ABS East 2022 Conference Notes

3:45 pm: Market Spotlight: RMBS

One panelist explains that the mortgage basis has widened by about 80 bps and that mortgage originations, both for refinancings and purchases, have sharply declined because of higher interest rates. Agency MBS have widened because of uncertainty about what the Fed will do with its $2.8 trillion portfolio of agency MBS (e.g., what coupons will it sell). MBS issuance is down, and home prices are at a turning point.

Another panelist explains that the Barclays MBS Index is displaying weak performance because of both rising rates and widening spreads. Rate volatility is the key driver of convexity. Credit operates with a lag; its effects have not fully worked their way through the system. A third factor is liquidity. The Fed is draining liquidity from the banking system, which reduces the system’s ability to price and trade bonds. The Fed has played the key role this year.

The private-label MBS sector is facing challenges. Any issuer that can dispose of loans outside of private-label MBS is doing so (i.e., through agency channels). This year’s issuance of MBS backed by prime jumbo loans is down 85% to 90% relative to the first three quarters of last year. Therefore, apart from CRT deals by the GSEs, the private-label MBS space has been dominated by securitizations of non-QM loans (i.e., loans that fall outside the CFPB definition of a “qualifying mortgage”).¹ Compared to last year, issuance of MBS backed by non-QM loans is essentially flat. Issuance has slowed over the year, however, and issuance in the third quarter is down roughly 30% compared to last year. Spreads are very wide, and conditions are very challenging for non-QM issuers. The key exposure for mortgage investors is credit risk, primarily though home prices. Home prices have declined in recent months by 1% to 3%. A typical private-label MBS is relatively well insulated from modest home price declines in the range of 5% to 10%. Most loans securitized through private-label MBS (whether jumbo or non-QM) started with LTVs of around 70%. That provides a meaningful cushion against the risk of home price declines. Additionally, deals issued more than a year ago have received the benefit of home price appreciation in the interim. Private-label MBS have only very limited exposure to loans with LTVs of 90% or higher. Interest-rate risk is secondary because only a tiny proportion of outstanding MBS are backed by ARMs.

Another panelist echoes the view that the credit quality of securitized mortgage loans is much better than it was in 2008. Additionally, the ATR rule² has helped to improve mortgage loan credit quality relative to loans from before the financial crisis. Other panelists voice similar views, highlighting improved underwriting and technological advances. Also, single-family-rental operators now provide a reservoir of demand for houses. Still home prices are the key dimension of risk. Servicer quality and possible government action are additional dimensions. Another factor is how quickly the lending community can adapt to the changing environment with higher interest rates. Lenders are likely to originate greater amounts of affordability products, such as IO loans and loans with 40-year maturities.

The definition of what constitutes a QM loan recently changed. It is no longer tied to a borrower’s DTI, but rather to a loan’s interest rate (i.e., relative to the average rate). New York’s subprime mortgage law may become an issue as interest rates rise.³ The law imposes substantive restrictions on loan terms and additional compliance burdens on lenders.

Loan modifications are likely to increase as delinquencies increase. However, some modifications—like extending a loan’s maturity—may not be feasible for securitized loans. Types of modifications that may be practical are step-rate modifications, principal forgiveness, and non-interest-bearing balloon payments.

Based on how it responded to the COVID-19 pandemic, the CFPB might aggressively encourage modifications and discourage foreclosures during the next episode of stress. Investment rental properties are at greatest risk. Government policies to protect renters could create exceptional stress for investor-owners.

Loan servicers are stronger today than they were 10 years ago. Many are associated with major banks. The same is not necessarily true of originators. Originators may be vulnerable in a rising-rate environment unless they fully hedge their production flow.

One panelist asserts that structures are dramatically stronger than they were going into 2008. Deals have higher credit enhancement and the structures incorporate a 2008-type scenario.⁴

Extension risk is heightened because of higher interest rates.

3:45 pm: Herbie Goes to Miami: Auto ABS

One panelist states that auto ABS issuance through September 2022 was around $71.2 billion, which is about 2% less than the corresponding period of 2021. Most issuer groups have lower issuance, except for banks, credit unions, and Ford. The top five issuers for 2022 so far are Santander, GM Financial, Toyota, Ford Motor Credit, and CarMax. Auto loan ABS issuance tends to rise and fall with auto sales. Rising auto sales in 2021 helped to support record auto loan ABS issuance of $98 billion. Origination volume started to soften in 2022Q2. Auto affordability is affecting consumers. Used vehicle prices have risen significantly, and the average financed amount has increased 33% over two years to $28,500. Combined with higher interest rates, this makes car purchases unaffordable for many consumers. In fact, 14% of auto loans have monthly payments of $1,000 or more (up from 8% in 2021). New auto ABS deals are coming to the market with wider spreads because of economic uncertainty. Projected auto ABS issuance for the full year is $90 billion, down 8% from last year.

A second panelist agrees with the issuance projection. The lack of new vehicle inventory is a factor. A greater share of loans will be for used-vehicle purchases. A third panelist predicts that retail auto loan and lease ABS issuance for the year will be roughly $115 billion; so far, it is around $95 billion. Vehicle production is expected to be somewhat less than 14 million units, and manufacturers are not pushing to increase production volumes because they are achieving good profits at current production levels. Auto loan and lease underwriting standards have been getting weaker for six consecutive quarters, according to Fed surveys of senior loan officers at banks. This has helped to support strong auto loan origination volumes. Additionally, increases in average loan size contribute to growing aggregate loan origination and ABS issuance volumes. According to Experian, the average amount financed on new vehicles was $40,290 in 2022Q2, up from just over $36,000 in 2020Q2.

Yields: One panelist explains that yields have increased to more than 5% from less than 1% a year ago on new-issue, triple-A-rated auto loan ABS with average lives in the range of 2.2 years to 2.5 years. Yields on triple-B-rated tranches of subprime deals have increased to roughly 7% from around 2% last year. The most recent deals have had triple-B-rated tranches yielding 7.8% and double-B-rated tranches yielding 11%. Yields rose very quickly and are now at unprecedented levels.

Credit: One panelist explains that low unemployment has been a major factor in keeping delinquencies and losses low. However, inflation is hitting subprime consumers. On a rolling portfolio basis, outstanding prime-quality, auto loan ABS transactions display an annual loss rate of 0.38% compared to 0.57% three years ago. On the other hand, 60-day delinquencies are higher today at 0.48% compared to 0.41% three years ago. Recoveries on defaulted prime-quality loans were around 59% for August. Performance also has improved on a static pool basis, possibly from COVID-related stimulus, enhanced unemployment benefits, and the ability to defer credit obligations. By contrast, losses on subprime auto loan ABS transactions have increased more quickly following the end of COVID-related relief measures. On a rolling portfolio basis, the annual loss rate for subprime auto loans was around 7.6% for August (which is still slightly lower than three years ago). Overall, the prime auto area is performing well but there is emerging cause for concern about the subprime area.

Another panelist adds that the performance deterioration in subprime auto ABS is concentrated in deals from certain issuers. Deals from other issuers are performing better. There is anecdotal evidence that a growing proportion of borrowers have rolling delinquencies (i.e., they make regular monthly payments but fail to cure outstanding arrears). A third panelist agrees that the key driver of credit performance for auto loan ABS is the labor market. As the economy enters a recession, unemployment will rise and auto loan ABS credit performance will decline. Unemployment is expected to reach 5.6% by the end of 2023. The subprime side will likely display greater performance deterioration. Recovery rates will likely deteriorate as used-vehicle prices decline from their inflated levels of 2022.

Auto lease ABS issuance has been around $16 billion for the first nine months of 2022. The lack of new-vehicle inventory has been depressing issuance. Also, fewer consumers are choosing leases. Historically, leases accounted for up to 36% of retail auto financings, but now the proportion is just 20% as of 2022Q2. Leases are performing very well because most of the obligors have very high FICO scores. Additionally, because used-car values are so high, many lessees are electing to purchase the leased vehicles at the termination of their leases and then sell them.

Loss severities are higher on loans with longer maturities. Some lenders try to balance the risk of longer maturities with lower LTVs or higher FICO scores. The typical loan today is 60 months, compared to 48 months before the pandemic. Some loans have maturities of 78 or 84 months. Loans with 84-month maturities account for only 2% of securitized prime-quality loans. However, for the industry as a whole, 34% of new loans have maturities in the range of 73 months to 84 months. GM, Ford, and Ally include roughly 10% loans with 84-month maturities in their deals. Subprime issuer AmeriCredit includes 17% loans with maturities in the range of 76 months to 84 months.

Auto ABS performed very well through the 2008 financial crisis. This suggests that auto loans and leases may be highly resilient through the upcoming recession. Investment-grade tranches likely will weather the stresses well. Another panelist adds that the use of sequential structures in auto ABS means that credit support for senior classes increases over time. If rating downgrades occur, they will likely be concentrated in subordinate, speculative-grade classes.

ESG: One panelist explains that the Structured Finance Association is leading the initiatives to develop tailored disclosures for different asset classes. Along the environmental dimension, disclosures might focus on miles per gallon or carbon emissions. Along the social dimension, disclosures might focus on responsible origination and servicing practices. The absence of standards is a challenge for investors today. Some investors are embracing a “double materiality” approach with respect to ESG considerations. Materiality from one perspective considers the financial impact of ESG factors on an investment. Materiality from the second perspective considers the positive or negative impact of an investment on the environment or society. There has been green bond issuance in the auto ABS sector. Toyota has done several deals backed by loans on hybrid or electric vehicles. The Inflation Reduction Act⁵ includes tax credits for clean vehicles, which means that they will likely account for a growing share of the market over time. ABS backed by clean vehicles will likely increase as well. Additionally, California has adopted a clean vehicle rule requiring all vehicles sold in the state to be zero-emission by 2035.⁶ Many states follow California, so California’s standard may apply to roughly 40% of the country.

Another panelist explains that the market does not have well-established definitions for ESG factors or standards for how to gauge them. Europe has progressed further and has established ESG standards.⁷ Nonetheless, most issuers use of third-party services to render an opinion that a transaction conforms to social or environmental principles. Investor demand and eventual SEC rulemaking will be key drivers for the evolution of ESG standards.

9:30 am: A New Era: ABS Market Overview

One panelist observes that 2022 has been an interesting year, so far. Last year delivered strong economic growth of 5.9% in the United States. By contrast, growth for 2022 and 2023 are projected to be just 1.9% and 1.3%, respectively. There are headwinds along three dimensions: 1) Fed tightening, 2) the Russia–Ukraine conflict, and 3) China.

High current inflation and uncertainty about future inflation create uncertainty about Fed policy. The prevailing view is that the Fed will continue raising interest rates through the second quarter of 2023, but that is highly uncertain. The Russia–Ukraine conflict is key driver of higher energy prices in Europe and global supply-chain disruptions. Until last year, China had been a key engine of global growth, delivering 8% growth internally. However, its internal growth has fallen to around 3%. Additionally, China contributes to supply-chain disruptions, particularly with respect to the United States, because of recent trade restrictions and related geopolitical factors.

Many factors contribute to the currently high rate of inflation. The Fed has a tough job reining it in. The strong labor market in the United States suggests that Fed actions have not yet produced strong effects. Pressures on the economy could lead to credit-rating downgrades, particularly in a “stagflation” scenario. Asset classes that are especially vulnerable include subprime autos and FFELP student loans. However, the proposed student debt forgiveness plan in the United States could potentially help FFELP borrowers. (Note: Because of subsequent developments, FFELP borrowers might not be eligible for relief under the plan.)

A second panelist observes that ABS issuance is running at a faster pace in 2022 than in 2021. As of mid-October, this year’s issuance is ahead of last year’s pace by 6.2% at $224 billion. Nontraditional sectors have been particularly active this year. Issuance was very strong in 2022Q1 but has been slowing since then. Still, there have been some recent bright spots in the market, particularly in nonconsumer assets. For example, Guggenheim was recently able to price a $700 million deal using a new structure to securitize oil and gas reserves (i.e., in the ground). Music royalties is another nonconsumer asset class that has recently been active. A growing proportion of new structured financings is not being registered with the SEC; they are being executed as private placements or under Rule 144A.

One panelist observes that, apart from the flow of new deals into the market, it is important to focus on outstanding deals. The rising-interest-rate environment means that outstanding deals backed by fixed-rate obligations are positioned to perform well, while those backed by floating-rate obligations are more likely to experience stress. More importantly, though, the quality of assets backing today’s outstanding deals is significantly better than the quality of assets backing deals from the period leading up to the 2008 financial crisis. Also, although there has been recent softening of home prices, the labor market remains very strong, which is a countervailing force.

ESG: Another panelist states that many issuers are focusing on ESG-oriented issuance in the current environment. They are viewing ESG as a way to gain an advantage in a difficult market. The principles published by the ICMA are the main process for issuing ESG-oriented deals. However, a challenge for the ESG space is that the definition of “greenness” changes over time. For example, most market participants today would consider a car that emits 50 grams of CO₂ per passenger-kilometer to be green. However, under standards that will apply in 2025, such a vehicle will not be green. It will therefore be tougher for deals to qualify as green as time passes. Likewise, the income thresholds for “social” status in consumer asset deals will have to change over time with inflation or the eligible population of borrowers will contract.

Another challenge for the ESG space is that standards for greenness vary geographically. Europe has relatively clear standards. The United States does not. The ABS market will be affected by the creation of prescriptive standards around the globe.

ESG considerations figure into credit ratings. For example, emerging taxes on the use of nongreen passenger cars in some areas are a factor in projecting future car values for analyzing auto lease deals.

There has been an increase in utility stranded-cost deals. Although they are not necessarily ESG-oriented deals, they are sometimes related to green issues.

Outlook: Most of the recent increase in funding costs comes from movements in the underlying benchmarks. For example, the yield on the three-year T-note has increased by more than 350 bps so far this year. By contrast, spread widening has been relatively modest—75 bps–80 pbs in auto ABS and 100 bps–200 bps in less-liquid asset classes. Current spread widening is about relative value rather than asset performance. Money managers are staying liquid and staying short. Insurance companies are still actively putting money to work because they continue to receive premiums. The use of securitization for nonmainstream asset classes is likely to grow (natural resources, music royalties, franchise fees, etc.). Issuance is likely to be lower in the coming quarters.

10:15 am: Better Investors Make Better Markets: Setting the FIIN Agenda, an Investor Roundtable

One panelist explains that changing regulatory requirements are a constant challenge for investors.

NAIC: Another panelist identifies the risk-based capital charges established by the NAIC⁸ as an example of a key regulatory requirement for many investors. Even determining what constitutes a bond is an issue. A third challenge relates to the use of private ratings.

One of the working groups at the NAIC is developing a standardized modeling approach for evaluating CLOs, which would eliminate the use of credit ratings from rating agencies. The NAIC has not yet revealed the full approach, but it is clear that it is focusing on the risk-based-capital arbitrage produced by CLO structures.⁹ The panelist argues that the NAIC should not penalize investment-grade CLO tranches because those tranches receive significant protection from triggers in the CLO structure. Conversely, speculative-grade tranches and CLO equity are subject to heightened risk and volatility (and reasonably should be penalized).

Another panelist disagrees, arguing that even pre-financial crisis CLOs (“CLO 1.0” deals)¹⁰ performed very well and must be distinguished from the poorly performing ABS CDOs that were backed by residential MBS. ABS CDOs were based on assumptions about huge pools of mortgage loans that had to viewed in the aggregate.¹¹ By contrast, CLO managers evaluate every single asset included in their deals’ portfolios. The panelist asserts that regulators ignore CLOs’ strong track record and improperly demonize the product.

One panelist discusses the NAIC position with respect to CLO combo notes.¹² CLO combo notes create an arbitrage. The NAIC has expressed a negative view of the product.

Basel framework: Another panelist explains that highly conservative capital requirements—including not only the NAIC requirements but also the Basel II and III international capital guidelines for banks¹³—have adversely affected investors by constraining the market’s liquidity. The capital requirements deter regulated institutions from maintaining large trading books. Another panelist observes that conservative capital requirements have made banks today stronger than they were before the 2008 financial crisis. However, although the capital standards have pushed banks to hold more capital, they do not seem to adequately address the issue of unrealized gains and losses in bank investment portfolios. This is because higher levels of regulatory capital have not produced proportionate increases in tangible capital. Liquidity requirements are as much an issue for banks as risk-based capital requirements. If liquidity requirements prompt banks to sell less-liquid instruments, there could be a flood of such instruments hitting the market all at once.

Solvency II: One panelist explains that Solvency II refers to the European capital requirements for insurance companies.¹⁴ There is a slightly different version in the United Kingdom. The UK standards are highly quantitative and extremely rigorous. It limits the types of assets that insurance companies can buy. It is hard to fit mortgages or other assets with embedded options into the Solvency II requirements. The standard should allow more flexibility.

Another panelist observes that European insurance companies were able to invest in CLOs and other structured products without significant restrictions. Solvency II changed that. Together with the Basel framework, Solvency II represents an effort to kill or constrain securitization and “shadow economy” activities in Europe. The fact that European insurance companies can no longer invest in CLO and other structured products will likely drive them to seek out riskier investments.

ESG: One panelist states that the European Union has released mandatory and extensive ESG disclosure requirements.¹⁵ However, the one-size-fits-all nature of the European requirements does not always serve investors. Another panelist adds that the European Union is at least a decade ahead of the United States with respect to ESG disclosures. The SEC has proposed an ESG disclosure framework, but it is not yet finalized.¹⁶ A key challenge is that there still is not a consensus definition of ESG and different investors prioritize different aspects. It is expensive for companies to produce relevant ESG data and for investors to analyze it. Analyzing ESG data increases costs for investors. Ideally, market forces will ultimately reveal the value of ESG data.

One panelist observes that there has been less focus on the “G” dimension of ESG. He asserts that the “G” dimension includes the strength of documentation in structured finance transactions. Another panelist adds that, as markets mature, there is a trend for deal documents to drop various restrictions. Ultimately, the loosening of documentation reaches a point where it is an issue for investor protection. Having solid protections helps to keep transactions liquid.

Dodd–Frank effects: One panelist describes the failure of SEC rule 17g-5,¹⁷ which requires rating agencies to make information available to each other for the purpose of producing unsolicited ratings. It is an example of a failure of the Dodd–Frank Act.¹⁸ Rating agencies have not produced unsolicited ratings as the rule contemplated. Instead, all the rule has done is to increase costs for issuers and constrain the dialogue between issuers and rating agencies during the rating process. The rule failed to address what was needed to make ratings better. Instead, it imposed more requirements with little beneficial effect.

Another panelist observes that only about two-thirds of the Dodd–Frank mandated initiatives have been implemented. Moreover, until recently (i.e., under the Trump administration), there had been a trend toward relaxing regulations. In some areas, such as risk retention,¹⁹ market forces have sustained reforms even as regulatory requirements diminished. In most areas, however, that has not happened. The impending episode of stress may be a test for the effects of regulatory relaxation and reveal weaknesses in the system.

One panelist argues that tighter regulations on banks pushed a substantial proportion of financial services outside of the banking system and into unregulated companies. One view is that the regulators do not properly appreciate or understand the unregulated financial services sector. So much of financial services has been pushed into the unregulated, unmonitored “shadow banking” industry that it creates a new type of systemic risk. There is an emerging movement toward imposing regulation on nonbank financial service providers. Panelists share the view that it is necessary to provide credit to risky, underserved borrowers, either through the banking system or otherwise.

Blockchain: One recent deal used blockchain technology to facilitate disclosure in the offering process. Increasing use of blockchain technology will continue to improve transparency and reduce costs.

Flight to quality: Investors have been stretching for yield over the past several years. Higher yields in the current environment allows them to stay in high-quality assets while still getting attractive yields.

11:45 am: Keynote: Macroeconomic and Geopolitical Market Assessment

One panelist states that a US recession is likely as the Fed has become more hawkish. The recession will likely be mild and last for only three quarters. Output will likely decline by 0.25%, and unemployment will likely rise to 4.9%. However, there is a risk that it could be worse if the Fed has to take stronger-than-expected measures. Another panelist states that labor market conditions are not the primary cause of current inflation. Rather, today’s inflation is caused mostly by excessively accommodative policies a year ago. Another driver of inflation is the size of the Fed’s balance sheet. Large household cash balances are another driver. A third panelist asserts that, apart from inflation, the economy is doing well and the risk of recession is small. Consumers are in good financial condition and banks are not tightening credit. There is a good chance that the economy will be as strong a year from now.

Another panelist challenges the assertion that the Fed balance sheet is a driver of inflation. A bigger factor was supply-chain problems over the past year. Inflation in the price of goods migrated into the labor market, which has become a key driver.

One panelist emphasizes that there is heightened uncertainty. The range of possible outcomes has expanded. The market incorporates the heightened uncertainty into prices.

Housing and Mortgages: One panelist explains that although consumers have rising balances of credit card and auto loan debt, rising interest rates have kept them from taking on more mortgage debt. Roughly 80 of all residential mortgage loans in the United States are conforming loans. The panelist asserts, however, that there is a problem in scoring borrowers because only 4.8% of conforming loans go to African American borrowers, even though African Americans represent between 12% and 15% of the population. The reason is a lack of competition in credit scoring. The FHFA is examining the issue and will promote a new rule to allow new credit score vendors to compete against FICO scores.²⁰ Increased demand for homes by underserved minority households will contribute to demand that keeps home prices rising.

Consumer credit: One panelist states that the nonmortgage consumer sectors are likely to get worse before they get better. However, the structural protections in securitization transactions provide better protection for investors than do corporate bonds, which rely on the abilities of corporate CFOs to navigate through periods of stress.

Corporate credit: The panelist states that corporate balance sheets are strong. Corporate credit risk is essentially a macroeconomic issue. Corporations’ ability to meet their financial obligations will depend on the severity and length of the next recession. Another panelist adds that a recession is not a certainty, and many corporate CFOs have expressed confidence in their companies’ abilities to withstand stress. A third panelist adds that although consumer delinquencies are rising slightly, they are still quite low. However, lower-income, younger consumers are using more credit and may become overextended. Also, the end of student-loan forbearances is likely to add stress for many consumers.

NAIC capital charges for CLO mezzanine tranches: One panelist explains that the NAIC is reexamining its capital charges for all securitization products. The NAIC learned a lesson from 2007–2008 that capital charges needed to be increased. Insurers invest a significant proportion of their assets in securitization products, sometimes as much as 45%. CLOs have come to represent a rising share of that category. Insurance companies have become major holders of single-A-rated and triple-B-rated CLO tranches. The NAIC is seeking to adopt a modeling approach for CLOs, similar to what it does with MBS and CMBS.²¹ That might not be a bad thing because it would improve transparency, as it has for MBS and CMBS. Moreover, it seems unlikely that the change would produce higher capital charges for CLO tranches rated at or above the double-A level, although it would probably increase capital requirements for tranches rated triple-B and lower. Even if capital charges increase for CLO tranches, insurance companies will be more likely to sell high-yield corporate bonds than CLOs if they need to raise capital.

Geopolitical risks: One panelist identifies the policies of the UK’s Truss administration as a key issue.²² The Truss government announced a major tax-cut package at the same time that it was trying to shield consumers from rising energy prices. That exposed a fundamental inconsistency between fiscal and monetary policy. Markets reacted by driving up the price of gilts. What was underappreciated through that episode was the role of financial stability and the effect of transitioning from quantitative easing to quantitative tightening. The withdrawal of quantitative easing created downward pressure on gilts. Some UK pension plans that had bet on declining interest rates had to liquidate gilt assets. This exposed liquidity issues. It is possible that a similar scenario could happen in the United States.

Another panelist highlights that the Fed’s inflation-fighting activities may come into conflict with the real economy and financial stability. The situation in the United Kingdom is strange in that the Bank of England is simultaneously buying bonds and raising rates. The United States’ federal funds rate will likely go above 5%. The financial system is highly leveraged (although the leverage is not fully visible), which might force the Fed to reverse some of its inflation-fighting moves in order to protect the economy.

ESG: One panelist highlights the “S” dimension of ESG. Wealth inequality is the big issue. There has been growing activism on the issue of inequality over the past several years. The issue will become more pronounced as we move into a slowing economy. The long period of benign conditions actually exacerbated wealth inequality in the United States. It will likely be a key risk for markets as companies and investors start to take increasing action on the issue.

Another panelist notes that the “E” dimension of ESG is becoming controversial. For example, environmental activists have disturbed the proceedings of some recent investment industry events. Meanwhile, certain Republican-dominated states are withdrawing investments from investment funds that apply ESG frameworks that disfavor fossil fuels.

A third panelist views ESG as part of credit risk. The “G” dimension includes CLO manager risk.

12:15 pm: CLO Market Overview

Credit performance expectations: One panelist remarks that that there was a period of improving credit quality in CLO portfolios from June 2020 to April 2022. The improvement is reflected in the WARFs of portfolios, par loss/gains, and OC tests. However, since April 2022, there has been a decline. The upgrade/downgrade ratio has deteriorated, and more portfolio credits have negative outlooks. Deals from the 2017 and 2018 vintages are showing the greatest degree of weakening. Deals from 2020 and later continue to show solid credit metrics. The share of healthcare industry credits in CLO portfolios has been declining. Another panelist observes that the proportion of loans priced at or below 80% of par has grown from less than 3% earlier in the year to more than 6% now. Twenty-nine percent of the loans in CLOs are currently at or below the B− credit grade.

One panelist predicts that loan defaults will increase from their current levels. There are likely to be many more out-of-court loan restructurings. Borrowers are likely to be able to exploit provisions in their loan documents to extract favorable restructurings from lenders. These may not appear as defaults, but they will translate into losses for lenders and investors. Another panelist predicts that leveraged loan defaults will be in the range of 2% to 3% in 2023 and 3% to 4% in 2024. By comparison, the default rate in the period from late 2008 to early 2010 was in the range of 14% to 15%, and the default rate during the stress episode of 2014 (oil and gas) was slightly over 3%. The leveraged-loan default rate was around 4½% in 2020. Defaults are not expected to be concentrated in any particular industry sector.

One panelist asserts that the pace of loan downgrades to accelerate in the near term. Another panelist asserts that even if many loans are downgraded the proportion of triple-C-rated loans in CLO portfolios will not rise as quickly as the overall pace of loan downgrade because CLO managers are likely to try to sell those loans. Triple-C CLO buckets could rise to the range of 8% to 10%.

Another panelist expects ratings on CLO tranches to remain stable. However, if the rate of loan defaults rises more than expected, CLO ratings might face downgrades, particularly among their lower-rated tranches.

Outlook for 2023: One panelist observes that CLO issuance year-to-date is around $105 billion, and the projection for the full year is around $120 billion. However, the pace is very stop-and-go. Fewer CLO managers have been active this year, and it has been harder to place triple-A tranches because banks have retreated from buying them. However, the amount of loans accumulated in warehouse facilities is very large and creates pressure for doing new deals. Additionally, there is the hope for lessening uncertainty as economic stresses run their course. All this means that CLO issuance next year is likely to be roughly on par with this year’s level.

Legal, regulatory, and ESG issues: One panelist notes that the United States and European Union differ significantly with respect to ESG practices. The dominant approach in the United States is based on negative screening. By contract, practices in Europe are more varied, and there are already definitive ESG regulations.²³ In addition, the European Union has an established framework for corporate sustainability reporting.²⁴ The SEC proposals are broadly similar to what already exists in the European Union. One is about corporate disclosure on climate change. A second is about disclosures by investment advisors.²⁵ Managers are likely to be very careful about how they market their deals in terms of ESG commitments and metrics.

Another panelist highlights that money managers are experiencing pressure with respect to ESG issues. In the absence of specific regulation, standards for ESG reporting will be driven by investor demands. So far, investors are not pushing trustees on the issue of ESG reporting. Money managers use their own internal ESG-scoring methodologies, which vary greatly. Some are quantitative, and others are qualitative. The GSEs are taking the lead on ESG reporting from the issuer side. Trade associations are becoming active on the issue. The LSTA has created model questionnaires for managers and borrowers. Nonetheless, various market participants have cautioned that emerging ESG disclosure and reporting standards should not undermine or unduly constrain the economically beneficial ability of CLOs to fund corporate loans.

Another panelist adds that it is too early to adopt rigid ESG metrics and reporting standards because there is not even a consensus about what constitute ESG-favorable or ESG-compliant attributes. There is disagreement about nuclear power and many other activities. There are several tools available that allow investors to view ESG through different lenses. Examples include DealScribe (https://dealscribe.com), Enverus (https://future.enverus.com/esg-energy), and FinDox (https://www.findox.com/solutions/esgx/).

Another panelist observes that ESG negative screens eliminate only about 2% of the potentially investable universe of borrower credits.

NAIC proposals: One panelist explains that the NAIC has taken heightened interest in CLOs because insurance companies have taken larger exposure to the sector. The NAIC is reacting to a perceived regulatory arbitrage produced by CLO structures.²⁶ The NAIC is proposing to end the arbitrage by using its own model and assigning its own ratings to CLO tranches, which would supersede the ratings assigned by the credit rating agencies. The new approach has not been finalized or adopted, and it now seems unlikely that it could have an effective date before 2024. The NAIC’s risk-based capital working group may implement an interim change in the treatment of CLO tranches in 2023. There is a separate NAIC proposal about accounting for collateralized fund obligations. This is part of the NAIC’s larger project concerning a principles-based definition of what is a bond.

Secondary liquidity: One panelist asserts that the market has been quite active. There are several initiatives to facilitate secondary trading of loans: IDX Markets, Octaura, New Debt Exchange, and so on. Some initiatives have the potential to improve bondholder communications.

12:15 pm: Market Spotlight: CMBS

One panelist states that 2022 has been a very difficult year because of Fed tightening. CMBS issuance is down and has slowed dramatically in the third quarter. Spreads have widened markedly. Spreads on last-cash-flow triple-A tranches have widened by about 70 bps for the year. However, credit fundamentals have held up pretty well. Credit metrics have been improving for the past two years. CRE fundamentals have not yet indicated any widespread distress. However, continued tightening by the Fed could trigger problems.

Fed action to raise interest rates creates pressure along several dimensions. With respect to commercial properties, higher interest rates affect capitalization rates (cap rates), NOI, and property prices.²⁷ Rising interest rates historically have triggered higher capitalization rates and higher property prices. Current cap rates have not yet risen in response to the recent Fed actions, but they are likely to do so. NOI is likely to be the key driver of property prices. Inflation will help to boost property NOIs, but a recession would create pressure in the opposite direction.

Another panelist explains that market participants are waiting for property prices to decline because cap rates have remained unrealistically low in the face of rising interest rates. Property values increased rapidly during the pandemic, particularly for multifamily and industrial properties. A positive feature of multifamily properties is that rents adjust annually (for the most part). By contrast, most office leases have terms of 10 years. Cap rates for multifamily properties have recently been around 5% (i.e., implying that a multifamily property’s value would be 20 times its NOI). Prices on commercial properties have started to decline, but only to a slight degree. There is plenty of room for commercial property prices to decline if interest rates continue to rise.

A third panelist disagrees, stating that property prices have already declined substantially and the property market has become dysfunctional. The market should expect a protracted period of declining valuations that produces stress on CMBS credit metrics. CMBS appear fairly priced after the recent spread widening. The speed of the recent widening has caused pain for many money managers, but the market has remained liquid.

Another panelist observes that long-term leases in the office sector helped to stabilize the sector during the pandemic, when the hotel sector was getting clobbered by daily repricing. What was a strength under one kind of stress becomes a weakness under another. Having interest rates higher than cap rates suggests that a significant downward repricing is likely. CBD office vacancy rates are in the range of 20% to 25% in most areas. Suburban office vacancy rates are actually lower than those for CBD office properties. This raises the issue of a possible secular shift in the demand for office space as workers increasingly operate remotely. New commercial loans are being made with lower LTVs compared to a year ago. Credit rating upgrades have been concentrated in the GSE and SFR portion of the market. Downgrades have been concentrated in older deals and those with significant exposure to the mall (retail) sector.

One panelist explains that issuers have been unable to sell some of the lower-rate tranches on recent deals. Additionally, spreads have widened so fast that deals end up closing at wider spreads than the issuers had originally anticipated. Another panelist adds that some major property owners have very negative outlooks and expect property values to decline significantly.

One panelist explains that refinancing risk is substantial in a rising-interest-rate environment. There will be roughly $247 billion of loans maturing by October 2024, of which $28 billion have DSCRs of less than 1.2. About $5 billion of that $28 billion have LTVs above 90%. Those loans are at greatest risk. Additionally, there are about $14 billion of loans with underlying properties that have occupancy rates below 80%. Occupancy rates are likely to drop further in a recession.

Another panelist concludes by stating that despite the current weaknesses and headwinds, the commercial property sector, the CMBS sector, and the broader securitization market are unlikely to experience severe spread widening comparable to what occurred with the 2008 financial crisis. Assuming that a recession occurs, it is unlikely to be as severe as the one associated with the financial crisis.

2:45 pm: Staying the Course: Non-QM²⁸

The key issues are the effects of higher interest rates and a possible recession on home prices, origination volumes, the size of the market, prepayments, and credit performance.

One panelist states that the level of non-QM activity will likely be lower in 2023 because of higher interest rates. Another panelist agrees. If the Fed embraces an extremely hawkish policy, that could strangle the non-QM sector. However, that has not yet happened and is not expected to happen. Even with higher interest rates, a good number of borrowers are still seeking loans. Cash-out refinancings have slowed sharply.

Non-QM originations: One panelist notes that newly originated loans have high interest rates that create significant potential prepayment risk in the future. This constrains the premium over par that buyers will pay for the loans and therefore diminishes the economics of origination and securitization. The volatility of rates and spreads is driving the economics.

Non-QM originations have dropped from around $6 billion per month at the start of the year to roughly $1 billion by October. The volume of non-QM MBS issuance is expected to drop to roughly $20 billion next year, from a projected level of $42 billion for 2022.

Credit standards: One panelist observes that new originations include an increasing proportion of affordability products (i.e., loans designed to allow borrowers to stretch financially in order to buy more expensive homes than they could otherwise afford). Examples include IO loans, loans with 40-year terms, 30-year loans with IO periods, ARMs, and short-term balloon loans (e.g., 5-year balloons). Also, the proportion of DSCR loans²⁹ is rising sharply, sometimes constituting half or more of the loans in a given transaction. Esoteric loan types are also appearing: small-balance-commercial loans, loans on mixed-use properties, and cross-collateralized loans (i.e., loans secured by multiple properties). Issuers are exercising creativity to keep interest rates high and to diversify pools.

Another panelist counters with a different view. According to that panelist, most non-QM lenders are not turning to affordability or loosening their lending standards (“expanding the credit box”) to boost origination volumes. The upshot is that origination volume is shrinking but credit standards are holding firm or tightening. A third panelist generally agrees that credit quality is holding firm and volume is declining.

Rating Non-QM MBS: For purposes of rating non-QM MBS, Fitch limits no-ratio loans to 2.5% of a pool and limits DSCR loans with low ratios (i.e., DSCRs of less than 0.74) to 5%. Additionally, Fitch applies risk factors (multipliers) of 1.6× for stated-income loans and 2.0× for DSCR loans and loans to foreign nationals. Fitch’s rating criteria require timely payment of interest for securities rated triple-A or double-A. This means that issuers must be creative in restricting interest on a deal’s subordinate tranches.

One panelist explains that the due diligence process performed by TPR/due diligence providers involves close cooperation with both the rating agencies and securitization issuers. TPR providers work to clear exceptions (i.e., remedy defects) whenever possible.

Another panelist asserts that today’s non-QM loans are much less risky than legacy alt-A loans because of the ATR rules³⁰ and TPR reviews. A different panelist asserts that prepayment speed rather than credit is the key feature of non-QM loans for investors. Credit is less of a concern because non-QM issuers typically retain substantial credit risk exposures in their deals.

Prepayment expectations: One panelist asserts that the average severity of loss upon the default of non-QM loans has been 15%. The outlook for loss severities going forward is slightly different, but not significantly so. This reinforces the view that the non-QM sector is more about prepayments than about credit. The panelist asserts that the prepayment performance of non-QM loans during 2018 to 2019 should be the relevant benchmark for expectations going forward. During that period, non-QM loans displayed relatively stable prepayment speeds. Based on that experience, non-QM loans with current interest rates (approximately 9%) are expected to prepay at a rate of 25% CPR, and those with interest rates of 5% are expected to prepay at a rate of 5% to 6% CPR because of slower housing turnover and reduced refinancing opportunities. However, the current rate environment is not likely to persist. The Fed’s interest-rate hikes are likely to end at 5½%, although there is risk to the high side. The yield on the 10-year T-note could be back to 2½% or lower within a year. This could create refinancing opportunities for non-QM loans with lower interest rates. The longer-term expectation is that the Fed will eventually cut its target rate to 1% and the 10-year T-note will yield 2%.

Structural issues: Another panelist explains that some recent non-QM deals provide for step-up coupons on their senior classes. This can require structural changes to make sure that the scheduled coupon on the senior classes does not exceed the available interest cash flow from the underlying loans. This is sometimes done by subordinating the coupon of the lower-rated classes. This has made the lower-rated classes harder to sell, and deal sponsors are retaining more of them.

One panelist explains that the change in the level of interest rates, combined with the change in step-up mechanics, creates increased uncertainty about whether issuers (servicers) will exercise cleanup calls (i.e., the option to terminate a transaction by purchasing the underlying loans at par plus accrued interest once the size of the pool declines to a specified level).

Another panelist explains that many issuers are holding large amounts of low-coupon loans in their warehouse facilities. Those loans must be securitized or sold at discounts to par in order to clear the warehouses. That forces the issuers to take losses. More broadly, however, the non-QM business model of accumulating loans in warehouse facilities is fundamentally broken. The business does not work with a 7% cost of funds and a 2.75% margin. There will need to be a way for investors and originators to come together on discounted prices for low-coupon instruments. It will not be feasible for issuers to execute deeply uneconomical securitizations for a whole year.

One panelist explains that structures shift to meet investors needs and market expectations. The market might eventually return to simple, sequential structures because simplicity is always preferable to complexity. However, that cannot happen until concerns about delinquencies and prepayments subside.

Servicing in a downturn: Another panelist explains that servicers would likely react quickly with loss-mitigation efforts if the next recession triggers a sharp spike in delinquencies. It would be difficult to use rate-reduction loan modifications unless then-current rates are lower than the rates on the loans (which seems unlikely). Step-rate modifications and debt forgiveness also would be unlikely. Term extensions would be difficult to use for loans that are already securitized. Non-interest-bearing balloons might be the best solution. A key issue for modifying non-QM loans is that the standard modification procedures under HAMP generally will not work. Those procedures call for a complete reunderwriting of a loan, including documentation of borrower income and assets. Many non-QM loans were originated without such documentation because the borrowers cannot supply it. Investment properties may present particular issues, because a recession could weigh especially heavily on tenants and reduce their ability to pay rent.

One panelist explains that the onset of the pandemic produced real credit effects by stressing small businesses.

Hurricane Ian: Loans secured by properties located in areas affected by severe weather create challenges. Lenders are ordering inspections on properties in those areas. However, property preservation companies (which do the inspections) tend to deploy all their resources to the hardest-hit areas and have very rigid processes. For example, it is impossible to get them to change the order in which they assess properties, even by paying extra. By contrast, a better approach is to use aerial photography to get fast and accurate assessments on large numbers of properties in a matter of days.

Social impact considerations in default management: One panelist explains that the onset of the pandemic caused many owners of small businesses to default on their home mortgage loans. Many lenders worked hard on training servicers to work on out-of-the-box solutions for keeping borrowers in their homes (i.e., foreclosure alternatives). Those kinds of measures are not expected to be necessary for the level of defaults that is likely in the next downturn. It is still too early to predict exactly how servicers will deploy modifications or deferrals to deal with default situations, but the recent experience of the Covid pandemic offers examples of measures that could be available for keeping borrowers in their homes.

Investor demand: The non-QM sector has less liquidity than other MBS sectors. There are roughly 50 active investors in non-QM MBS, compared to 380 active investors in GSE CRT deals. Uncertainty about prepayments and the ongoing actions by the Fed further dampens demand for non-QM deals.

Outlook for 2023 and beyond: Each panelist states a view on the outlook for the non-QM sector:

• ▪ Next year will likely be very tough, but conditions should improve in 2024.

• ▪ There will likely be contraction of the market and consolidation among lenders. Those that uphold credit standards will come out ahead.

• ▪ LTVs on newly originated loans will be lower. Supply should match the level of 2021.

• ▪ Agrees with the preceding view.

• ▪ The second half of 2023 will present opportunities for lenders without having to loosen lending standards.

• ▪ Current conditions make non-QM MBS very attractive, and the best relative value is in the most senior tranches.

4:00 pm: On the SLAB? FFELP and Student Loan ABS

Student debt relief program: One panelist explains that the DOE’s stated rationale behind the student debt relief program is to help borrowers transition from the payment pause (during the pandemic) into repayment, hoping to minimize defaults on the DOE’s portfolio. The program provides for forgiveness of up to $20,000 of student debt for borrowers with PELL grants and up to $10,000 for others. The DOE is now accepting and processing applications. The deadline for applications is the end of 2024. Only federal student loans are eligible. Private student loans are not eligible. Borrowers on most FFELP loans are not eligible for the program unless they submitted an application before September 29. To be eligible, a single borrower must have had an AGI of less than $125,000 in either 2020 or 2021 and a married (filing jointly) borrow must have had an AGI of less than $250,000 in either of those years. For dependent borrowers, the income thresholds apply to their parents. To be eligible, a loan must have been disbursed before June 30, 2022. According to the DOE, the loan forgiveness will reduce the median borrower’s monthly payment by 38%. The total amount to be forgiven will be roughly $465 billion.

The loan forgiveness program may affect FFELP loans by encouraging some FFELP borrowers to seek loan consolidations (based on the erroneous view that doing so would make them eligible for the program), to switch into the Direct Loan program, or to strategically default.

Court challenges: Another panelist explains that there are five active court cases challenging the student debt forgiveness program. One is Laschober v. Cardona (D. Or., No. 3:2022cv01373). That case challenges the power of the executive branch to cancel student debt without Congressional action. The other cases pursue similar arguments. In Laschober, the plaintiff is a homeowner who claims that the student debt relief program will cause him to pay more interest on his mortgage loans. A second case is Garrison v. U.S. Dept. of Education (S.D. Ind, No. 1:22-cv-01895) in which the plaintiff is a borrower with an IBR plan and who is eligible for PSLF. The plaintiff alleges that the loan forgiveness program will make him incur state tax liability to his detriment. A third case is Brown County Taxpayers Association v. Biden (E.D. Wis., No. 22-C-1171). There the plaintiffs claim that the loan forgiveness program violates the separation of powers. The Brown County plaintiffs also argue that the debt forgiveness program’s objective of providing disproportionate benefit to minorities (in order to lower the racial wealth gap) is unconstitutional and violates the equal protection clause. A fourth case is State of Nebraska v. Biden (E.D. Mo., No. 4:22-cv-01040). The plaintiffs there are the attorneys general of six states: Arkansas, Iowa, Kansas, Missouri, Nebraska, and South Carolina. That case argues that Congressional action would have been required to authorize the student debt relief program. The fifth case is State of Arizona v. Biden (D. Ariz., No. 2:2022cv01661).

Credit ratings: A third panelist explains that the student debt forgiveness plan should not affect credit ratings of student loan ABS because it does not include FFELP loans. There may be a moderate effect on prepayments over the coming year. IBR plans and the PSLF program created significant stress by slowing prepayments for outstanding student loan ABS over recent years. Many issuers responded by amending their deals to extend the legal final maturity dates. As of now, only speculative grade–rated tranches are expected to be affected by slowing prepayments.

Side effects: Another panelist adds that an interesting by-product of the student debt relief program is that it prompted some colleges to announce that they would not ask their students to incur debt, including Amherst College, Bowdoin College, Brown University, Dartmouth College, Davidson College, Duke University, Grinnell College, Harvard University, Massachusetts Institute of Technology, Northwestern University, Pomona College, Princeton University, Smith College, Swarthmore College, University of Pennsylvania, Vanderbilt University, Vassar College, Washington University in St. Louis, Wesleyan University, Williams College, and Yale University.

One panelist notes that the announcement of the student debt relief program originally produced spread tightening on student loan ABS. When it subsequently emerged that FFELP loans would not be part of the program, spreads returned to their prior levels. A key question is whether the debt relief program will trigger changes to the IBR and PSLF programs.

In April 2022, the DOE changed the IBR program in ways that encourage borrowers to pursue consolidation loans. The DOE also changed the PSLF program to permit a greater number of borrowers to avail themselves of the benefit. Both changes produced increases in prepayments.

Private student loans: One panelist explains that refinancings are being done primarily by borrowers who are older and more financially secure. In many cases, they are refinancing to get lower interest rates. Refinancing activity has been low for the past year because of both rising interest rates and uncertainty about the scope of the student debt forgiveness program. A typical refinancing borrower has a graduate degree, has been out of school for at least five years, and has a prime-quality FICO score. Available interest rates on refinancings today are often higher than the rates those borrowers had on their Grad PLUS loans from five or more years ago.

Another panelist explains that the payment moratorium associated with the Covid pandemic discouraged many borrowers from refinancing while the government was paying their interest. It will probably be some time before interest rates adjust to make refinancing student debt attractive.

Credit performance: One panelist states that delinquencies and defaults on FFELP loans are quite low and are expected to increase. IBR plans have been very stable through the pandemic, which is a sign that borrowers were comfortable with their finances. A recession in 2023 could cause IBR cash flows to decline as a greater proportion of borrowers suffer job losses. Delinquencies and defaults on loans to in-school borrowers have increased to above prepandemic levels.

Another panelist explains that when borrowers receive forbearances because of natural disasters they are much more likely to subsequently default. A recession next year will likely produce weaker student loan credit performance.

Outlook for new issue volume: One panelist explains that originations of FFELP loans stopped in 2010. Therefore, FFELP student loan ABS issued since then have been backed by purchased portfolios or opportunistic repurchases. The average annual issuance over the past 10 years has been $6 billion, but there was no issuance in 2020. Therefore, the expectation for FFELP student loan ABS issuance going forward starts at $6 billion and trends downward. Private student loan ABS issuance is expected to be roughly $4 billion to $5 billion. Issuance of ABS backed by refinancings is expected to be very low because the volume of refinancings is expected to be very low.

Transition from LIBOR to SOFR: Most of the FFELP student loan ABS market uses three-month LIBOR as a rate benchmark and does not have strong transition language in the governing agreements. The federal LIBOR legislation³¹ will likely apply to those deals. There could be a small basis mismatch if the deals adopt term SOFR, because the DOE has ruled that the underlying loans will be tied to 28-day average SOFR.

9:45 am: Advancing ESG in the Capital Markets

One panelist asserts that, because there are not well-defined quantitative metrics for the damage that companies cause along the E, S, and G dimensions, the most appropriate way to measure a company’s ESG performance is whether it delivers on its ESG-related commitments. Another panelist counters that there are strong performance metrics in some areas, such as the amount of greenhouse gas abatement produced by solar energy projects. Likewise, wind power projects produce important water savings when they replace fossil-fuel turbine power plants.

One panelist explains that viewing companies, assets, and structures through an ESG lens requires thinking beyond the constraints of traditional balance sheets and income statements. It calls for thinking in terms of cash flows, which is a natural connection to structured finance. The approach should be forward looking. This notion is already being embraced in relatively new accounting standards, such as CECL in the United States and the IFRS 9 international standard.³²

Another panelist asserts that the environmental dimension of ESG is the most popular in Europe, the social dimension is the most popular in the United States, and the governance dimension is the most popular in Asia. Europe has imposed regulatory standards. ESG progress in the United States is primarily driven by investors. Although ESG considerations have received a surge of attention in the past several years, a small number of market participants and policymaking bodies have been focusing on the issues for years. For example, the United Nations promulgated a slate of sustainable development goals in 2015.³³ However, it does not provide quantitative measurements of progress. Heightened focus on ESG issues by investment managers is clearly a positive development. The panelist states that investment managers might someday screen investors based on their ESG characteristics.

One panelist observes that corporate 401(k) plans are starting to offer ESG-themed options. The growing importance of ESG is also evident in the fines that the SEC has imposed on companies for greenwashing.³⁴

One panelist notes that there are not enough ESG-favorable assets to create the volume of securities needed to meet demand. A continuing challenge is the difficulty in defining what constitutes an ESG-favorable or ESG-compliant asset. Another panelist observes that the market is still in the early days of ESG investing. It must develop a common definition of what “sustainability” means in different contexts. An inevitable complication is that sustainability can have different meanings in different places. For example, water considerations are very different in California and Hawaii. A third panelist states that evolving technology, such as the growing prevalence of electric vehicles, will give investors the opportunity to indicate the strength of their ESG orientation buy paying more for ABS with higher proportions of ESG-themed assets (e.g., electric vehicles).

One panelist discusses the need for democratization in the area of residential solar installations. So far, residential solar installations have been highly concentrated among prime and super-prime borrowers. Borrowers with lower FICO scores have been excluded. One recent transaction focuses on allowing individuals with lower FICO scores to participate in community solar installations.³⁵

Another panelist challenges the value of ESG considerations, asserting that ESG-themed securities have not produced superior returns for investors. He asserts many investors privately state that their ESG objectives are secondary to their interest in maximizing investment performance.

One panelist argues that the European ESG rules³⁶ are unclear and vague. The situation in the United States is not actually much worse. The US market is waiting for a major player to take the lead in setting standards. It could be a regulator, or it could be an organization of market participants. Another panelist explains that the SEC’s proposed ESG disclosure rules³⁷ are still subject to significant uncertainty about implementation. Companies will be rewarded for having positive ESG policies.

One panelist highlights the recent improvements in battery technology, which have allowed storage of solar power generated during the day for use at night. This development allows power companies to greatly increase their use of green sources of energy.

Panelists express differing views about whether there should be a regulatory requirement for ESG ratings. Panelists agree, however, on the need for relevant stakeholders to have a way to participate in the dialogue for creating good policies and regulations. One panelist states the New York City ESG regulations for buildings are ridiculous, but there has not been organized pushback because there is no organization to speak on the issue from the perspective of building owners and managers.³⁸

10:30 am: Word from the Hill: Regulating the Capital Markets

Surprising developments: One panelist states that the most surprising regulatory development of the Biden Administration was the executive order concerning responsible development for digital assets.³⁹ It proposes a central bank for digital currencies. It establishes a framework for shaping future policy for digital assets. Another panelist identifies the lack of policy consensus in key areas as the most surprising development. The conflicting economic policy moves in the United Kingdom—simultaneous easing and tightening moves—are the prime example. A third panelist identifies the SEC’s ambitious regulatory agenda as a surprising development. Another key surprise is how silent the Treasury Department has been in major economic/financial discussions over the past two years. The Financial Stability Oversight Counsel also has been silent.

Supreme Court: One panelist explains that the US Supreme Court recently decided two important cases in the area of administrative law. In American Hospital Association v. Becerra, 596 U.S. ___ (2022), the Court applied the principle that when a statute is unclear, the regulatory agency responsible for administering it is supposed to fill in the details, and courts should defer to the agency’s decisions unless they are unreasonable (the Chevron doctrine).⁴⁰ The Court directed the lower courts to follow the statute because it was clear. In West Virginia v. Environmental Protection Agency, 597 U.S. ___ (2022), the Court ruled that a regulatory decision to move the US energy industry away from fossil fuels and toward renewable sources of energy was too big a decision for the agency to make under its statutory authority. Such a decision must be made by Congress. Interestingly, after the release of the West Virginia v. EPA decision, a number of Republican members of Congress sent letters to SEC chairman Gensler warning him not to exceed the SEC’s authority or the agency would be challenged. Also, the Supreme Court appears to be looking for opportunities to challenge regulations. It did not have to take West Virginia v. EPA, and it almost went out of its way to do so.

Another panelist highlights the possibility that Congressional oversight committees will challenge actions by regulatory agencies once Republicans gain control.

One panelist emphasizes that ambiguity and conflicting objectives (e.g., credit availability versus safe lending) are common in statutes and are a natural consequence of negotiation and compromise. The Chevron doctrine is a necessary element for regulatory effectiveness.

Student loans: Another panelist states that student loan debt relief is a hot issue. It has been difficult for those who object to it to get standing to bring lawsuits. If Republicans get control of either house of Congress in the upcoming midterm elections, it is possible they could bring a lawsuit against the executive branch, as happened in U.S. House of Representatives v. Burwell, 30 F. Supp. 3d 53 (D.D.C. 2015).

GSEs: One panelist explains that Fannie Mae and Freddie Mac (the GSEs) are currently operating as regulated utilities. There seems to be consensus that that is how they should operate. The question of who owns them is contentious. It is quite possible that they will end up being formally owned by the government. Both of the GSEs currently issue uniform MBS that can be delivered for TBA trades. Another panelist observes that CRT deals are a positive development for the GSEs. CRT deals provide a form of “synthetic equity” for the GSEs and reduce the risk to taxpayers. It seems unlikely that the GSEs will emerge from conservatorship under a Democratic administration because they have been given extensive mandates to promote affordable housing.

ESG: One panelist asserts that the social and governance dimensions of ESG have received less focus than the environmental one. There is only limited consensus about the specific corporate and asset attributes that are positive and negative for the social and governance dimensions. The lack of clarity is likely to continue for the near to medium term. Another panelist emphasizes that developing workable disclosure standards will be essential for investors to apply ESG principles. ESG started as an issue from the Democratic side, and now it has become an issue on the Republican side. Several Republican-controlled states are embracing anti-ESG positions in order to protect or promote local economies that are tied to fossil fuels. The anti-ESG position is likely to change soon. However, a greater challenge for ESG over the longer term is greenwashing. The solution for greenwashing will be better transparency and disclosure.

12:30 pm: SOFR So Good: LIBOR to SOFR Transition

One panelist explains that the LIBOR legislation⁴¹ enacted earlier this year addressed many of the issues related to the LIBOR to SOFR transition but not all of them. The legislation addresses older legacy deals that either never contemplated that LIBOR could disappear or implicitly assumed that any disruption would be temporary and short-lived. The greater challenge is deals that envisioned the possible demise of LIBOR and included a wide array of provisions about how a replacement rate would be determined and who would do so. A third category is new deals that follow the industry guidance for fallback language.

Another panelist explains that LIBOR will end or become nonrepresentative on June 30, 2023, which is only eight months away. This is a short time for all the remaining CLOs to transition to SOFR. The last possible payment date for which LIBOR can be the reference rate will be in July 2023. It is the responsibility of CLO managers to handle the transition process. It seems likely that the transitions will coalesce around “term SOFR” (rather than “SOFR in arrears”).⁴² Consent from a CLO’s controlling class or equity class might be necessary for using another index.

One panelist states that certain Eurodollar deals might not be covered by the LIBOR legislation and might end up in court as Article 77 proceedings in New York. Upcoming regulations from the Fed might address the issue. Transaction parties can negotiate to use a reference rate other than SOFR or to use credit spread adjustments other than those embodied in the LIBOR legislation; the legislation merely provides a fail-safe if the parties do not act. (Note: The panelist does not address how the existence of the fail-safe as a default result affects the dynamics of any such negotiation. The legislative fail-safe provisions effectively set a floor for what investors will accept and a cap on what issuers will be willing to pay.)

Another panelist explains that there is still a small number of old ABS CDOs, which generally specify the prime rate as the fallback in case of a LIBOR cessation/disruption. The coupon on those securities will likely jump by 3% or more. Likewise, a small number of US deals is governed by English law, and the transition for those still needs to be figured out.

Synthetic LIBOR: There is a possible issue about whether LIBOR might continue to exist after its scheduled termination date if the UK FCA orders the publication of synthetic LIBOR, which would probably be SOFR plus a credit spread adjustment. If that happens, agreements providing for the use of LIBOR unless it is not available might have to use the synthetic LIBOR instead of SOFR. The need for a synthetic LIBOR comes from the trillions of dollars of non-US contracts that reference LIBOR but are not covered by the US LIBOR legislation.

One panelist encourages investors—particularly MBS and CMBS investors—to find out how their deals work with respect to the LIBOR transition, particularly including who will determine fallback reference rates and spread adjustments.

New deals: One panelist explains that new CLOs use SOFR as the reference rate and do not include a credit spread adjustment. The spread over SOFR essentially includes what would have been the credit spread adjustment. A large number of CLO transactions were executed in late 2021 using LIBOR as their reference rate. This year (2022) started with a slow pace of CLO issuance, but it accelerated quickly. This year is likely to be the second or third highest CLO issuance year on record, despite being down 22% relative to last year.

Nearly the entire syndicated loan market is using “CME term SOFR” for new loans. CME term SOFR is the one recommended by the Alternative Reference Rate Committees. Alternatives such as “ICE term SOFR” (https://www.theice.com/iba/term-rates), Ameribor (https://ameribor.net/), and the Bloomberg Short-Term Bank Yield Index (https://www.bloomberg.com/professional/product/indices/bsby/) have not caught on in the syndicated loan market. The use of alternative reference rates that include a credit-risk component will likely be limited to regional and community banks.

When MBS market participants use the word SOFR, they generally mean 30-day-average term SOFR published by the Fed (which is compounded in advance). The key point is that the word SOFR does not yet have a single universally accepted meaning.

Another panelist observes that the proportion of outstanding mortgage loans with floating interest rates is low by historical standards. This is probably because interest rates remained very low for a long time. Now that interest rates are rising, it seems likely that a larger proportion of mortgage loans will have floating interest rates.

Final thoughts: One panelist encourages CLO managers to become actively engaged in managing their CLOs’ transition away from LIBOR. Trustees will not initiate the process for them. There is operational risk from waiting until the last minute. It is still necessary to bring everyone to the table and to execute documents to archive a smooth transition. Operational fumbles could translate into reputational damage if deals fail to make smooth transitions. Another panelist agrees. Upcoming regulations from the Fed will provide additional guidance. A third panelist observes that the process of actually documenting the transition away from LIBOR takes longer than market participants expect. Therefore, it is better to start the process earlier rather than later.