January 10, 2019 - As even most grandmothers now know, LIBOR – the world’s most important number – may end after 2021. For this reason, responsible loan market participants are preparing for a transition. Step One: Ensure you have robust and actionable LIBOR fallback language in your loans and CLOs. Step Two: Recognize that loans and CLOs likely will have slightly different fallback language, and prepare for the hopefully modest risks that raises. Below we flag potential differences so lenders can prepare.
Lenders and CLO players have been working hard to develop more standard LIBOR fallback language. In September 2018, the Alternative Reference Rates Committee (ARRC) released a syndicated loan LIBOR fallback consultation (and posted responses in December). Also in December, the ARRC released a LIBOR fallback consultation for securitizations (including CLOs) and on January 7th, the ARRC (via SFIG and CREF-C, co-chairs of the ARRC’s Securitization Working Group) released a webcast and slides explaining the securitization consultation. While there is considerable overlap between the securitization fallback language and the loan hardwired fallback language, areas of difference likely will be unavoidable because the asset classes are different. These differences must be recognized and internalized. After all, U.S. CLOs hold more than $580 billion of syndicated loans and market participants need to know that differing fallbacks can introduce risks. Forewarned is forearmed.
Below we flag the components of fallback language and highlight major differences between securitization and syndicated loan fallback language. (For those not steeped in loan fallback language, we gently recommend the following links explaining i) loan triggers and ii) the loan hardwired approach.)
First, it is important to note that, like the syndicated loan fallback, the securitization LIBOR fallback language comprises three main components:
- The trigger. This is the event that precipitates a transition from LIBOR to a new reference rate.
- The benchmark replacement process/waterfall. This is the process by which the rate that replaces LIBOR is determined.
- The replacement benchmark spread adjustment. Because SOFR (the likely replacement rate) is expected to be lower than LIBOR, there likely will need to be a one-time spread adjustment to make the rates more comparable.
First, triggers. The mandatory triggers for syndicated loans and securitizations are generally the same and are based on the cessation, expected cessation or decline in quality/fitness of LIBOR. However, the ARRC’s securitization consultation has an additional trigger (see slides 14-16). If more than half of a securitization’s assets have transitioned to a new reference rate (such as SOFR), then the securitization’s liabilities also will transition to the new reference rate. This may be particularly relevant for CLOs for two reasons. First, lenders expect new loans will be done on SOFR before the end of LIBOR. Second, loan fallbacks have an optional “opt-in” trigger whereby if SOFR loans are being originated, an existing LIBOR loan can flip to SOFR. Thus, a CLO’s assets may quickly flip to SOFR while its liabilities are still tied to LIBOR. This can introduce basis risk.
Second, the mechanism for switching the rate. The loan amendment approach to fallbacks is different than proposals in other cash markets; it relies on the agent and the borrower identifying a replacement rate and spread adjustment, and the bank group having a five-day negative consent period. In contrast, the loan hardwired fallback has a replacement benchmark rate waterfall. When a trigger occurs, the first fallback rate would be forward looking term SOFR plus a spread adjustment (either identified by ARRC or ISDA). However, if term SOFR is not available, the next option is SOFR compounded in arrears plus the spread adjustment. If neither of these options are available, then the loan hardwired approach converts to an amendment approach.
The first two steps in the securitization replacement benchmark waterfall are the same (forward looking term SOFR and compounded SOFR). However, after those two steps, the loan and securitization fallback language diverges. As Slides 17-18 of the presentation shows, the securitizations’ third waterfall step is the replacement rate recommended by the ARRC, the fourth step is the replacement rate in the then-current ISDA definitions and the final step is the replacement rate proposed by the “Designated Transaction Representative” (a party that will be designated to take on specific roles and obligations).
In reality, compounded SOFR can be calculated today. (Indeed, Clarus publishes it here daily.) Thus, there is little expectation that it will be necessary to go further down the replacement rate waterfall. However, in the event that does happen, market participants should recognize that the loan benchmark and CLO benchmark may differ. Please take this into consideration as you structure CLOs. After all, forewarned is forearmed.