Replacing LIBOR presents challenges for the structured finance (SF) market that are likely to be addressed in the context of industry-wide initiatives, Fitch Ratings says.
The long lead time and a desire to avoid disruption to floating-rate bond markets such as SF should support the transition to standard benchmarks as successor reference rates. The impact on SF will depend on which rates are adopted, how consensual the process is across all market participants, and how they deal with technical and administrative challenges.
LIBOR is the reference rate for SF bonds and related derivatives contracts in several large SF markets. Almost all of the USD450 billion of US CLO notes outstanding reference LIBOR, as do USD186 billion of US sub-prime/Alt-A RMBS and USD24 billion of US prime RMBS. US student loan ABS commonly reference LIBOR. Elsewhere, nearly all UK RMBS reference Libor. Some underlying loans, such as leveraged loans, US hybrid adjustable-rate mortgages, US student loans, and auto loans, reference LIBOR.
Panel banks will maintain LIBOR until end-2021. This gives capital markets four-and-a-half years to agree a successor regime for the bulk of bonds currently linked to LIBOR, enabling a coordinated transition to as few benchmarks as needed. This would avoid costly ad hoc negotiations and potentially complicated bespoke transaction amendments. Loan markets may follow suit, although the risk of fragmentation geographically and by asset class could create SF basis risk in respect of existing loans, or alter the level of credit-enhancing excess spread.
There are practical challenges in co-ordinating transition. Voting rights in SF transactions, in some cases requiring majority consent of all classes of notes, may complicate any amendment process and even increase the scope for inter-creditor disputes. Trustees will also have an important role in determining what conditions are placed on transaction parties. These challenges will require effective use of the long lead time available.
To preserve liquidity, we think bond markets will generally follow initiatives in the derivatives market, where funding is hedged and discount rates determined. The International Swaps and Derivatives Association is examining fall-back provisions in LIBOR swap contracts, and working groups in some jurisdictions have recommended alternative near-risk free reference rates for the derivatives market, including the Sterling Overnight Index Average (SONIA) in the UK and the Broad Treasuries Repo Financing Rate in the US.
But it remains unclear whether the eventual successors to LIBOR will be overnight rate benchmarks or forward rate benchmarks, how far this will vary from country to country, and whether loan markets will adopt the same reference rates at the same time (reducing basis risk). At the heart of these questions is the effect on the value of currently contracted interest payments.
Any move to replace LIBOR with a benchmark that increased interest costs, particularly for retail borrowers, would face political objections. But a reduction in interest earned could also face opposition. Balancing these interests may prompt efforts to adjust margins to leave loan and bond coupons unchanged. Challenges coordinating the transition for assets and liabilities could leave SF transactions with basis risk, or change the level of excess spread. Possible consequences for ratings would also depend on the weighted average life remaining after 2021.
Commercial borrower behaviour may contribute to these risks. For example, some commercial real estate and leveraged loans include fall-back provisions aimed at managing temporary disruptions in LIBOR determination (such as polling a small panel of banks). These could make it harder to co-ordinate the transition for underlying loans and SF bonds, particularly in the leveraged loan market.
Unlike floating-rate commercial mortgages, leveraged loans are typically not hedged against interest rate risk, and may have more latitude in diverging from standardised successor benchmarks emerging from the derivatives market. If leveraged loan borrowers felt it was in their commercial interests to argue that fall-back provisions apply, basis risk would arise if CLOs moved to more liquid successor benchmarks.