Regulators expressed their dismay about asset-backed securities (ABS) deals completed last fall that priced over the term version of the secured overnight financing rate (SOFR), when only banks' business loans and floating-rate consumer loans and the securitizations that pool them have been given the green light to use it.
However, issuers of other securitizations, especially those securitizing amortizing assets, see significant benefits to term SOFR and there's no rule preventing them from using it--an issue without a firm resolution moving into 2023.
Investors also appear to view securitizations' floating-rate tranches priced over term SOFR more favorably than any of the methodologies to generate interest payments using daily SOFR. The Toyota Motor Corp.'s $1.6 billion securitization priced at the start of last November, Toyota Auto Receivables Owners Trust (TAOT) 2022-D included a $298 million floating rate tranche that priced at par over one-month term SOFR at a spread of 69 basis points, well below the 72 to 74 initial guidance, according to the Arizent Deal Database.
A few weeks later, World Omni Financial, which securitizes assets originating mainly from Toyota dealerships, initially sought to include a floating-rate tranche priced over term SOFR in a $1 billion securitization and completed the deal using daily SOFR, according to Arizent. That deal priced at the top end of guidance.
World Omni's flip to daily SOFR coincided with the Alternative Reference Rates Committee's (ARRC) November 9 meeting in which some members of the Federal Reserve-sponsored industry group that designed SOFR expressed concerns about recent securitizations using term SOFR when their securitized assets were not priced over term SOFR.
Toyota also appears to have heard regulators' concerns, and the floating-rate tranche in its first 2023 ABS deal from the TAOT shelf priced recently over daily SOFR, not term, according to Arizent.
"The ARRC reiterated its existing best practice recommendations and plans to continue to discuss and follow the use of Term SOFR as part of its ongoing work related to Term SOFR's recommended scope of use," according that meeting's minutes.
The language in the minutes suggests the ARRC may be open to a compromise. Since then, however, Rostin Behnam, chairman of the Commodity Futures Trading Commission, stated in mid-November that the "use of term SOFR rates in derivatives and most other cash markets must be limited." Securities and Exchange Commission Chair Gary Gensler made similar remarks Dec. 16 that he delivered to the Financial Stability Oversight Council (FSOC).
Defeating the Purpose
The regulators are concerned that the growing use of term SOFR will reduce demand for daily SOFR futures that are used to construct the SOFR forward curve. That could degrade the viability of SOFR as a forward-looking term rate now used for business loans and CLOs in a similar dynamic that led to the demise of Libor, the floating-rate benchmark that SOFR has replaced.
The term SOFR rate, like outgoing Libor, is particularly helpful to corporate borrowers, since they know precisely what their interest payments will be at the end of the term and can better forecast their cash. A July 21, 2021 statement from the ARRC acknowledged that reality, stating that term SOFR rates "will be especially helpful" to syndicated, middle market and trade finance loans. In addition, "best practices" also include term SOFR rates for derivatives borrowers use to hedge loans linked to term SOFR rates, and "certain securitizations with underlying assets that are themselves tied to" term SOFR rates.
Those securitizations are primarily collateralized loan obligations (CLOs) that pool broadly syndicated and middle-market loans. Those floating-rate loans were typically priced over term benchmarks—Libor and more recently SOFR. Similar to corporate borrowers, CLO issuers face complications using daily SOFR instead of a term rate, as do investors in those securities.
Daily SOFR complexities
The simple and compounded methods necessarily stop aggregating daily SOFR rates a few days short of the allotted period in order to calculate the rate. However, both lenders issuing the ABS bonds and their investors discover what the interest payment is at practically the end of one-month, three-month or other period, instead of at the start of the term. That's particularly complicated for securitizations, because multiple parties are typically involved in the payment process, and must follow a specific contractually agreed cash flow waterfall.
"Certain sectors in our market are facing operational challenges," said Kristi Leo, president of the Structured Finance Association, adding that auto-loan deals and other securitizations with amortizing assets face the even bigger challenges, since "unlike most other fixed-income products the principal balance of the securities are dynamically declining."
Floating-rate ABS tranches can also be priced using SOFR-in-advance, in which the daily SOFR rate is averaged over the previous month and then used to set the rate for the next month. That approach provides issuers with the rate at the start of the chosen rate period, but some investors have balked at applying it.
"Human beings have three basic needs: Food, shelter, and the need to know their interest rate in advance," said Stuart Litwin, a partner at Mayer Brown. "SOFR in advance can create a mismatch in a rising rate environment" between the SOFR-in-advance previous month's average rate and the current market rate.
"Some investors have refused to buy those securities," Litwin said.
The volume of floating-rate tranches in securitizations other than CLOs is relatively small. A banker familiar with the Toyota transaction said that auto ABS issuers generally issue fixed-rate bonds and add a floating-rate tranche—when the fixed-rate market is advantageous—to increase investor participation. The Toyota ABS deal's floating-rate tranche was 20% of the total transaction. However, should the ARRC and/or regulators offer a compromise that permits some additional floating-rate ABS, it likely will be limited.
"Given the statements from the CFTC and other regulators, they likely would seek to define any permitted use of term SOFR in ABS narrowly, and not to permit it to be used generally in rate risk-generating circumstances," said Nihal Patel, partner, financial services, at Fried, Frank, Harris, Shriver & Jacobson.
