October 29, 2020 - CLO practitioners are buckling down to do the hard work of LIBOR transition. First, managers are beginning to remediate their portfolios. Second, rating agencies are wading into fallback language – and risk assessments. Third, Wells Fargo analyzed the fallback situation and offered some words of wisdom. We discuss remediation nearby, and dig into the other two topics below.
In early October, S&P announced that “As the Deadline for the Transition from LIBOR Approaches, Work Remains for U.S. Structured Finance.” That’s putting it mildly. S&P analyzed more than $700 billion in structured finance transactions, including $345 billion of CLOs, to assess the state of their fallback language and determine where weaknesses could emerge. S&P reviewed ultimate fallback language – i.e., the fallback language that would exist after other potential fallbacks are exhausted – and determined how it would affect the securitization’s credit risk profile. Having “no fallback” or “bank polling” as an ultimate fallback led to a weaker credit risk profile. Falling back to a fixed rate (i.e., last quoted LIBOR) or having a key transaction party identify the fallback required further review to determine the impact on the structure’s credit risk profile. However, having a specified fallback rate (such as Prime) or using an ARRC-like hardwired fallback strengthened a structure’s credit risk profile.
So, how did CLOs look? Eyeballing the chart on p. 5 of the S&P report suggests that about 69% of the $345 billion of tracked CLOs will have their rate determined by the key transaction party and about 12% will go to last quoted LIBOR. (The impact on the credit risk profile for both of these approaches “needs further review”.) Meanwhile, about 19% appear to use ARRC-like hardwired fallbacks, which strengthens the credit risk profile.
So how do LIBOR fallbacks impact CLOs – and what should CLO investors consider? Wells Fargo shared their views this week as they “Step into the LIBORatory”. On page 16, Wells noted that, in late 2020, investors may start charging higher premiums – eventually getting to at least 20 bps – on CLOs with weak or non-existent fallback language. To address this weakness, noteholders may be incented to seek amendments to improve fallback language. Meanwhile, equity holders might be incented to do these amendments… alongside provisions to improve flexibility in workout, the proposed WARF calculation change by Moody’s and the provision of bond buckets. (We humbly note that the LSTA worked with its CLO Committee to develop a standard form of amendment to insert hardwired fallbacks into CLOs that have inadequate fallback language. The CLO Amendment Exposure Draft was released to membership in early October, and will be published in final form shortly.)
On page 20, Wells Fargo identifies LIBOR exposure risks to investors across the capital stack. Senior note holders often are highly regulated institutions, subject to regulatory pressures, and likely would prefer consistent (and regulator-friendly) fallback language. Mezzanine investors likely would like consistency, as well as avoiding basis risk between assets and liabilities. (Do note that the second step in the ARRC hardwired fallback differs for loans (Daily Simple SOFR) and CLOs (SOFR Compounded in Arrears); however the basis between the two has typically been a basis point or less.) CLO equity investors are particularly exposed to and concerned with basis risk (which, per above, is very small for Simple and Compounded SOFR).
Wells Fargo left readers with a few final words of wisdom. P. 21 recommends that noteholders should scrutinize fallback language to ensure it doesn’t ultimately go to last quoted LIBOR. In addition, LIBOR replacement language should contain a spread adjustment and the replacement rate should have a zero floor; replacement language should compel the issuer to propose a new rate if none can be agreed upon, and should be consented to by the majority of the controlling debt class and equity. Meanwhile, equity should eliminate the potential for basis risk between assets and liabilities.
And, finally, while neither Wells Fargo nor S&P actually used these words, the subtext might be “get cracking, people”.