Likely postponement of USD Libor expiry gives structured finance market breathing space

The demise of USD Libor seems likely to be delayed until mid-2023, which gives the structured finance market another two and a half years to gets its house in order - but the time must be used wisely, stress well-placed market observers.

A December 1 announcement by the ICE Benchmark Administration, which administers Libor, that it was seeking an extension of life for the benchmark was immediately endorsed by key regulators like the Financial Conduct Authority (FCA) and the Federal Reserve. The alacrity with which such support was offered gave the impression to onlookers that the ICE announcement was did not come as a surprise to regulators, and consequently it is deemed very likely that there will be a stay of execution for the venerable benchmark.

The tenors to be granted a reprieve are overnight dollar Libor, one-month Libor, three-month Libor, six-month Libor and 12-month Libor. One-week Libor and two-month Libor will expire as planned at the end of 2021, but these benchmarks are rarely used.

This news is particularly pertinent to the structured finance market. Firstly, a high proportion of structured finance instruments use dollar Libor as a benchmark. Fitch reported last year that around 2500 structured finance notes and covered bond programmes which it rates have legacy exposure to USD Libor or GBP Libor.

The US RMBS market makes especially heavy use of dollar Libor, and it is a very large market. The MBS market comprises over a third of all US dollar fixed income issuance (more than Treasuries) and total issuance was over $4trn at the end of 2020, according to the most recent SIFMA quarterly report. The CDO market is also largely priced against Libor.

But the format of most structured finance transactions is also often rigid (“brain dead”, in the words of one source) so that the balance of liabilities and assets cannot be easily altered without risking a mismatch. In most cases, if there is no transition rate put in place then notes will simply pay the Libor rate at the last published rate, meaning, in effect that they will become fixed rate deals. Assets backing the transaction would remain floating, however.

Moreover, most structured finance trades in the US are governed by the Trust Indenture Act, passed in the 1930s to protect investors. This means any change in payment of interest must be approved by 100% of noteholders, which will be difficult to achieve.

Given the size of the difficulties and the fact that they have been largely unaddressed by the US structured finance market means that the delay of the expiry of US dollar Libor is welcome. But it has not been cancelled, only postponed. Unless the issue is taken in hand, the difficulties have been merely kicked down the road.

There are two areas that need to be addressed: the primary markets and the treatment of legacy bonds. Unless issuance is moved to SOFR, the recognised substitute rate, in short order, then the pile of legacy bonds which will need adjustment gets larger and larger. The Alternative Reference Committee (ARRC), a body of private market participants convened by the New York Federal Reserve and the Fed to help manage the transition, recommended in May 2020 that all CLOs cease using Libor from September 30 2021 while all other securitizations cease by June 30 2021.

“The industry now needs to shift the primary market away from Libor because every day that you don’t you’re basically creating more legacy bonds. This has to be done by the industry itself,” says Andreas Wilgen, group credit officer, structured finance, at Fitch Ratings in London.

In the MBS market, a healthy lead has been provided by Freddie Mac, and it began pricing STACR bonds against SOFR in 4Q 2020. JP Morgan also sold its first SOFR-referenced mortgage securitization at the end of last October.

Fannie Mae was unavailable for comment on whether it will transition issuance to SOFR as well.

In its review of the structured finance and securitization markets in 2020, leading law firm Hunton Andrews Kurth stresses “US financial institutions should stop using Libor as soon as practicable, but no later than December 31, 2021 and before then should include robust Libor fallback language.”

The bigger issue is the treatment of the trillions of dollars of legacy bonds, the great majority of which have no transition language and assume a world in which Libor goes on for ever and ever. It is a monumental task to re-arrange every single deal, so regulatory intervention is required, say onlookers.

“It needs a legislative approach. They need to say, ‘If you haven’t transitioned, the new floating rate will be SOFR plus a margin,” says one market source. Most deals are governed by New York state law, so action should proceed from New York lawmakers, and there are sign of progress in this regard.

Governor Andrew Cuomo’s fiscal 2022 budgetary proposal, released this week, incorporates proposed legislation whereby the use of the benchmark replacement recommended by the Federal Reserve, the New York Fed, or the ARRC would be required wherever existing contract language is silent or the contract’s fallback provisions prescribe the use of Libor. Where the fallback provisions are discretionary, the proposed legislation’s safe harbour is intended to encourage the selection of the recommended benchmark replacement.

Commenting on the proposal, which will now be considered by the state legislature, the CEO of the Structured Finance Association Andrew Bright commented, “We welcome inclusion of this language, which provides clarity and promotes financial stability, and we are hopeful this proposal will become law once the legislature analyzes the governor’s budget.”

However, in MBS deals, while issuance is governed by New York law, the constituent assets are often governed by the states in which the loans were made. So, at some stage, federal action is likely to be  required. This is more difficult to attain, particularly in the first year of a new administration.

At the moment, SOFR is at 20bp while three month Libor is 22bp, so bonds which incorporate SOFR as the new rate are likely to have to incorporate a thin credit margin.

All other Libors will cease publication as planned at the end of this year, including the widely used GBP Libor. The transition has gone more smoothly thanks, on the one hand, to a more centralised regulatory regime in London but also because the FCA has taken the issue in hand more authoritatively than its US counterparts, say sources.

In a document published in March last year, when it seemed that dollar Libor was due to expire at the scheduled date, Fitch Ratings wrote “.. the BoE and FCA have told market participants to prioritise transition even when factors such as the lack of a term rate have not been fully addressed, on the basis that this avoids bigger, potentially systemic, risks.” This no nonsense approach has, in the case of sterling Libor, yielded dividends.

Simon Boughey