Key Takeaways
- We analyzed a representative sample of private student loan transactions to determine the potential rating impact of the ongoing transition from LIBOR to a SOFR-based index.
- Based on our analysis, we expect the transition to result in minimal negative rating actions.
In anticipation of the cessation of the remaining U.S. dollar settings for the London Interbank Offered Rate (LIBOR) on June 30, 2023, and the expected transition to a Secured Overnight Funds Rate (SOFR)-based index, we conducted a scenario analysis on a cross-section of private student loan asset-backed securities (ABS) transactions rated by S&P Global Ratings. Our analysis considered the current state of regulatory guidance and other financial market actions, as well as interest rate transition scenarios, to determine the potential rating impact on private student loan transactions.
The LIBOR To SOFR Transition Thus Far
In the U.S., financial market participants and regulatory authorities have taken various actions that we believe have significantly narrowed the range of potential outcomes for the complete transition to SOFR from LIBOR in June 2023. These actions include the Consolidated Appropriations Act of 2022, which was signed into law on March 15, 2022, and contains the Adjustable Interest Rate (LIBOR) Act. This legislation provides a benchmark replacement framework for LIBOR contracts that lack clearly defined or practicable fallback language. It also provides a legal safe harbor for transactions containing weak fallback language or that rely on a determining person to select a new rate, if the statutory replacement rate is chosen as the new rate.
The legislation also affirmed that the statutory replacement rate for LIBOR will be a SOFR-based rate, which the Federal Reserve will publish within 180 days of the legislation's signing. However, the Federal Reserve has made no such announcement to date. The law includes tenor spread adjustments (see table), some of which were recommended by the Alternative Reference Rates Committee (ARRC). These spread adjustments are suggested margins that will be added to the SOFR replacement rate to compensate lenders for the difference between LIBOR (which includes a credit component) and SOFR (which is a risk-free rate) to minimize the expected change in the value of financial contracts.
| Recommended Spread Adjustments | |
|---|---|
| Tenor | Tenor spread adjustment (%) |
| Overnight U.S. dollar LIBOR | 0.00644 |
| 1-month U.S. dollar LIBOR | 0.11448 |
| 3-month U.S. dollar LIBOR | 0.26161 |
| 6-month U.S. dollar LIBOR | 0.42826 |
| 12-month U.S. dollar LIBOR | 0.71513 |
Analytical Assumptions For Assets And Liabilities In Student Loan Transactions
Approximately half of the 206 private student loan transactions rated by S&P Global Ratings may be exposed to basis risk in connection with the transition of trust assets and liabilities to SOFR from LIBOR, which must occur on or before June 30, 2023. Basis risk may arise when the interest rates on the assets diverge from the interest rates on the liabilities. To assess this risk, we performed cash flow scenario analyses on a representative sample of private student loan transactions with a range of characteristics, including loan type (in-school or refinanced), capital structure (sequential or pro rata), and asset and liability composition (the proportion of floating rates indexed to LIBOR). This sample consists of seven private student loan transactions, which we believe represent approximately 91% of the tranches that could be affected.
We assumed that all assets and liabilities currently linked to LIBOR transition to a SOFR-based index on day one of the cash flows. Although the legislation provides for the tenor spread adjustment on the assets to be implemented over a one-year phase-in period, we did not assume any phase-in period in our analysis because we believe its effect will be de minimis. We also used rating-stressed assumptions to obtain a break-even default percentage, assumed the assets and liabilities were both indexed to the same SOFR index, and applied the relevant SOFR vectors (e.g., the one-, three-, or six-month rate) (see "Methodology To Derive Stressed Interest Rates In Structured Finance," published April 8, 2022). All other assumptions were held constant between the LIBOR and SOFR scenarios, including existing fees and expenses.
The Expected Credit Impact Is Negligible
Based on our scenario analysis of the representative sample of private student loan transactions, we believe the transition to SOFR from LIBOR is unlikely to result in negative rating actions. Despite the relatively wide range of assets and liabilities indexed to LIBOR, we found the difference between the existing LIBOR-indexed and the projected SOFR-indexed cash flow results to be de minimis in the modeled transactions (see chart). We also observed that there were no material differences between the LIBOR-indexed and the projected SOFR-indexed break-even default percentages across all rating stress levels.
Overall, we believe these cash flow results and our conclusions are consistent with the actions market participants and regulators have taken thus far to encourage an orderly transition from LIBOR to SOFR. We also believe these actions will leave all parties fairly and similarly situated, and we will continue to take market updates into consideration as they arise.
This report does not constitute a rating action.
| Analytical Contacts: | Matthew Monaco, New York + 1 (212) 438 6263; matthew.monaco@spglobal.com |
| Mark W O'Neil, New York + (212) 438-2617; mark.o'neil@spglobal.com | |
| Bryan Albright, CFA, Centennial + 1 (303) 721 4932; bryan.albright@spglobal.com | |
| Shane N Franciscovich, New York + 1 (212) 438 2033; shane.franciscovich@spglobal.com |
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