or liability and/or hedge agreements before the transition. In some cases, this was required by the trustee. However, a RAC is not a requirement before a change to transaction documents materializes. If the transition occurred without a RAC, we would then assess the updated transaction details during our surveillance process.

We quantify a potential discrepancy between notes' and assets' interest rate benchmark post-transition by stressing basis risk. The levels are laid out in paragraph 26 of our RMBS criteria guidance. As mentioned above, the basis risk stress captures notes paying daily compounded SONIA or synthetic LIBOR, whereas assets pay either a SONIA rate, BBR, or synthetic LIBOR.

Related Criteria

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Arnaud Checconi, London + 44 20 7176 3410;
ChecconiA@spglobal.com

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