LIBOR Transition LinkWrap: A Compendium of Recent Developments
What’s happening right now in the world of LIBOR transition? Friedman Kaplan’s LIBOR Transition Task Force sees five big trends:
1. The official sector has made it easier to put off abandoning LIBOR, while urging the market to abandon LIBOR ASAP.
Recommended contractual fallback language for LIBOR-based transactions has been promulgated by the ARRC for floating rate notes, syndicated loans, bilateral business loans and securitizations. One consequence of the availability of this standardized, industry-approved fallback language is that it now will be harder for issuers, lenders, etc. to exploit LIBOR transition through bespoke contract language. Also, some market participants are likely to begin factoring the quality of fallback language into pricing of LIBOR-based instruments.
Importantly, the adoption of the ARRC-approved fallback language does not require acceptance or adoption of SOFR. Indeed, it makes SOFR adoption less urgent as a practical matter. But that is not the line the official sector is taking. On the contrary, official-sector rhetoric has strengthened in recent weeks. By way of example, in a recent speech, Federal Reserve Vice Chair Randal K. Quarles admonished market participants to stop using LIBOR promptly, stating “after LIBOR stops, it may be fairly difficult to explain to those who may ask exactly why it made sense to continue using a rate that you had been clearly informed had such significant risks attached to it.”
Nonetheless, as one market participant observed at a recent conference on benchmark transition, the regulators’ approach remains all carrot and no stick – the regulators are telling market participants that they need to act, but are not telling them what to do, much less how or when. Some market participants believe that stance may change as the 12/31/21 deadline approaches. In particular, there have been suggestions that regulatory capital requirements may be changed to make the use of LIBOR economically disadvantageous for banks. That would be both an indirect and a blunt way to address market procrastination, which has been coming primarily from the banks’ customers rather than the banks themselves. What seems more probable is that the SEC may challenge issuers’ LIBOR-transition-related risk disclosures. Perhaps we will even see some sort of tax, reminiscent of the tax on municipal bearer bonds used in the 1980s to incentivize the switch to book-entry securities.
Whether it comes through regulation or from banks and other lenders, it is clear that borrowers and other market participants will be reluctant to abandon LIBOR until they have a real economic incentive to do so. And banks will be reluctant to deny their customers the LIBOR- based lending they continue to demand as long as they fear losing customer business more than other consequences.
2. The official sector still has substantial work to do.
The completion of the initial rounds of ARRC fallback language is a huge accomplishment, but the ARRC and other official-sector participants have a lot of further work ahead. ISDA has two consultations pending, and more are expected over the summer. One is expected to come from the ARRC, seeking input on fallback language for consumer products such as mortgages and another from ISDA on some details of the credit-spread adjustment, such as mean vs. median and the length of the appropriate lookback period. In addition, the ARRC and others have sought official guidance or regulatory relief on a number of challenges and obstacles that must be addressed before the markets can truly adopt SOFR. At the moment, requests are outstanding on, among other things, relief from certain Dodd-Frank regulatory requirements, issues surrounding the tax impact of interest-rate changes on some debt instruments, and hedge-accounting issues. Look for developments on all of these issues before the end of the year.
An area in which it seems like developments will not be forthcoming in 2019 is the much-anticipated term structure for SOFR. In April 2019, the ARRC published a “User’s Guide” to SOFR, which focuses on compounding and averaging. As for term structure, it says “those who are able to use SOFR should not wait for forward-looking term rates in order to transition.” In recent weeks, the message from the ARRC and others has changed from the SOFR term structure being among the next major waypoints in the ARRC’s Paced Transition Plan to market participants being admonished not to wait for a term structure. Thus, where once the ARRC expressed confidence that term SOFR eventually will be published, its message now is that there is no guaranty that that will happen before LIBOR ends, or ever.
3. The market has started to act – but only very slowly, and not uniformly.
A Moody’s survey indicates that banks, insurers and asset managers “expect material risk in the move from IBORs to transaction-based overnight alternative reference rates.” Consulting firm FINCAD conducted a survey which concluded, among other things, that “the vast majority of financial firms do not yet know how they will value portfolios under a new benchmark regime.” The UK FCA also recently published a summary of responses it received to its September 2018 “Dear CEO” letter to major UK banks and insurers inquiring about the status of LIBOR transition work, which paints a sobering picture of the status of these firms’ efforts.
Market activity in SOFR-based products is increasing, although some have called the levels of activity disappointing. SOFR futures have been trading on the CME and the ICE for nearly a year, and several SOFR-based transactions have been issued, although primarily by ARRC members. British firm ABP Finance PLC recently conducted the first-ever consent solicitation to amend an existing deal to use SOFR instead of LIBOR. The consent solicitation was successful, although unlike in many deals, ABP needed the consent of only 75% of its holders, not 100%. At the other end of the spectrum, some market participants are switching from floating-rate transactions to fixed rates in an effort to avoid the costs and risks of LIBOR transition.
Also, while the FCA continues to insist that it will not relent on the 12/31/21 deadline, markets continue to hope for “zombie LIBOR” and other stopgap solutions.
While the bank sector is generally active in working toward the discontinuation of LIBOR, other market sectors have only recently engaged, while some have stayed on the sidelines entirely. The MFA, which represents the alternative investment management sector, only recently announced its intention to engage with regulators and members. Corporate borrowers and non-bank lenders have largely been silent in the process so far.
On the consumer front, the MBA recently issued guidance on how to talk to mortgage borrowers about LIBOR transition. Meanwhile, Freddie Mac announced that it will no longer purchase certain types of LIBOR ARMs. It is particularly concerning that focus on consumer lending remains wanting from the ARRC and the market, both because the standard fallback language used in GSE-compliant mortgage documents is particularly problematic and because of the special challenges that the transition away from LIBOR poses. It will of course be absolutely critical that borrowers on adjustable-rate mortgages understand the legal and economic consequences of a discontinuation of LIBOR and of any replacement, and lenders will need to tread particularly carefully in this area. Moreover, developments in the mortgage market have particularly complex and largely unpredictable consequences for RMBS and CDOs. A similar dynamic can be expected in other ABS classes, such as SLABS.
While the official sector is working hard, the market largely remains in a waiting mode. No market conventions have emerged yet beyond the fallbacks promulgated through the ARRC, and changes to operations such as models and databases are lagging as well. One speaker at a recent benchmark transition conference observed that the slow progress in operationalizing compounded SOFR has delayed the adoption of SOFR for syndicated loans in particular.
4. The market has started to get creative.
While there is a lot of procrastination to be found, green shoots of action and creativity have begun to appear.
Several alternatives to LIBOR have emerged as possible competitors to SOFR, and the likelihood of a proliferation of different rates rather than a single alternative seems increasingly likely. ICE Benchmark Administration has launched testing of a new “ICE Bank Yield Index,” and continues to incorporate feedback as it refines its approach to determining that rate. The NY Fed has revised the composition of its Overnight Bank Funding Rate. The AMERIBOR benchmark has captured a lot of attention, and AMERIBOR futures appear to be on the horizon. Earlier this Spring, the Bank for International Settlements observed that “It is possible that, ultimately, a number of different benchmark formats will coexist, fulfilling a variety of purposes and market needs.”
There also are signs that some market participants may be taking positions designed to profit from the ultimate credit spread adjustment that ISDA proposes. (Many expect that adjustment to be in the 20-25 bps range.)
A number of market participants have observed that SOFR-based borrowing can be expected generally to cost more because the spread that is added to SOFR in new transactions will have to compensate in part for the fact that a SOFR-based asset cannot completely offset LIBOR-based liabilities in a crisis. More specifically, the feature of LIBOR that makes it most attractive to lenders and money-market participants is that it goes up in a crisis. For a bank, this means that at the same time as a bank’s LIBOR-based liabilities are costing more, its LIBOR-based assets are generating correspondingly more revenue. In contrast, for a substantial period of time after the discontinuation of LIBOR, many banks will find themselves with LIBOR-based liabilities while they are accumulating increasing levels of non-LIBOR-based assets. As a result, in a crisis, the cost of the LIBOR-based liabilities will increase, while the yield on the non-LIBOR-based assets decreases. This phenomenon will present a serious risk management challenge and also erode bank profits. An idea recently has been floated to address this by keying the spread applied to new SOFR-based instruments to the CDS spreads of the borrower, so that as the borrower becomes more distressed, whether because of macroeconomic conditions or its own business situation, it will pay a higher rate of interest. This approach is not feasible for every situation, since not every borrower has CDS (although perhaps CDS index spreads could be used), and it stands to generate massive wrong-way risk for lenders. (Indeed, it is for this reason that CDS on CDS-dealer banks are not included as components of CDS indexes.) The operational challenges of adjusting an interest rate to reflect CDS spreads also may make this impracticable. Its many potential flaws notwithstanding, this suggestion illustrates that market participants are beginning to think creatively about how to live in a post-LIBOR world.
5. Some harsh realities have begun to set in.
Amid these encouraging signs, a couple of sobering facts have emerged as well.
Both the official sector and the markets now appear to have reconciled themselves to the fact that no matter how strong fallback language is, and no matter how carefully calibrated any credit spread adjustment is, there will be value transfer in the transition of existing transactions from LIBOR to SOFR (and other rates). For example, ISDA CEO Scott O’Malia recently noted regarding his organization’s contemplated credit spread adjustment, “That doesn’t mean the adjusted RFR will exactly match the relevant IBOR – it won’t, so there will be winners and losers.” (emphasis in original).
So-called “legacy” LIBOR-based transactions present the biggest remaining LIBOR-transition task by far. The official sector has not even attempted to prescribe a solution for these transactions, most of which currently either lack LIBOR-cessation fallback language entirely or contain fallback language that transforms floating-rate transactions into fixed-rate transactions. The effort to identify these transactions is for most institutions still in very early stages. Nonetheless, it already has become clear that there are entire categories of “legacy” LIBOR-based transactions cannot be amended before the 12/31/21 deadline. This problem occurs primarily in transactions such as securitizations where the governing documentation requires any amendment to a key term, which may include the interest rate, to be approved by all holders. The difficulty arises both because it will be practically impossible to locate all of the holders, and because it is anticipated that some holders may strategically withhold their approval. While the official sector is exploring the viability of state and federal legislative fixes for this issue, it is unclear whether such measures will work, including because of concerns about their constitutionality.
What Should Market Participants Be Doing Right Now?
Market participants large and small should already be undertaking several tasks concurrently:
For new transactions:
-- Stop using LIBOR and start using SOFR or other appropriate alternative rates
-- Where LIBOR use continues, use industry-standard fallbacks where they are available
-- Identify systems that need to be updated to use non-LIBOR rates (e.g., for discounting, interest computations) and develop a plan for updating them
For existing transactions:
-- Find all documents for LIBOR-based transactions and inventory and analyze them for provisions regarding LIBOR use, LIBOR fallbacks, amendments, etc.
-- Develop a plan to:
-- Amend LIBOR-use provisions and/or old fallbacks wherever possible
-- Identify unamendable LIBOR exposures and develop a strategy for remediation
-- Operationalize all remaining LIBOR fallbacks (amended or not) so they are administered correctly when the time comes
How Friedman Kaplan Can Help
Friedman Kaplan’s LIBOR Transition Task Force is ready to:
-- Help clients understand the legal, business and operations implications of LIBOR transition
-- Inventory and analyze clients’ LIBOR-related exposures
-- Develop strategies to address LIBOR-related exposures in advance of the 12/31/21 deadline
-- Identify, mitigate and, where appropriate, litigate disputes arising from LIBOR-transition-related activities and issues