Much has been written over the past decade, in this journal and elsewhere, about the manipulation of the London Inter-Bank Offered Rate (LIBOR) and the subsequent decision to end its use as a benchmark interest rate. This article addresses the challenging issue of LIBOR transition—that is, moving from LIBOR to another benchmark rate—for asset-backed securities such as residential mortgage-backed securities (RMBS). RMBS is one of a class of assets that face the complication of two levels of transition: LIBOR-indexed mortgage notes that are assets of an RMBS securitization trust, and LIBOR-indexed interest rates paid on the securities issued by the securitization trust.
LIBOR-Indexed Mortgage Lending and Securitization
To understand the challenge, first consider how residential mortgages are securitized into RMBS trusts. When a lender makes a home loan, the loan typically is secured by note and a mortgage. The notes often have variable interest rates. In the run-up to the 2008 financial crisis, residential mortgage notes—and particularly sub-prime residential mortgage notes—often were indexed to LIBOR. This means that the annual interest rate the borrower paid was not set at a fixed number but instead as LIBOR plus an additional percentage, such as LIBOR plus 3%. As LIBOR changed, the rate the borrower paid was (at agreed time intervals) changed.
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