5 minute read 25 Jul 2019
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Four LIBOR considerations for the US securitization industry

By

Roy Choudhury

EY Americas Capital Markets Advisory Leader

Banking and capital markets transformation leader with extensive global experience. Voracious reader. Globe-trotter. Father to a son.

5 minute read 25 Jul 2019

If LIBOR ends, how can the structured finance market mobilize, respond and prepare for the transition to alternative reference rates?

The potential for the London interbank offered rate (LIBOR) to be permanently discontinued in 2021 is pushing a broad segment of the market, including those within the US securitization industry, to focus on their long-standing exposure to interbank offered rates (IBORs).

The complexity and scale of the transition from US dollar (US$) LIBOR to alternative reference rates (ARRs) is expected to be a significant transformation effort for market participants. The inherent complexities of securitizations further compound the already substantial issues associated with the LIBOR transition.

How the industry is getting ready

In the US, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to identity leading practices for selecting ARRs, and develop an adoption plan to facilitate the acceptance and use of ARRs on a voluntary basis. A working group within the ARRC is focused on developing approaches for the securitization industry to transition from US$ LIBOR to ARRs.

In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents the best practice to use in certain new US$ derivatives and other financial contracts.1

A current priority for working groups in the US securitization market is to provide recommendations for fallback contract language to implement SOFR as a fallback for US$ LIBOR in new securitization transactions based on feedback from market participants. The language is designed to establish an effective fallback rate in the event that LIBOR is discontinued or is no longer usable. These working groups also consider the efforts of other product-specific working groups for derivatives and cash products to drive consistency in fallback language between asset classes and find solutions that reduce basis risk between the securities and the corresponding underlying collateral as well as any related hedges.

Industry groups are also expected to consider approaches to transition existing securitization portfolios referencing LIBOR and provide guidance to the market on ARRs being used as the reference rate within new securitization transactions.

Structured finance market participants — including banks, issuers, investors, trustees, rating agencies and servicers — should participate in or actively monitor these discussions to the extent appropriate for their exposure to LIBOR-linked products and contracts.

In January 2019, the UK’s Financial Conduct Authority reiterated the wide recognition that LIBOR will end and explored different approaches to the final stages of the transition.2 As of the end of 2016, the total exposure to US$ LIBOR across cash and derivative products was close to US$200t, of which securitizations transactions represented US$1.8t.3

Four considerations for the US structured finance market

1. Valuation 
  • Uncertainty about future liquidity of LIBOR markets and the value of any US$ LIBOR-based product following the transition to ARRs or other fallback rates may cause significant changes to the valuation of LIBOR-based portfolios (value transfer).
  • Structured finance market participants need to consider the impact of potential mismatches in timing and the fallback language for the securities and underlying collateral of a transaction.
2. Legal and reputational issues
  • Different stakeholder interests in a securitization transaction increase the risk of litigation, fines or reputational damage related to the transition to ARRs.
  • Legal and reputational impacts can be mitigated by clear communication between parties to avoid misunderstanding.
  • Assessing fallback provisions within legacy products and managing the repapering process will require significant effort due to the volume and complexity of the securitization contracts throughout the lifecycle of the transaction.
3. Operational changes
  • LIBOR is deeply embedded across the business and technology infrastructure of securitization market, and organizations should be preparing to implement the operational changes required to adopt ARRs.
  • The operational impact can be sized by assessing the dependencies to LIBOR within current processes, systems, data and models. 
  • Detailed analysis across risk and pricing models is required to understand the depth of impact as models will need to be redeveloped, recalibrated and revalidated for ARRs. 
  • Preparation for a phased transition or the potential for timing differences between the securities and underlying collateral of a transaction may require operational capabilities to be enhanced to support multi-rate environments (e.g., LIBOR and ARRs).
4. Financial reporting 
  • Transitioning to ARRs requires firms to analyze accounting treatments that may have a direct impact on an instrument’s fair value and related hedging strategies.
  • A change in index for a security requires an entity that consolidates the corresponding special-purpose vehicle and holds both the liabilities and assets to consider whether such change is considered a modification or extinguishment to the liability.
  • A change in index related to an investment classified as either trading or available-for-sale results in changes to the fair value of an investment, requiring investors to account for the mark-to-market impacts of the fair value changes due to fallback rates.
  • Servicing assets and liabilities are initially recognized at fair value. Subsequently, an entity may choose to follow either an amortization approach (evaluating impairment and increased obligation based on fair value) or a fair value mark-to-market approach. Where a fair value mark-to-market approach is selected, a change in discount rates may lead to an immediate change in fair value of the servicing asset or liability that will impact P&L.
  • The Financial Accounting Standards Board has added SOFR as a benchmark interest rate for hedging purposes. However, several other transition implications are still outstanding that impact the assessment of hedge effectiveness, probability of cash flows, and mismatches in timing of the hedging instrument and hedged item’s transition.

What should securitization market participants do now?

The transition to ARRs is expected to be a multiyear effort requiring constant monitoring of market developments and an approach that can evolve as progress is made by the industry. Actions that market participants should undertake include:

  • Appointing senior executives to be accountable for assessing, planning and coordinating transition activities 
  • Mobilizing an enterprise-wide LIBOR transition program office with dedicated resources to own and execute all project activities across lines of business and control functions
  • Updating contract documentation for new transactions to include fallback language based on the recommendations from the ARRC and other industry groups
  • Conducting an enterprise-wide LIBOR transition impact assessment to inventory LIBOR-linked products, legal contracts, risk exposures, models, business processes and infrastructure
  • Developing a LIBOR transition road map based on the results of the impact assessment that describes the prioritized plans, resources and activities required for the adoption of ARRs
  • Participating in or monitoring working groups so that the latest market developments, leading practices and market dependencies are reflected within LIBOR transition planning
  • Defining and executing a communication and education strategy for issuers, investors and other key parties to increase awareness and help to avoid the perception of conflicts of interest

Summary

With the likely transition from the London interbank offered rate (LIBOR) to alternative reference rates (ARRs), the US securitization industry will need to determine what approaches to take and the extent of their exposure to LIBOR-linked products and contracts. 

About this article

By

Roy Choudhury

EY Americas Capital Markets Advisory Leader

Banking and capital markets transformation leader with extensive global experience. Voracious reader. Globe-trotter. Father to a son.