In relation to the asset-backed securities themselves, i.e. the front-end of an ABS structure, the considerations highlighted elsewhere in relation to FRNs apply equally, both in relation to legacy and new issuances.
A complicating factor, however, is that ABS structures are dependent (from a cash-flow and rating perspective, often critically) on the economic performance and behaviour of a host of underlying assets and related instruments – e.g. the loan/mortgage pool (and any hedges for the same), any interest rate and cross-currency hedges for the ABS and any swaps providing guaranteed balance, liquidity, transformation or credit enhancement. ABS structures may also feature liquidity facilities, GIC accounts and repo. To the extent that any of the foregoing contains an IBOR component, care will need to be given to repapering, in relation to legacy transactions, and to initial structuring, in relation to new transactions that reference RFRs.
So far the only work that has been done in relation to European ABS is by AFME, which has published Benchmark Rate Modification language intended to apply to newly orginated RMBS securitisation transactions. This provides a mechanism for the interest rate benchmark for the notes to be changed, although not for the interest rate hedging or the underlying assets in the deal (if LIBOR linked). UK RMBS are not usually benchmarked from LIBOR (it is more common in the US) but this was seen in pre-crisis sub-prime UK deals originated by some US investment banks. The AFME language obliges the note trustee and issuer to concur in deciding how to deal with IBOR discontinuance according to a fall-back waterfall. When deployed, it needs to be conditional on other consequential LIBOR payments having been changed. Typically, those would require a manual amendment outside the structure. The note issuer and trustee are also involved in those as owner or security trustee of the LIBOR cash flows, which then involves the note-holders in terms of consents and so on.
While we have recently seen this language used in newly originated RMBS transactions, it is not a panacea. This is because the language is largely “mechanical” in providing the means to effect a change to the benchmark rate rather than specifying the applicable rate. This being the case, the language does not advance the position with respect to legacy ABS deals (see below). In any event, the language needs to be tailored to each ABS transaction to cater for the features of the particular deal (not least as the AFME language is designed for RMBS) – it cannot therefore simply be “copied and pasted”.
Even with the inclusion of AFME based benchmark replacement language, when the time comes to implement changes, the process will remain manual and document intensive.
Further, the AFME waterfall is, notably and problematically, different to the fall-backs set out in the ISDA Benchmarks Supplement (which is the equivalent solution with respect to the OTC derivatives market that has been developed by ISDA) and so is not suitable if, as will more often than not be the case, related hedges are intended to move in tandem, economically, with the notes.
Parties may address this risk by expressly providing in the relevant Confirmation(s) that, in relation to hedging transactions that are subject to the terms of the Benchmarks Supplement, the provisions of the Benchmarks Supplement are disapplied and instead bespoke fall-back provisions, themselves set out in the relevant Confirmation(s), apply.
A further and related issue is that ABS prospectuses will need to include the question of IBOR discontinuance as an additional risk factor.
The AMFE language is designed for inclusion in new deals of a certain type. While issuers and originators could change existing transactions now to include the mechanism to make the necessary changes in the future, we think there is little point in doing this. The main reason is that, even with the mechanism included, the bigger job will be to make changes when the time comes. However, there is some doubt as to whether even the mechanism will achieve what it seeks to do. One thing which can be done now though, is to identify the LIBOR flows and the things that would need to be changed in order to make the transition – including any changes to economics and which parties are involved and who will pay for the costs of making the changes. See our checklist below
Frequently Asked Questions
Q. At the note level, can’t I just substitute an RFR for IBOR?
A. No. The metrics are different and without an adjustment (e.g. to the spread) to compensate for this, the note economics will be fundamentally altered. In addition, interest will accrue differently, payment mechanics will alter and systems will need to be modified accordingly. Furthermore, noteholder consent requirements must be considered and satisfied on a case-by-case basis.
Q. Is a Protocol or similar solution to the problem contemplated?
A. No. It is likely that repapering will have to occur on a transaction by transaction basis. Industry help may be at hand, however. In the US for example, the Structured Finance Industry Group and the ARRC have each issued similar recommended best practices for the phasing out of LIBOR as a benchmark for securitisations and for the transition to a replacement benchmark. In July 2019, Ford of America became the first US securitisation issuer to utilise ARRC fall-back language in relation to a tranche of ABS. Recognising that ABS structures constitute “tough legacy” transactions, in January 2020 the UK RFR WG made dealing with legacy ABS a top priority for the coming year.
Q. Can’t I just use the AFME language?
A. The AFME language is intended for newly originated RMBS transactions. It therefore provides a good starting point (and it can be adapted, of course, to other forms of ABS) but consideration will still have to be given to the particular features of any given ABS; in particular, how any related hedge deals with transition, so as to ensure that the note and any hedges move in tandem. Thought will also have to be given to every instrument within the structure that references an IBOR that is to be substituted for an RFR, so as to ensure ongoing structural integrity. In relation to new transactions, perhaps the only viable short-term solution is to structure the deal around the underlying assets as best one can, tailor hedges and other instruments accordingly and include IBOR discontinace as a risk factor in the note prospectus. The other obvious solution is to structure the deal around an existing RFR. The 2018 Elland RMBS and 2019 Silverstone securitisation are both examples of recent, long-dated, SONIA-based deals. In February 2019 S&P reviewed the implications of using SONIA in UK securitisations. Since then, over 50% of new securitisations are reported to have been SONIA-based.
Q. What if I do nothing?
A. Failure to address IBOR discontinuance carries with it various risks over and above pure economic turbulence (including basis risk and the risk of conversion of the note coupon to a permanent fixed rate). In addition to contractual continuity issues, there are risks of regulatory censure, adverse reputational consequences and that investors may be able to sue issuers or arrangers for misselling or to make disclosure-based claims. There are rumours that hedge funds may be considering acquiring positions solely for the purposes of suing issuers and other deal participants.
Check list of things to consider
- What are the relevant RFRs for my currencies/tenors?
- When do I want the change to take effect?
- Is there to be a spread adjustment?
- Do my terms and conditions need amending? Ditto risk factors in prospectuses?
- Do I need noteholder and/or rating agency consent? Who pays?
- Are there regulatory capital and/or compliance implications?
- Are there implications for payment mechanics, financial covenant testing, mark to market etc.?
- Are there accounting and tax implications as well as implications for P&L generally.
- What other instruments are in my structure? How is IBOR disappearance being dealt with in those and what do I need to do to ensure ongoing structural and economic integrity (including ongoing hedge accounting treatment)? Should I include IBOR discontinuance as a risk factor in the note prospectus? Do I need expressly to disapply the terms of the ISDA Benchmarks Supplement with respect to such instruments?
- Can I do a SONIA-based deal instead?