More than 2,500 Fitch-rated structured finance transactions face significant challenges transitioning from Libor to an alternative floating-rate benchmark, but the rating-agency doesn’t foresee that resulting in potential ratings downgrades until 2022.
Fitch Ratings says in “Legacy Libor Exposure is Significant in U.S. and UK Structure Finance,” published July 30, that the transition for many transactions remains uncertain, especially for “legacy Libor” exposure. Those transactions closed before mid-2019 and their maturities extend past 2021, when Libor is at risk of no longer functioning as a benchmark for floating-rate financial products. The challenges arise because those deals do not contain the robust language to “fall back” to alternative benchmark that was put in later transactions.
“Transactions with legacy Libor exposure face particularly challenging obstacles due to the lack of clear guidance for transaction parties upon a permanent Libor cessation,” the Fitch report says.
Fitch says the higher number of Fitch-rated transactions with Libor exposure is in U.S. residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). It adds that it will determine the robustness of plans to transition the transactions on the relevant parties’ adherence to guidance from the Alternative Reference Rates Committee (ARRC), and that the potential impact will also depend on the magnitude of several risks.
“We believe that the main Libor transition risks for [structured finance] are operational, legal and interest-rate mismatch risks,” the report says, adding the risks are magnified for US transactions issued under the Trust Indenture Act of 1939, which requires 100% consent from investors.
The ARRC’s recommended fallback language provides greater clarity about how and when the replacement index rate will be chosen, but when to execute the transition of various transactions will vary by sector and jurisdiction.
“A transaction-by-transaction approach is therefore needed to identify the bondholders,” the report says.
In terms of a timeline, Fitch believes market participants will need to develop plans in more detail by the end of this year or early 2021, and regulatory and/or legislative changes will likely be required to facilitate the transition. If there’s insufficient progress, the ratings agency says, affected ratings could be put on Rating Watch Negative starting in mid 2021, with downgrades unlikely to occur before early 2022.
“In the U.S., approximately 65% of Fitch rated [structured finance] transactions have some form of Libor exposure either through notes or assets,” the report says, and that exposure falls to about half when only legacy-libor transactions are considered. In the US, RMBS has the greatest legacy-Libor exposure, followed by CDOs, including mostly CLOs and some trust preferred securities, and then asset-backed securities, with most of that exposure in FFELP student loan securitizations.
