The US securitization market may be moving to a decisive resolution on how it will deal with regulatory demands that no new contracts be based on Libor, the benchmark rate underpinning trillions of dollars of securitizations and other securities, after the end of December. But legacy deals — those so old that they make no provision for an alternative benchmark rate — are proving a thornier problem to fix.
“The market is rapidly moving towards the regulators’ firm cut-off date,” says Douglas Youngman, a partner at law firm Holland & Knight. “We have seen a recent uptick in deals starting out with a Sofr rate, even in product areas that had lagged behind before.”
While recent securitizations in the US market have either already adopted the Secured Overnight Financing Rate (Sofr) as their alternative benchmark rate, or contain fall-back provisions to handle alternative rates to Libor, there is still a chunk of the market that make no provision for an alternative.
That chunk comprises legacy deals that were issued long enough ago that there is no successor interest rate benchmark rate clearly identified in the contracts. Those deals have until the end of June 2023 to find an alternative, after which the dollar Libor rates not discontinued at the end of 2021 — the one week and two month tenors — will cease to be published.
In such cases, shareholders must all consent to any contract amendments — a near impossible feat to achieve given the sheer number of parties typically involved and their different, sometimes competing, motivations.
To clear this hurdle, market participants have long discussed the possibility of a regulatory solution, but it is only recently that any real progress has been made.
New York became the first state to make legislative progress when, in April 2021, it passed legislation that enabled two fixes for tough legacy contracts. The new rules automatically replace Libor by the “recommended benchmark replacement,” most likely Sofr, or, in the case the contract has a “determining person,” they gain the power to replace the benchmark rate themselves.
A federal bill has also been drafted and is now at the House, awaiting a full vote. The bill is expected to be a “game changer,” sources say, especially for floating rate ABS like federal student loans.
And there are many reasons why the bill will be taken very seriously, according to Joseph Lynyak, a partner at Dorsey & Whitney.
For one, the supporters of the legislation include strong capital markets advocates such as the New York Federal Reserve and Federal Reserve Board-led Alternative Reference Rates Committee — a group of market and public sector participants assembled to ensure a smooth transition away from dollar Libor, consisting of large corporations, financial institutions, trade bodies and government agencies, among others.
Moreover, the legislation will allow for the market to avoid “a potential tsunami of litigations,” another “compelling argument” to pass the bill, says Lynyak.
Kristi Leo, president of the Structured Finance Association, also has high hopes for the legislation. “There is support on both sides — a bipartisan bill, which is a rare sight in Congress these days,” she says.
For all the optimism, there is a real need to have the legislation passed, which Leo suspects could happen in December. The alternative will “just be a mess,” says Chris DiAngelo, a partner at Katten Muchin Rosenman.
Under that scenario, switching reference rates on legacy deals is likely to cause disputes between shareholders and lenders, which often have the power to choose the fall-back benchmarks, according to the contracts.
Nonetheless, others argue that the legislation will not be a cure-all solution. “Federal and/or state legislative solutions are not clear solutions,” says Lynyak. “The authority of the government to dictate winners and losers in what are essentially contractual payment disputes will certainly be challenged.”
Not everyone expects delivery of the bill to be quick and easy either. Some believe it will take longer than anticipated due to how busy Congress’s schedule has been with other legislation in the past few months.
“We’re not optimistic that it will be picked up any time soon, just given other Congressional priorities and the multi-jurisdictional complexity of the issue,” says Youngman. “Unfortunately, securitizations in particular — like certain other types of debt instruments — can be very difficult to change.”
Thanksgiving crossroads
In the US CLO market, market participants will spend even longer figuring over how the Libor transition will work, even with the help that the new legislation may provide.
It is a sector of the market that may have flown in 2021 in terms of growth and issuance volume, with supply expected at the time of writing to hit $150bn by year-end, but it lags behind in the adoption of Sofr and, at the time of writing, had produced only two tranches linked to the new benchmark rate, let alone a full deal.
But that is expected to change as the end of the year approaches with the Thanksgiving holiday out of the way.
New issues typically take four to six weeks from pricing to the closing date, and market participants want to avoid headaches with deals priced in the Libor era having their closing dates spill into 2022.
That means that deals priced late in the year will be most likely to reference Sofr as institutional buyers avoid lumbering themselves with Libor-based products for the new year.
“By mid-December, it is unlikely that many new money Libor referencing CLOs will price,” says Scott Macklin, director of leveraged loans at AllianceBernstein.
Right adjustment
So far, only two managers have brought deals that reference Sofr. In October, Onex Credit Partners reset a CLO originally printed in 2015 and included a liability tranche linked to the new benchmark rate. Then, in mid-November, Marathon Asset Management became the first manager to issue a new CLO priced off Sofr.
That raised another concern, which is the spread adjustment to be made between Libor and Sofr. Marthon’s deal implied a 20bp spread adjustment to Libor.
But adding such a spread worsens the economics of CLOs. Bank of America analysts calculated that if that 20bp spread adjustment had been applied to the whole capital stack, the arbitrage in the deal would fall by 10bp, hitting the equity tranche.
The Alternative Reference Rates Committee (ARRC) recommendation is to make a 26bp spread adjustment, creating a battleground for equity and liability investors.
The basis between Libor and Sofr in the rates market is closer to 10bp-11bp, illustrating a large disconnection between the ARRC recommendation and reality.
“CLO equity investors believe the spread adjustment should equate to that current market differential,” says Macklin.
“However, existing liability investors have a vested interest in establishing a standard basis at wider levels because many existing Libor-referencing CLO deals contain language in their documents allowing for a benchmark transition at market levels,” he says. “As a result, there is a significant bid-offer between CLO liability and equity investors as to the right spread adjustment levels.”
Market sources believe the CLO market will find a balance but until it does, Sofr-based issuance will be hindered.
Difficult legacy
Many CLO managers, particularly the smaller ones, have preferred to wait before pricing deals to see how the transition shakes out.
“The market is ready,” says Chris Jackson, a partner in the securitization practice at Allen & Overy. “It takes a few transactions linked to Sofr before the market will know what the boundaries of the negotiations between debt and equity are.”
Law firms, after a frenzied year of US CLO issuance, are once again fielding questions about — and examining the documentation of — legacy deals.
There are various provisions in place. CLOs done in the last 12-18 months have contained clauses dictating that Sofr will become the benchmark rate 60 calendar days after notice of a benchmark rate transition. Other CLOs have fall-back clauses that allow CLO liabilities to flip to referencing Sofr once 50% of the underlying loan assets also pay a rate based off the new benchmark.
The challenge will be refinancing older deals. “Some provisions from three or two years ago say that you can replace Libor on all the notes with any rate that the controlling class [the triple-A rated tranches] consents to,” says Jackson. “A manager can replace a triple-A investor with a new investor that requires Libor fall-back language.
“Then a triple-B investor, whose fall-back rate could be determined by the consent of the triple-A investor, is subject to a different set of Libor fall-back provisions. You might have two regimes that apply for determining interest on two different portions of the debt, two sets of rules. That is a sort of a strange result that we may or may not see in the future.” GC
