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SF Credit Brief: What the Federal Forbearance Extension Could Mean for the FFELP Student Loan ABS
European structured finance issuers will step up efforts to phase out sterling LIBOR before December 31 this year . To minimize the impact of credit on structured finance transactions, references to sterling LIBOR must be replaced with alternative benchmark rates, usually Risk Free Rates (RFRs), and appropriate adjustments to credit spreads on assets and liabilities. Structured finance issues are sensitive on the interest transition process, as their transaction conditions usually only allow a limited amount of changes after the closing. Implementing significant changes often requires the approval of a wide variety of parties, including transaction participants and non-owners. The risk of payment disruptions generally depends on the complexity of the operation in determining the note coupon when the LIBOR is completely suspended. Even so, the European structured finance market’s advances in moving away from LIBOR have outpaced the US market as the Sterling Overnight Index Average (SONIA) is now a popular alternative for new issues.
However, challenges remain this year including dealing with « hard legacy » contracts or contracts that cannot realistically be renegotiated or changed. In addition, about half of asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) transactions exposed to LIBOR have interest rate hedges that need to be changed to reflect the replacement interest rates.
As of 2017, the Bank of England Working Group on Sterling Risk Free Rates has recognized SONIA as the preferred RFR for sterling markets. Because SONIA rates are fundamentally different from Sterling LIBOR, the transition is more complex than just replacing one rate benchmark with another. LIBOR is a term and forward-looking rate, while SONIA is an overnight rate that requires compounding and a review period (until a term for the SONIA rate is available). Since the LIBOR is not an RFR, it has exceeded the composite SONIA in the past by a risk premium that reflects the bank’s credit risk. In the long term, the one-month gap between Sterling LIBOR and the compound daily SONIA was approximately 15 basis points.
The conversion of LIBOR to SONIA under a financial contract requires an adjustment of the credit spread to allow for a transfer of value between the lender and avoid the borrower. We believe that minimizing the transfer of value will help prevent disputes. Market participants and regulators have held several consultations to reach consensus on the method of adjusting credit spreads. However, due to our discussions with market participants, challenges remain. Some service providers have expressed concerns that the Working Group’s recommendation to use a historical five-year median to determine the spread may not preserve the economic value of the contracts given the current low interest rate environment and the difference in weighted average maturity between transactions.
Although a Term Rate is not yet available for SONIA, new structured finance questions in Europe have been using the benchmark frequently since 2019, which has boosted market confidence. This is in contrast to the still low use of the Secured Overnight Financing Rate (SOFR) on the structured financial market denominated in US dollars, where the lack of a term rate is often cited as the reason.
Daily composed SONIA in retrospect a five day lookback period is often used as a coupon benchmark for sterling ABS and RMBS. By the end of 2020, we had valued 71 SONIA-related structured finance problems in sterling worth £ 56 billion, including legacy assets transferred from LIBOR to SONIA. In 2020, all sterling floating rate issues were related to SONIA. For comparison: So far we have not assessed any structured financial problems in US dollars in connection with SOFR.
Shortly before the deadline, the clock for LIBOR replacement for legacy transactions is running. In the final quarter of 2020, 16 ABS issues from two different securitization programs were valued to replace sterling LIBOR with SONIA. We anticipate that the transition process will accelerate in 2021 and encourage the parties to the transaction to inform us of their transition plans as early as possible (see « Early notification of interest rate changes for structured finance transactions due to the requested LIBOR transition, » published on 13th January). 2021).
One complex issue that continues to be discussed is the replacement of benchmark interest rates in existing financial contracts. UK regulators and market participants held an important consultation on January 18, 2021, on the ability of the Financial Conduct Authority (FCA) to approve a so-called « synthetic LIBOR » under proposed changes to the Financial Services Act. This can be used in « hard inheritance » contracts or in contracts that cannot realistically be renegotiated or changed. A synthetic sterling LIBOR is intended to be a reasonable approximation of the sterling LIBOR after 2021, while it would in no way restore the representativeness of the outgoing benchmark.
It remains an open question how « hard legacy » contracts should be defined. Based on the FCA’s recent announcement, these would include loan agreements that did not require borrower consent to change the benchmark rate or bonds that did not require creditors’ consent to convert the coupon rate. Despite this announcement, market participants are waiting for a more precise definition and their ability and willingness to use synthetic sterling LIBOR for eligible contracts remains uncertain. The use of synthetic LIBOR outside the UK market is also questionable. We expect further consultations to provide more clarity during the course of the year.
By the end of 2020, we had assessed 170 issues related to sterling or US dollar LIBOR in the Europe, Middle East and Africa (EMEA) region . Most of these transactions are covered by assets sourced from the UK and RMBS represents the largest exposure in our monitoring portfolio (see Figure 1).
For these transactions we have the feasibility of determining the coupon rate on post-expiration bonds of LIBOR is checked based on two factors: the language categories for the disclaimer language and the ability to change transaction documents.
For each transaction, the bond terms define the LIBOR and provide a decision-making chain, who is the appointed agent who acts on behalf of the issuer , to derive the LIBOR applicable on a particular determination date. Most transactions follow this path:
Based on the ultimate LIBOR setting option when screen rate is not available, we have identified five fallback language categories described in the table below and ranked from weakest to strongest.
We have analyzed the transaction-specific terms for note reference rate replacement and the creditors’ consent requirements.
According to the recommended AFME language, the bond trustee would agree with the issuer to change the applicable benchmark interest rate for the notes without the consent of the creditors or secured creditors if certain conditions are triggered, including indefinitely setting LIBOR as the current benchmark interest rate. The only change would not be made if more than 10% of holders of the highest class of bonds objected during the reporting period, although this could still be agreed by an extraordinary resolution. We consider this form of non-owner consent to be a kind of « negative consent ». It is clear that there is less operational burden on issuers than options that require explicit shareholder consent, which makes the transition process easier from that perspective.
For most transactions completed prior to 2018, represents a change the interest rate setting represents a « change in the basic conditions » which the creditors concerned must approve as an extraordinary resolution. The quorum for passing an extraordinary resolution typically requires a vote of 75% (or in some limited cases 66.7%) of the creditors concerned. Compared to the US market, which requires 100% of the votes, passing an Extraordinary Resolution is more practical for UK deals. This underpins our expectation that most sterling LIBOR issues will be converted to RFR in 2021.
RMBS represents 55% of our EMEA surveillance portfolio that is exposed to LIBOR. At the end of 2020, we rated 102 RMBS issues pegged to policy rate, including 426 classes pegged to sterling LIBOR and 18 classes pegged to US dollar LIBOR.
Our review of the note terms for RMBS resulted in a high degree of consistency in fallback language and the approval of the creditors required to replace the benchmark. All transactions have either bank queries or LIBOR fixing as a fallback, and the wording of the relevant note terms is very similar, if not identical, in each category. None of the RMBS issues have any discretion on the part of the transaction party with regard to the applicable rate. For most of the contaminated sites, the consent of the non-holders to replace the reference rate is obtained.
If the screen rate is not available, 63 issues, all of which were closed before mid-2018, can access the LIBOR coupon according to the terms of the transaction documents last quoted LIBOR. A change in the coupon benchmark will usually be treated as a change in the basic conditions, subject to the approval of the shareholders in an extraordinary meeting with a quorum of 75% for each class concerned.
Nineteen RMBS issues closed in 2018 or 2019, adhered to the AFME language and allowed for a smoother changeover to an alternative tariff if consent of the negative shareholders allowed it. All UK floating rate RMBS issues in pounds sterling placed from 2020 are already linked to daily compound interest.
There are 20 RMBS issues in our portfolio with relatively weak LIBOR fallback contingent liabilities: they are the last based on bank surveys Funds and will ask at least 75% of Shareholders for approval to replace the Reference Rate. From our point of view, these transactions would be under the greatest pressure this year to switch to an alternative course in order to minimize payment disruptions.
By switching from LIBOR to RFR, structured financial notes on the basis risk can be introduced. This risk has several causes, including the size of the adjustments to credit spreads, timing gaps between the conversion of the assets and liabilities when the transition affects both, and changes in the swap terms for hedged classes. In addition, expenses related to the tariff change may contribute to the priority transition costs. In order to evaluate the possible impact on the rating for each issue, we analyze these factors individually as soon as we become aware of the changed transaction documentation. Since junior tranches tend to be more dependent on excessive spread than senior tranches, they are most sensitive to the basis risk resulting from the interest rate conversion.
In the fourth quarter of 2020 we have the UK RMBS servicers after asked about their transition LIBOR plans for the bonds and the underlying mortgage contracts.
For note coupon rates, most servicers indicated that they intend to replace LIBOR with retrospective daily SONIA as the market standard for transactions in the UK in 2021. For some legacy transactions, the goal is to exercise the call option this year before the LIBOR phase. out.
Servicers said the hardest part that could slow the transition is sizing a credit adjustment spread to minimize the economic impact. For those transactions that require explicit shareholder consent to approve the new RFR, the servicers expect the approval process to take anywhere from one to three months.
While some servicers plan to start the first quarter with the To begin notifying borrowers and completing the transition within months, others said they would wait for more FCA guidance on « hard inheritance » contracts and decide on a final course of action in mid-2021. The changeover to an alternative tariff may depend on the underlying contracts: If the changeover is only possible after the end of LIBOR, the transfer can only take place after the end of the year, unless the FCA expressly allows an earlier start date.
Im Unlike structured finance liabilities, there is no market standard for the new benchmark interest rate that would replace LIBOR for underlying loan agreements. Depending on the servicer, converted loans follow the base rate of the Bank of England (BBR) or a BBR-linked floating standard rate.
Synthetic LIBOR is considered the last option if conversion to an alternative benchmark fails. Some servicers believe there may be legacy contracts that could introduce synthetic LIBOR after December, albeit to a limited extent. Some service providers may also consider using fixed term SONIA rates in the loan agreements if those rates are available and widespread in the market. Most service providers indicated that their final strategy would largely be determined by further market consultations and regulatory guidance, as well as consumer protection and litigation risk considerations.
Based on servicer feedback, we expect the asset rate conversion to be more than half of RMBS transactions lag behind the coupon rate transition. This is due to the time it takes to develop and implement a borrower notification strategy and regulatory considerations. Services expect this to be a multi-step process this year and possibly even beyond 2021. Even if the LIBOR transition does not reduce the excess spread, some RMBS issues may be temporarily exposed to a higher basis risk than in the period prior to the transition, with a negative impact on the rating.
Almost half of the outstanding UK LIBOR-linked RMBS notes that we are hedged with swap or cap arrangements that cover basis risk or foreign currency mismatch or both.
The International Swaps and Derivatives Association (ISDA) 2006 definitions include a fallback – US dollar and sterling LIBOR language, in the event the screen rate is not available for every floating rate option, effectively, at the discretion of key transaction parties or bank surveys. The original provisions were developed to regulate the temporary, rather than permanent, suspension of LIBOR. In October 2020, ISDA published the IBOR fallback supplement to the ISDA definition from 2006, which contains the new fallback provisions. This went into effect on January 25, 2021 for those parties who adhere to the fallback protocol or otherwise bilaterally agree to include the new fallbacks in swap contracts.
Based on our discussions with the servicers, most transactions are targeted on changing swap agreements with the involved counterparties on a bilateral basis. Changes to the terms of a swap agreement will normally require notification of Shareholders but not prior express consent from Shareholders. The exact procedure is specified in the notes on a case-by-case basis. The common intention is to align the timing and terms of the swap changes with the remaining changes in the transaction documentation. The need to change hedge contracts can add additional delay to the transition process, and the changed swap terms will be one of the key cash flow considerations when assessing the rating impact on the Notes (see « Credit FAQ: SONIA as an alternative to LIBOR « In UK Structured Finance Transactions », published on February 6, 2019) We consider compliance with the new ISDA fallback protocol to be unlikely.
For all other asset classes, our portfolio of LIBOR-linked transactions includes 24 ABS with 44 rated bond classes, 21 structured credit transactions, 18 CMBS, five corporate securitisations and four covered bond programs.
In the fourth quarter of 2020, 16 of the 24 issues were novated to replace LIBOR with daily composed SONIA, and the novation did not result in any negative rating measures. Only one of the outstanding issues has bank surveys as the ultimate fallback settlement and is being repaid this year. In addition, a transaction allows LIBOR to be pegged, but does not describe the required form of non-holder consent to replace the coupon reference rate.
16 of the 24 issues contain AFME-compliant LIBOR fallback contingent liabilities. Six other experienced transactions, which were completed between 2012 and 2017, allow the LIBOR to be set and at the same time ask the voting rights holders to vote on the new benchmark with a quorum of 75%.
In contrast to RMBS, most ABS- Transactions with fixed income assets secured and therefore not exposed to LIBOR on the assets side. This limits the base risk associated with the LIBOR conversion timing mismatch for the assets and the debt securities.
Half of the LIBOR linked ABS classes are hedged and consist of 20 sterling tranches and one dollar denominated tranche Tranche. For them, the need to change swap contracts is an important factor to consider in the changeover process.
Of the weaker provisions we have observed, nine topics include a combination of bank surveys with an extraordinary meeting of creditors to approve the transfer to an RFR that requires 75% or 66.7% of the voters. One transaction involves fixing LIBOR with a quorum of 100% of the shareholders required for the switch, and another issue describes bank surveys without a defined form of shareholder consent.
For other transactions we observed a stronger fallback language with six Cases of LIBOR fixing and a quorum of 75% or 66.7% for transfer to an RFR. two cases of LIBOR fixing without a defined form of consent from the shareholders; a case according to the AFME language; and a case of discontinuing a note coupon at the discretion of the main transaction parties in combination with a switch to RFR, provided that the negative creditors agree.
Half of our structured credit issues with a rating that are exposed to LIBOR are repackaged securities, whereby the underlying collateral is also linked to LIBOR. As these transactions do not have an excessive spread, synchronizing the transfer of assets and liabilities to an RFR is key to limiting potential cash flow risks.
Under the provisions for nine issues, all of which closed before mid-2014, the LIBOR can be set at the last available time that the LIBOR screen rate is no longer available, but there is no specific language for transmission to an RFR.
Four transactions allow LIBOR to be set and transmitted to an RFR with Negative creditor approval with a quorum threshold of 10% or 25%. This is the least risky solution.
In five transactions, LIBOR can be fixed on the last available date and the issuer would hold consultations with shareholders about the new RFR in a manner it deems appropriate to without any formal need for an express vote or negative consent of the shareholders. For most transactions, the consultation period is limited to 10 days. It is difficult to assess whether consultation of non-holders is an operationally more efficient form of approval compared to a formal general meeting, as we believe it depends largely on the concentration of bond ownership.
We rate five corporate securitisations in the UK as variable Sterling LIBOR Interest Bearing Notes. For two, fixing LIBOR is the ultimate tool, while the remaining three rely on bank queries. In either case, the transfer to a new RFR would require express shareholder approval by 75% of the quorum for all bonds. Since corporate securitisations are typically only held by a small number of investors, achieving the required quorum may be easier compared to more general issues in other asset classes.
We are evaluating two other corporate securitisations in the UK, AA Bond Co. and RAC Bond Co., which contain LIBOR-indexed bank debt that ranks pari passu with rated senior notes so that if LIBOR is discontinued, the rated notes will be indirectly exposed to the revised terms.
We are evaluating four covered bond programs with exposure to sterling LIBOR, three of which will be redeemed before December or use the last LIBOR rate as the reference rate for redeeming bonds in early 2022. The issuer of the other program has confirmed its intention to replace LIBOR before the end of 2021.
Since covered bonds are backed by the general obligations of the issuing banks that are expected to remain solvent in the short term, long term issuer ratings in the category Maintain “A” or higher and continue to be actively involved in their debt management The replacement will be done through a consent process with the creditors. The issuers may offer a small premium on the Notes to offset the conversion costs in addition to adjusting the credit spread in line with previous precedents. We therefore do not expect any setbacks in the transition process.
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