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.

In an RMBS securitization, these notes and mortgages (among other rights relating to the loans) are transferred to a securitization trust. The trust pays for the loans by issuing securities entitling holders to a share of the revenue generated by the loans. Generally, the interest paid to investors in a securitization trust is not tied to (although it certainly correlates to) the interest rate borrowers agreed to pay in their mortgage notes. Rather, the rates paid to investors are set in the securitization document and vary by the amount of risk an investor is willing to take using sometimes-complex payment waterfalls. For many older trusts, the interest rate paid to investors was indexed to LIBOR.