Weak contract language may result in Libor ARM securities losses

The majority of Libor floating rate mortgage-backed securities could experience interest losses or capital losses as Moody's weak records dictate that the underlying loans remain at the last published interest rate.

Of the 2,719 RMBS deals rated by Moody & # 39; s that use Libor as an index, 59% could freeze at the last published price due to the structure of the securitization documentation.

In most cases the trustee or securities manager is responsible for making the determination. However, according to Moody & # 39; s, the treaty documents "provide a waterfall of impractical options for identifying a Libor [alternative], such as asking banks to get an interest rate. The final course of action instructs the businesses on the last available Libor. " This would set the interest rate after 2021. Such an interest rate could be very low given the current interest rate environment. "

These interest losses or major write-downs are likely to occur in transactions with no weighted average coupon caps. The caps prevent a bond's coupon from exceeding the net WAC of the assets.

"However, interest rate mismatches would create an excessive spread for transactions if the bond's WAC is lower than the net asset WAC, which is positive for bondholders," the Moody & # 39; s report said. "This increase in excess spread would help improve credit enhancement by repaying bonds and providing a cushion to protect against collateral losses."

Another 15% of the deals rated by Moody & # 39; s contain no information on the availability of Libor. As with the transactions above, in almost all cases the trustee or administrator would be responsible for determining the Libor.

Moody & # 39; s said in these cases the trustee or administrator is likely to seek advice from a court of law. But there were some other scenarios as well: a party could try to change the documentation to determine an alternative interest rate after obtaining the approval of the bondholders, or the bonds could be converted to a fixed rate after the Libor expires.

"When deal parties need judicial guidance, the funds are on hold until a court is available, causing payment disruptions and trust costs," said Moody & # 39; s. "In addition, the calculations are at risk of revision and depend on the outcome of the court's trust process and the final replacement of the benchmark.

"If a deal party attempts to change documentation, it is unlikely that the required percentage of Certificateholders will be approved, especially if the stock is a majority or 100%. In such cases, the deal would -Party probably looking for it. " judicial guidance that exposes transactions to potential payment delays and trust costs. "

For the remaining transactions, contractual terms apply, according to which the trustee or securities manager must choose an alternative to Libor immediately or after three distribution cycles after the end of the publication.

"However, there is often a lack of guidance in documents on how such parties should select an alternative index and, if necessary, make spread adjustments to make such a selection comparable to Libor," the report said. "In addition, the party responsible for selecting an alternative index differs between the bonds and the assets that they may not be able to vote on the choice of replacement. Furthermore, the documents do not contain any information on spread – Adjustments that are necessary to make the choice comparable to Libor. "

Transactions completed in 2018 or later are generally less at risk than older transactions because they contain provisions to implement a Libor replacement, according to Moody & # 39; s.

The work of the Committee on Alternative Reference Rates, including choosing the structured overnight finance rate as the preferred replacement for Libor, can help mitigate or even eliminate the transition risk.

However, as the implementation of the ARRC's recommendations is voluntary, transactions remain exposed to transitional risk.

Moody & # 39; s discovered that there are other options. For example, older languageless RMBS contracts that provide an alternative tariff are prone to indirect risks such as increased operating costs and litigation from parties seeking to protect their own interests.

"For these contracts, providing clarity by strengthening fallback language through courts, law or amendment would help reduce cash flow and indirect risk," said Moody & # 39; s.

Small banks have complained that SOFR is not suitable for their needs and have suggested using another Libor alternative on the market, Ameribor, published by the American Financial Exchange.

Separately, the ARRC issued a call for proposals on September 10, asking a potential administrator to publish forward-looking SOFR term sentences.

The proposed SOFR term rates should include one-month and three-month rates and may include six-month or one-year rates depending on feasibility.

"We are excited to start this RFP process," said Tom Wipf, ARRC chairman and vice chairman of institutional securities at Morgan Stanley, in a press release. "This is a necessary step in the ARRC's assessment of whether a term SOFR phrase is recommended and to ensure that each recommended phrase can be produced in a timely manner."

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