Fitch Ratings: Synthetic Libor Proposal Would Minimise Near-Term Risk for UK RMBS

The FCA said on 29 September it would require the benchmark administrator to publish synthetic Libor throughout next year, and it proposed to permit legacy use of synthetic sterling and Japanese yen Libor in all contracts except cleared derivatives ‘at least for the duration of 2022.’ The publication of synthetic Libor beyond 2022, for up to 10 years, will depend on annual decisions from the FCA. If synthetic Libor were not directly applicable to all RMBS transaction components, the affected notes would face heightened disruption risk.

The proposed scope for the application of synthetic Libor for its first year, which is under consultation until 20 October, should cover all Libor-related contracts in structured finance (SF) as cleared derivatives are not used in SF transactions. UK RMBS is the SF sector with the largest exposure to sterling Libor (about two-thirds of Fitch-rated transactions have exposure on the asset and/or liability side) although most sponsors have started, or are in the middle of, transition plans to move to replacement rates. Fitch views the extended transition period as a sufficient mitigant for Libor disruption risk for the next year. 

We also expect Libor exposure in UK RMBS to decrease by end-2022 for notes as more issuers obtain noteholder consent to change the reference rate to the Sterling Overnight Index Average (SONIA), although the pace may slow given the extra year available. Recent RMBS, issued mainly from 2019 onwards, have typically referenced SONIA rather than Libor and already make up the majority of Fitch-rated outstanding UK RMBS notes. 

Fitch has less confidence that underlying mortgages paying Libor, the vast majority of which are in non-conforming or buy to let transactions, will fully transition to alternative rates next year. This is because many older contracts can only switch to a new rate once Libor is no longer available. However, Fitch does not view the use of synthetic Libor in these contracts as a significant risk because sufficient fall back provisions exist in such mortgages that would take effect when Libor ceases to be published.

Transactions that still have Libor-paying exposures at the end of 2022 will be dependent on the FCA’s decisions on whether to continue the use of synthetic Libor for a second year (and for each additional year on an annual basis up to the maximum 10 years) and on which contracts can use synthetic Libor. Fitch views it as likely that mortgages will continue to be allowed to use synthetic Libor as it is intended to advance the FCA’s objectives of consumer protection and enhancing the integrity of the UK financial system. 

Fitch will continue to monitor actions by transaction parties to reduce Libor exposure, regulatory developments, and other factors such as the potential for legal challenges to switching to an alternative rate, for their potential impact on rated RMBS. 

In UK asset classes other than RMBS, Fitch views the Libor transition risk as negligible. Assets in these sectors do not typically carry a Libor linked interest rate or will repay more quickly than residential mortgages. Notes and derivatives have already been, or are in the process of being, converted to SONIA in the majority of cases. UK banks’ tail-risks associated with LIBOR transition have effectively subsided with the significant progress on transitioning primary market issuance to SONIA, and with legislative fixes such as the FCA proposal.