The structured finance and residential mortgage backed securities market are currently preparing themselves for an event that is being described as the equivalent of Y2K for banking: December 31, 2021, when the London Interbank Offered Rate (“LIBOR”) will no longer be an available index. When asked about the potential disruption of the market on a scale of 1-10 in a recent discussion of LIBOR, Structured Finance Association President Kristi Leo said, “I would say its closer to the scale of 10 – as far as if we don’t do it correctly and do the transition right, it really can be fairly disruptive to financial markets… In worst cases, you may not receive monthly interest payments, which could be very disruptive…”
While the massive undertaking of moving contracts over to new benchmarks has been underway for some time, some RMBS Trustees have begun providing informational notices relating to the upcoming cessation of the LIBOR, including Wells Fargo, Deutsche Bank, and U.S. Bank. The impact of this change varies depending on the RMBS’ trusts exposure to LIBOR and the extent of the fallback provisions provided in the underlying documents. Most RMBS trusts have some form of exposure to LIBOR. Typically, the certificates and the collateral use LIBOR as an index, and some trusts have additional exposure in the form of SWAPs, derivatives or hedges.
Fallback Language for LIBOR Transition to Alternative Reference Dates
As Ms. Leo points out in the aforementioned discussion, the cessation of LIBOR beggars the question, “if you own a mortgage loan and its based off of LIBOR – it’s a floating rate mortgage loan – what payment do you make come the beginning of 2022?”
An S&P Global Ratings’ initial transaction sample review in the U.S. indicates six general categories of liability fallbacks. Liability fallbacks are dominated by the transaction party selecting a new rate and fixing the last posted LIBOR rate. Official bodies, most predominantly the Alternative Reference Rate Committee (“ARRC”), which are working with market participants on LIBOR transition, have sought to minimize any transfer of value between borrower and lender in their recommendations regarding new rate selection. However, existing documentation typically does not specify adding a credit spread to new risk-free-rates, including SOFR – which both Fannie Mae and Freddie Mac have announced as their LIBOR replacement index.
In anticipation of the cessation of LIBOR, most U.S. securitizations issued since 2019 have incorporated hardwired AARC fallback language, available here, into deal documents. However, most older legacy transactions do not even consider this possibility, and due to the legal necessity of unanimous investor approval to modify interest rate liability language, these transactions pose the greatest challenge for the market moving forward. Based on our research and review of the underlying documents the LIBOR fallback provisions vary significantly. All these alternatives will have an impact on your investment. In some cases, the impact could be negative.
Oakleaf Group LIBOR Transition Client Support
The Oakleaf Group has extensive expertise in analyzing RMBS trusts performance and in-depth knowledge of the underlying governing documents (“Documents”). We have developed an in-house database which can extract language relating to specific terms from the Documents. This database permits us to analyze the underlying Documents associated with a pool of RMBSs in an efficient and automated manner.
Depending on the LIBOR alternative, The Oakleaf Group is equipped with expertise to assist in the understanding of the potential investment and legal risk, associated with this transition. Please reach out to Maclean Amlalo if you are interested in learning more about how this could impact your portfolio.
 LIBORcast: A Conversation with the Structured Finance Association. YouTube, 5 October 2020.
 “As the Deadline for the Transition from LIBOR Approaches, Work Remains for U.S. Structured Finance.” S & P Global, 6 October, 2020.