Two auto loan securitizations late last year tested an officially recommended boundary to use of the term version of the secured overnight financing rate (SOFR), a replacement for the floating-rate Libor benchmark. U.S. regulators denounced and effectively grounded those trial balloons, affecting a relatively small but important part of the asset-backed securities (ABS) market that could benefit significantly from a term debt structure.
The Alternative Reference Rates Committee (ARRC), the SOFR governance body sponsored by the Federal Reserve Bank of New York, recommended those limits. Although there may be some wiggle room for other deals that could not easily use daily SOFR rates, the regulators contended that the auto securitizations did not conform to stated post-Libor principles and best practices.
A banker at a joint lead bank on one deal noted that most securitized auto loans are fixed-rate, as are the securitizations’ liabilities. Floating-rate tranches are added to increase investors’ participation when their appetite for fixed-rate debt is satiated.
“That said, it doesn’t often happen that an issuer like Toyota issues floating-rate ABS,” said the banker, who asked not to be identified, adding that if risk-averse ABS investors had concerns about the robustness of term SOFR, then they would ask for a daily SOFR rate.
Varying Timeframes
A term structure, in which issuers know their interest payments at the start of the term, is a feature of the legacy Libor benchmark. Kristi Leo, president of the Structured Finance Association (SFA), explained that daily SOFR is calculated by averaging overnight SOFR until a few days before the end of the term in question and the interest payment. Applying the methodology to transactions with steady principal balances and one party calculating and making payments is relatively straightforward, she said.
SFA President Kristi Leo
The mechanics are more complicated for certain ABS. For auto securitizations, Leo added, amortizing assets requires halting the averaging of overnight SOFR 10 or more days before the end of the term. That allows the servicer to calculate payments for tens to hundreds of tranches and payment agents.
An alternative is averaging overnight SOFR over a previously specified term, such as 30 days, to generate a rate to use at the end of the current term. However, that backward-looking methodology creates a lag of more than a month between the rate used and the current rate and a mismatch for investors when rates are rising or falling.
Setting the rate at the beginning of the period by looking backwards is “something some investors don’t want to see, and so they would prefer term SOFR,” Leo said.
Official Considerations
Concerns were aired at a November 9 ARRC meeting about securitizations using term SOFR when their underlying loans did not. Shortly thereafter, a World Omni Financial auto receivables ABS with a term SOFR tranche switched to daily SOFR, and other planned auto deals with term SOFR were withdrawn.
CFTC Chairman Rostin Behnam
Commodity Futures Trading Commission Chairman Rostin Behnam, in a November 17 speech, cited “a rather large securitization that referenced term SOFR,” adding, “if this practice were to begin trending, it would increase the use of term SOFR derivatives, which could lead to a decline in the overnight SOFR derivatives markets on which term SOFR is based . . . Therefore, it is important that the use of SOFR, term SOFR, and any other reference rates continue to align with the recommendations of the ARRC, the FSB [Financial Stability Board] and the Financial Stability Oversight Council [FSOC].”
The FSOC, in its 2022 annual report, stated, “If more cash products were to reference term SOFR, it likely would cause an increase in term SOFR derivatives, which could lead to a decline in the overnight SOFR derivatives market.”
Securities and Exchange Commission Chair Gary Gensler brought up term SOFR in remarks for a December 16 FSOC meeting: “While term SOFR is not based on the thin, short-term credit markets, I think it is important to continue to ensure that its underlying references of SOFR, and the SOFR futures rates’ term SOFR references, are truly deeply, liquid, and fully clad.”
Strengthening the Foundation
Also at that FSOC meeting, Federal Reserve Vice Chair for Supervision Michael Barr said it is not plausible to use SOFR to price all or most cash products, and “such a world would not be consistent with sustaining a robust market for overnight SOFR derivatives, the foundation for term SOFR rates.”
Because term SOFR’s forward-looking curve is generated from the overnight SOFR derivatives market, regulators worry that its decline could lead to a fate echoing Libor’s. However, recommendations of the ARRC, which has both regulatory and private-sector participation, do not have the force of law, and there is no formal restriction on the use of term SOFR.
Despite their public statements, the regulators, to market participants’ dismay, have yet to detail when use of term SOFR becomes perilous. The ARRC has recommended using term SOFR in large markets such as business loans and the collateralized loan obligations that securitize them. In 2022, the CLO market reached $126 billion in new deals, according to LSEG Deals Intelligence, compared to just $18.6 million for floating-rate ABS, of which auto ABS is a part.
The ARRC has also approved term SOFR for consumer products such as floating-rate mortgages and student loans, and their securitizations. Auto ABS, where underlying loans are fixed-rate, falls outside the ARRC’s scope of use. But the committee appears willing to make exceptions, stating in best practice recommendations that it “also supports the use of the SOFR term rate in areas where use of overnight and averages of SOFR has proven to be difficult.”
Floating-Rate Expectations
SFA’s Leo said that low interest rates in recent years prompted fixed-rate ABS issuance, but as today’s higher rates may fall again, ABS could include more floaters. She added that there could be more floating-rate credit card ABS, though it’s easier for them to adhere to ARRC recommendations because their bullet payments and steady balances enable them to adapt to daily in-arrears SOFR more readily.
“Operationally, it may be a bit more difficult for some credit card issuers to calculate within two days, but not as hard as issuers of amortizing asset classes like auto ABS,” Leo said.
Stuart Litwin of Mayer Brown
Proponents of expanding the scope of term SOFR point out that the ARRC in 2019 recommended it as the first-choice benchmark to use for existing ABS when switching to a replacement rate becomes necessary.
“Isn't it somehow bizarre that they were recommending term SOFR as first in line in the fallback waterfall, and now they're saying don’t use it?” said Stuart Litwin, co-head of the Structured Finance and Capital Markets practices at Mayer Brown.
He added that term SOFR offerings outside the ARRC’s recommendations are likely “at some point” from nonbank issuers and willing underwriters.
Chance of a Compromise?
In 2021, the ARRC recommended that new ABS products use the average of the previous 30 days of overnight SOFR as the rate for the future accrual period.
The ARRC has always distinguished between different uses of term SOFR “and tried to be clear throughout that use as a fallback did not connotate recognition of new use,” said a high-ranking regulatory official familiar with the issue.
After the auto ABS trial balloons, there was talk among market participants that the SEC might recommend term SOFR for a limited selection of new transaction types. However, that has become increasingly unlikely in light of the approaching June 30 deadline to leave Libor, and the take-no-chances stance of the regulators.
The ARRC has done a good job of creating a new and highly robust benchmark,” said Marcus Burnett, CEO of SOFR Academy. “The reality is that increased use of term SOFR leading to a decline in overnight SOFR derivatives would not be a good thing – no one wants to have to redo this Libor transition.”