The impending demise of Libor is the talk of the U.S. securitization industry.
But what is not in vogue at the moment is action.
In just over two years, the key benchmark rate used to price trillions in global derivatives, bonds and loans will likely disappear after the UK’s Financial Conduct Authority plans to cease quoting empaneled banks on daily interbank lending rate estimates.
Plans are well underway to develop and build adoption of an alternative term rate for U.S. dollar-Libor. A private industry working group convened by the Federal Reserve, the Alternative Reference Rate Committee, has recommended the adoption of a replacement benchmark based on the Secured Overnight Financing Rate. SOFR, based on overnight repurchase agreements backed by Treasuries, is published daily by the New York Fed.
The ARRC’s endorsement has pushed SOFR as an early favorite to succeed Libor, as some securitization issuers have issued SOFR-based notes or established it as the designated fill-in for Libor when the market switch occurs.
But a large majority of investors, ABS issuers and bankers are far behind schedule in the planning stages for the switchover that most expect to occur after 2021.
“Less than a third of the industry has had any communication” with counterparties about replacing Libor, according to Deloitte & Touche partner Alex Surkov, speaking on one of three Libor replacement panels that ran concurrently on Sept. 22, the opening day of the three-day, 25th annual ABS East securitization industry confab in Miami in September.
That figure was alarming to the panel members alongside Surkov, since the undertaking of replacing the benchmark not only requires picking the new rate, but formally laying out the steps for when to adopt it – and apply it to both new-issue assets as well as retroactively re-price legacy securities that were originally issued with a floating-rate Libor term rate.
The challenge is that any new rate must ensure that investor value and expected returns are preserved.
Surkov’s dire statistics from on online survey taken during a recent Deloitte webcast on Libor replacement plans also included this: only 5% of attendees had issued securities products or made investments in vehicles based on SOFR rates.
That doesn’t mean SOFR itself is off to a slow start. SOFR-based products already tally more than $1 trillion in daily trading volume (compared to $500 billion for Libor), and the rate has been applied as the benchmark to $230 billion of U.S. ABS issuance, according to Meredith Coffey, the host panelist for one of the Libor discussions at ABS East and the executive vice president for research and public policy for the Loan Syndications and Trading Association (Coffey also sits on the ARRC).
The volume of deals with Libor rates is daunting. Check Weilamann, the chief credit officer and ratings agency analyst with Morningstar Inc.’s DBRS, noted that 12,000-14,000 rated securitizations in the U.S. contain variable-rate Libor tranches – 45% of them within residential mortgage-backed securities, 20% in asset-backed deals and another 20% in structured credit/collateralized loan obligations.
“People cannot wait for Superman to come in on this,” warned Weilamann.
Much of the legacy deals remain vulnerable to a Libor disappearance because of incomplete or inconsistent contract document language that does not cover circumstances for the absence of Libor.
“There’s a small minority that have, as the ultimate fallback, Libor as ‘last in effect,’” said Melanie Gnazzo, a partner at Chapman and Cutler. “With a temporary unavailability, it’s not that big a deal.
But “for permanent unavailability, you’re converting to a fixed-rate security something that was a variable rate security, which nobody really expected,” she said.
Nitish Idnani, an advisory principal at Deloitte, added in a separate panel discussion on that Sunday that it was important that ABS participants “don’t underestimate the amount of testing that will need to happen” when trying to affix replacement rates.
A handful of issuers have adopted the ARRC recommendation as “fallback” language in existing securitization deal documents that would formally replace Libor with SOFR under certain conditions (such as the lack of a published Libor rate).
There remains some belief that Libor could be continued in another capacity besides its expert-opinion polling.
At a prior ABS show in 2018, ICE Benchmark Administration president Timothy Bowler declared that ICE intended to continue publishing Libor benchmark rates - although perhaps far fewer than the 35 different currency and tenor configurations currently quoted
But that is not something the industry, or regulators, are banking on. Pete Phelan, deputy assistant secretary for capital markets at the U.S. Treasury, also appeared at the panel to lend support to the SOFR transition effort. He revealed that the Treasury is “at early stages” of looking into conducting SOFR-based issuance. He noted, without disclosing details, Treasury has recently attended a closed executive session meeting with the Financial Stability Oversight Council, as part of “doing everything we can from the official sector side to help create an environment that will be conductiv eot private sector transformation.
“It’s really important to remember that Libor is based in Londin; it’s regulated by the UK’s Financial Conduct Authority, said Phelan. “Executive director Andrew Bailey stated very clearly that FCA will not compel banks to submit to the panel after 2021...It would seem very reasonable to expect bansk to stop contributing at that point.”
If issuers and investors believe the endeavor too difficult, the Monday panel with Coffey included a London-based trade group executive who explained that the transition to the UK’s replacement benchmark rate - SONIA, or Sterling Overnight Interbank Averager Rate - has gone much more smoothly across the pond.
“There’s been a huge amount of progress,” said Richard Hopkin, the managing director and head of fixed income, capital markets for the Associaiton for Financial Markets in Europe (AFME). “Nobody looking to issue beyond 2021 would even think about issuing in (British-sterling) Libor. They would issue in Sonia.”
The rate gained early support with bond issuances last year by the European Investment Bank (EIB) tied to the SONIA benchmark for a GBP-denomianted five-year bond. That was quickly followed with covered-bond issuances, leading to a total volume of 30 securitizations sized at £17 billion - £15 billion since April aone. That leaves “only a small amount left issuing Libor” notes, said Hopkin.
Two issues of note over the U.S. SOFR rate were addressed by the Sunday panels. SOFR compounded rates have been lower than comparable Libor rates since being launched in Apri 2018. In addition, the SOFR rates have shown volatility during year-end and quarterly-end periods.
Greg Hertrich, a managing director of Nomura - which in No.3 on investment-bank league tables for SOFR issuance - said that Nomura “initially” found there was a slight premium investors would pay to lock into a SOFR rate, but that has dissipated now that some large investors are using their buying power to negotiate lower rates for SOFR-benchmarked deals that are becoming more prevalent. “These numbers are not going to get smaller,” Hertrich said. The industry “is at a point now where issuers and investors are accepting” of SOFR-rate deals, said Hertrich.
Coffey’s panel included a presentation explaining how SOFR rates in use(new issue or replacement) are being determined to fill in for Libor. Since there is no published SOFR term rate, these ABS issuers have had to adapt the daily SOFR into makeshift benchmarks by compounding the daily rates over a 30-day or other contract period, according to a panel chart presentation. The accumulated rates are either “advance” rates calculated by prior 30-day figures, or “in arrears” that would add apply interest based on the rates published during the interest period of a contract).
