On May 31, 2019, the Alternative Reference Rates Committee ("ARRC") published "ARRC Recommendations Regarding More Robust Fallback Language for New Issuances of LIBOR Securitizations" ("ARRC Recommendations").1 The ARRC Recommendations include a definition of what constitutes a cessation of LIBOR and provide a "waterfall" of replacement rates to be used when LIBOR is no longer published or is no longer representative. The waterfall of spread adjustments, designed to adjust for the differences between the replacement rate and LIBOR, was also finalized, although the method of calculation for two of the adjustments has not yet been fully determined.
LIBOR Cessation Definitions
There are four "Benchmark Transition Events," the occurrence of any of which will trigger a move from LIBOR to the replacement rate.
The first two Benchmark Transition Events are triggered on a permanent cessation of LIBOR and align with the LIBOR triggers in the International Swaps and Derivatives Association, Inc. ("ISDA") 2018 Consultation. These two triggers require that the LIBOR administrator (currently ICE Benchmark Administration), the LIBOR regulatory supervisor of the LIBOR administrator (currently the UK Financial Conduct Authority), the US Federal Reserve System (as the central bank for the currency of USD LIBOR) or a bankruptcy/resolution official or court with jurisdiction over the administration of LIBOR publicly state or publicize information that LIBOR has actually ceased or is expected to cease. These Benchmark Transition Events will not trigger a change (referred to as a "Benchmark Replacement Date" in the ARRC Recommendation) from LIBOR until the date that LIBOR ceases to be published, if that date is later than the date of the relevant announcement. In contrast, for the precessation trigger described below, the change from LIBOR would begin on the date of the announcement or publication.
The ARRC Recommendations also added two pre-cessation triggers. The first is predicated on "a public statement or publication of information by the regulatory supervisor for the administrator of the Benchmark announcing that the Benchmark is no longer representative." This and two other precessation triggers were proposed by the ARRC in its December 7, 2018 consultation, but only the current pre-cessation trigger was retained.2
The second pre-cessation trigger is predicated on an "Asset Replacement Percentage" being greater than a specified percentage, as reported on the most recent servicer report. We note that the ARRC Recommendation provides the transaction parties with flexibility to set the appropriate trigger percentage. The Asset Replacement Percentage is defined as the outstanding principal balance of the assets that were indexed to LIBOR (or other relevant original benchmark) as a percentage of the outstanding principal balance of all relevant assets. This trigger is meant to minimize basis risk between securities and the assets underlying such securities by providing a conversion event if a set percentage of the underlying assets have converted to the replacement benchmark or have been replaced by assets accruing interest at the replacement benchmark. The ARRC Recommendation notes that the transaction parties may elect not to include this precessation trigger if the particular structure of the securitization transaction makes this trigger unnecessary or inappropriate or, if included, the trigger should be specifically tailored to the particular transactions (including the specific reporting mechanics). This Benchmark Trigger Event will not trigger a Benchmark Replacement Date from LIBOR until a specified number of business days selected by the transaction parties after the date of the relevant servicer report showing such trigger event.
The ARRC has tried to be consistent with LIBOR replacement provisions in other products such as derivatives, loans and floating rate notes. The ARRC Recommendations note that while ISDA has proposed the same permanent cessation triggers, it is considering adding a precessation trigger, which may be the same as the ARRC's pre-cessation trigger regarding LIBOR no longer being representative. However, the ARRC Recommendations warn that if ISDA's cessation triggers do not match those used for securitizations and a benchmark replacement occurs based on one of the ARRC's pre-cessation trigger, the related hedges may not match the terms of the securitization.
Benchmark Replacement Waterfall
The ARRC also finalized the order of replacement rates for LIBOR securitizations in a "Benchmark Replacement Waterfall":
- Step 1: Term SOFR + Adjustment
- Step 2: Compounded SOFR + Adjustment
- Step 3: Relevant Governmental Body Selected Rate + Adjustment
- Step 4: ISDA Fallback Rate + Adjustment
- Step 5: Designated Transaction Representative Selected Rate + Adjustment
If a benchmark replacement is selected pursuant to Step 2, then the ARRC recommends that on the first day of each calendar quarter (or other period selected by the transaction parties) following such selection, if a redetermination of the benchmark replacement on such date would result in the selection of a benchmark replacement under Step 1, then (x) the Adjustment will be redetermined on such date utilizing the unadjusted benchmark replacement corresponding to the benchmark replacement under Step 1 and (y) such redetermined benchmark replacement shall become the benchmark on each determination date on or after such date. If redetermination of the benchmark replacement on such date as described in the preceding sentence would not result in the selection of a benchmark replacement under Step 1, then the benchmark shall remain the benchmark replacement as previously determined pursuant to Step 2.
A Designated Transaction Representative3 may not move down the Benchmark Replacement Waterfall in the event that some LIBOR tenors have become subject to a Benchmark Transition Event but both shorter and longer tenors are available. In that event, the missing LIBOR tenor would be interpolated based on the nearest tenors that can be determined. For example, if a 3-month USD LIBOR has ceased publication but a 1-month and a 6-month USD LIBOR are still being published, the Designated Transaction Representative would use an "Interpolated Benchmark" (i.e., interpolated USD LIBOR) before proceeding to the Benchmark Replacement Waterfall.
Each step is accompanied by helpful commentary.
Term SOFR + Adjustment: This would be a forward-looking term rate with a tenor matching the LIBOR tenor selected or recommended by the "Relevant Governmental Body" (the ARRC for USD LIBOR). As the ARRC has previously noted, it is not expected that a term Secured Overnight Financing Rate ("SOFR") that is IOSCO-compliant and based on a broad derivatives market will be available prior to the expected LIBOR cessation.4 Also, because ISDA is not expected to reference a forward-looking term rate, the use of this rate in securitizations may cause a hedging mismatch. Consequently, the ARRC confirms that Designated Transaction Representatives may wish to delete the term SOFR from the Benchmark Replacement Waterfall and adjust other terms accordingly.
Compounded SOFR + Adjustment:
Compounded SOFR, which was discussed extensively in the ARRC's "A User's Guide to SOFR," is a method to create an interest rate for a period by using a compounded average of the daily SOFR rates during the interest period. The interest calculation is done "in arrears," i.e., at the end of the interest period. The definition of Compounded SOFR specifically allows for a lookback or suspension period or compounding of SOFR in advance, and flexibility for change in the future due to direction from the ARRC or market-accepted conventions. The ARRC Recommendations also allow users to use a simple average of SOFR, rather than compounded SOFR, plus an adjustment, if desired.
Compounded SOFR requires a lookback or suspension period because SOFR is a backward-looking rate, and the rate announced each day is actually the rate that was used the previous day. The plumbing issue here is that a normal securitization interest period begins on the settlement date or the previous interest payment date, and interest accrues from that date to but excluding the next interest payment date or the maturity date, as applicable. If an interest payment date falls on a Friday, the rate announced on that Friday would be Thursday's rate, allowing the interest rate to be calculated on Friday but with no advance notice to holders and insufficient time to ensure that the paying agent can receive funds from the issuer and then pay the interest payment to holders on that day.
The ARRC's answer is to allow use of a lookback or suspension period. Using a suspension or "lockout" method, the daily SOFR rate would "lock in" a certain number of business days before the last day of the interest period. For example, if the interest payment date was Friday, with interest accruing through Thursday, and a fourbusiness-day lockout period was in effect, the SOFR rate for the Friday before the interest payment date, which would be published on the Monday prior to the interest payment date, would hold to and include Thursday. Consequently, on Monday morning, the issuer, paying agent and the holders would have advance notice of the interest payment to be made on Friday. Similar results can be obtained with a lookback period, pursuant to which each day's daily SOFR rate is the rate published a certain number of days previously.
The ARRC Recommendation is also allowing for Compounded SOFR to be compounded in advance, which would allow SOFR to be calculated by compounding the overnight SOFR for the previous relevant period. The ARRC Recommendation provides an example whereby, with a 30-day SOFR security with an interest period beginning on April 1, the rate could be overnight SOFR compounded daily from March 2 to March 31.
The ARRC Recommendation is also allowing for retesting of such benchmark replacement on a periodic basis. Comments received by the ARRC to the 2018 Consultation indicated that the working group believed that a Term SOFR is a superior benchmark to Compounded SOFR, so the ARRC Recommendation permits the benchmark to ultimately fall back to Term SOFR should Term SOFR not be available at the time of the Benchmark Trigger Event. The ARRC Recommendation notes that, in determining whether to allow for retesting, the transaction participants should consider the impact it may have on the ability for investors to hedge the issued securities and any other operations impacts.
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1 The ARRC Recommendations are available at: https://www.newyorkfed.org/medialibrary/Microsites/arrc/fil es/2019/Securitization_Fallback_Language.pdf.
2 The ARRC Consultation New Issuances of LIBOR Securitizations (Dec. 7, 2018) (the "2018 Consultation") is available at: https://www.newyorkfed.org/medialibrary/Microsites/arrc/fil es/2018/ARRC-Securitizations-Consultation.pdf.
3 The ARRC Recommendation defines a Designated Transaction Representative to mean "with respect to a particular securitization transaction and a particular obligation to be performed in connection with the transition to a Benchmark Replacement, the party identified by the transaction documents to perform that obligation."
4 See "A User's Guide to SOFR" at: https://nyfed.org/2USOC9v.
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