Today’s Manipulation Monitor post moves beyond our usual focus on manipulation of the financial markets to part of the collateral damage resulting from that manipulation: the end of LIBOR and other inter-bank benchmark rates (see here, here, here , here, here and here).
This post is the first in a series of posts on the particularly complex issue of LIBOR transition on asset-backed securities, such as residential mortgage-backed securities, which face the additional complication of there being two levels of transition: LIBOR-indexed mortgage notes that are assets of the securitization trust and LIBOR-indexed interest rates paid on the securities issued the securitization trust.
This multi-level aspect of the securitization creates potential mismatches between the interest rate paid by the trust’s assets and the interest rate paid to the trust’s investors. To the extent stakeholders in the trust structure, such as the trustee or servicer, have discretion to choose what the LIBOR replacement rates will be, there is the question of how they will exercise that discretion and to whose advantage they will exercise it. Adding to the complexity, who will benefit and how will vary depending on many factors, including the status of the securitization trust and of each class of securities issued by the trust, the design of the trust’s payment waterfall, whether the trustee also is a security-holder and who has the right to do a clean-up call (that is, the right to purchase all of the trust’s assets).
Uncertainties in the LIBOR transition—whether because of the right of players in the trust structure to exercise discretion or because of questions about how laws passed to facilitate the transition will (or can) be implemented—bring into question how asset-backed securities should be valued and whether such uncertainties create financial risk or, alternatively, trading opportunities. And, of course, uncertainties create the potential for litigation and its attendant costs (including depletion of the trust estate to pay the trustee’s legal fees) and delay.
This post sets the scene by giving some background to the structure of securitization trusts and the potential for different approaches to LIBOR transition at different levels of the trust. In later posts, we will discuss legislative fixes to the transition problems (one already implemented and others proposed) and how investors in LIBOR-indexed asset-backed securities might be affected by, and react to, the LIBOR transition.
There are many other types of securitization that involve LIBOR-indexed assets, and each type likely presents challenges unique to it or a class of similar assets. I have chosen RMBS not just because it is the security with which I am most familiar, but also because it is a large asset class with long-lived assets. While most mortgages in an RMBS trust typically are paid off or refinanced within ten years of a trust’s creation, there are many much older trusts that still have performing mortgages to which the LIBOR transition rules must be applied. In other words, the LIBOR transition problem is not going to go away soon for RMBS, as it will through the normal attrition of short-lived assets or agreements in other asset classes.
LIBOR-Indexed Mortgage Notes
The RMBS securitization process begins when a lender makes home loans, secured by mortgages, to borrowers. Those loans sometimes are secured by notes having variable interest rates indexed to LIBOR. And it is here that the first complication arises. Many lenders use the FannieMae/FreddieMac standard note template, and that template contains LIBOR replacement language that commonly was used in mortgage notes that I discuss below. But even though most mortgage notes have used the FannieMae/FreddieMac LIBOR replacement language, at some point soon, trustees and servicers will have to analyze every mortgage note to make sure that they know for every loan how the interest rate on that loan will be affected by the end of LIBOR. The question for investors (and homeowners, of course) is what to do if trustees and servicers forego that expensive and time-consuming process and just work off the assumption that all notes use the LIBOR replacement language in the FannieMae/FreddieMac standard note template.
FannieMae/FreddieMac have adjusted their standard note template and policies to account for the LIBOR transition and as of the end of 2020, no longer offer LIBOR-indexed products. Prior to that, however, the FannieMae/FreddieMac standard note form used this LIBOR definition and fallback language:
The “Index” is the average of interbank offered rates for one month U.S. dollar-denominated deposits in the London market (“LIBOR”), as published in The Wall Street Journal. The most recent Index figure available as of the date 15 days before each Interest Rate Change Date is called the “Current Index”. If the Index is no longer available, the Note Holder will choose a new index that is based upon comparable information. The Note Holder will give notice of this choice. The Note Holder will deliver or mail to me [Borrower] a notice of any changes in the amount of my monthly payment before the effective date of any change.
Here, once LIBOR no longer is published, the trustee of the securitization trust, as the owner of the note, gets to “choose a new index that is based upon comparable information.” This is great for the trustee, perhaps not so much for the borrower, but “comparable information” is a vague term that is sure to be the subject of litigation. As I will discuss in a later post, there are legislative solutions (both adopted and proposed) to the problem of litigation over the trustee’s choice of a replacement rate.
LIBOR-Indexed Payments to RMBS Investors
The further complication when it comes to RMBS—where these mortgage notes are securitized—is that there potentially is another level of LIBOR transition to consider. In an RMBS securitization, the originators of mortgage loans sell those loans and they ultimately are transferred to a securitization trust. The trust pays for the loans by issuing securities entitling holders to a share of the revenue generated by the loans. The investment bank creating the securitization sells the securities to investors and uses the proceeds to pay for the loans.
Generally, the interest paid to investors in a securitization trust is not based on (although it certainly correlates to) the interest rate borrowers agreed to pay in their mortgage notes. Rather, the rates paid to investors are set in the securitization document and vary by the amount of risk an investor is willing to take using sometimes-complex payment waterfalls.
For many trusts, the interest rate paid to investors is indexed to LIBOR. As with individual mortgage notes, there is no standard LIBOR fallback language in securitization documents. Because there are only thousands of RMBS securitization trusts, rather than tens of millions of mortgage notes, it will not be particularly burdensome for a trust’s servicer or trustee to determine how the trust is supposed to pay investors if LIBOR no longer is available.
Still, complications remain. For example, the definition of LIBOR in the pooling and servicing agreement for a typical RMBS securitization trust, ABFC 2006-OPT1, explains what the trustee is to do if LIBOR is not available, offering a waterfall of choices based on what information is available to the trustee.
“One-Month LIBOR”: With respect to each Interest Accrual Period, the rate determined by the Trustee on the related LIBOR Determination Date on the basis of the interbank offered rate for one-month United States dollar deposits in the London market as such rate appears on the Telerate Page 3750, as of 11:00 a.m. (London time) on such LIBOR Determination Date. If such rate does not appear on that page (or such other page as may replace that page on that service, or if such service is no longer offered, another service for displaying One-Month LIBOR or comparable rates as selected by the Trustee) on a LIBOR Determination Date, One-Month LIBOR for the related Interest Accrual Period will be the Reference Bank Rate, determined by the Trustee as follows:
(i) If on such LIBOR Determination Date two or more Reference Banks provide Reference Bank Rates, One-Month LIBOR for the related Interest Accrual Period shall be the arithmetic mean of such Reference Bank Rates (rounded upwards if necessary to the nearest whole multiple of 0.001%);
(ii) If on such LIBOR Determination Date fewer than two Reference Banks provide Reference Bank Rates, One-Month LIBOR for the related Interest Accrual Period shall be the arithmetic mean of the rates quoted by one or more major banks in New York City, selected by the Trustee after consultation with the Depositor and the NIMS Insurer, as of 11:00 A.M., New York City time, on such date for loans in U.S. Dollars to leading European banks for a period of one month in amounts approximately equal to the aggregate Certificate Principal Balance of the Offered Certificates and the Class B Certificates; and
(iii) If no such quotations can be obtained, One-Month LIBOR for the related Interest Accrual Period shall be One-Month LIBOR for the prior Distribution Date.
This LIBOR fallback language—which is common—is well-suited to the situation where LIBOR is temporarily unavailable, but is unsuited to the situation we now face, which is that LIBOR will permanently be unavailable. In particular, clause (iii) means that variable-rate securities would become fixed-rate securities, with the rate permanently set at the LIBOR rate last used by the trust before LIBOR terminated.
It is uncertain what trustees will do with this language, and this, plus the uncertainty associated with how LIBOR transition will be handled for each mortgage note, creates a double dose of litigation risk and valuation questions for RMBS owners.
Other Securitized Assets
While I have focused on RMBS, similar LIBOR transition issues exist with other securitized or structured assets, such as commercial mortgage-backed securities and collateralized loan obligations, although for various reasons I will touch on later, the LIBOR transition issues likely will be less severe.
Here, I have explained the contours of the LIBOR transition problem for securitized assets, and particularly for RMBS. My next post will cover the legislative solutions (both adopted and proposed) to the problem of LIBOR transition in securitization trusts. They offer solutions to the issues I have discussed above, but uncertainty—and hence substantial litigation risk—remains on their ultimate scope or effectiveness.
I am grateful to my colleague Hannah Zelcer and to Chris Milner of the Oakleaf Group and Joshua Stein of Joshua Stein PLLC for their assistance and insights in drafting this post.