Following the sounding of LIBOR’s death knell last summer, a flurry of governmental and industry activity culminated in the selection of SOFR as a replacement index rate for commercial loans. Accordingly, a sequel of our August 2017 column “The Passing of LIBOR” is in order.
London Interbank Offered Rate (LIBOR)
Recall on July 27, 2017, the Brits prospectively announced a sunset date for maintenance of LIBOR: December 31, 2021. Dating back to 1986, the benchmark eventually became the industry standard for variable rate loans and interest rate swaps. By the end of 2016, a staggering $3.4 trillion of “business loans” employed LIBOR. But then the London-derived index darling fell on hard times due to a manipulation scandal too mathematically-slanted for a Grisham thriller.
ARRC & SOFR
In the U.S., the Federal Reserve Board (FRB) and the Federal Reserve Bank of New York (FRBNY) convened the Alternative Reference Rates Committee (ARRC) to help select a LIBOR replacement. In June 2017, ARRC “identified the secured overnight financing rate (SOFR) … as the rate that, in its consensus view, represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.” On March 5, 2018, ARRC released a 40-page second report (“ARRC Report 2”) reaffirming SOFR and advising FRBNY would begin daily publication of the rate on April 3, 2018. Published quotations for SOFR rates back to April 2 are found at https://apps.newyorkfed.org/markets/autorates/sofr.
What is SOFR? A reasonable person might be content just knowing that SOFR stands for
“secured overnight financing rate.” FRBNY describes the rate as “a broad measure of the cost of borrowing cash overnight collateralized by [U.S.] Treasury securities … calculated as a volume-weighted median of transaction-level tri-party repo data.” More importantly, SOFR appears to be the choice of the U.S. government and financial industry to replace LIBOR.
But when and how is that going to happen?
EXISTING LIBOR-BASED LOANS
Of the estimated $3.4 trillion of LIBOR-based business loans outstanding as of December 31, 2016, the March 2018 ARRC report predicts $2.846 trillion will mature by December 31, 2021, the projected LIBOR sunset date. By the end of 2025, the estimated residuary is predicted to shrink to $90 billion. Yet, in 2017 and even now in 2018, banks have continued to use LIBOR. Hence those numbers are stale. Still, the fact remains that a significant volume of LIBOR-based loans will be paid off or refinanced prior to December 31, 2021.
Commercial loans are routinely amended. Once the market adopts a replacement rate, loan documents can be amended to substitute the stated rate or merely provide for a replacement rate should LIBOR fail.
NEW COMMERCIAL LOANS
As new commercial loans are closed, the parties are incorporating a variety of new loan documentation provisions to address the anticipated cessation of LIBOR reporting. Since last summer, we have seen provisions ranging from aspirational to categorical. Some provisions call for seeking quotes to calculate an “IBOR” (sans London), while other clauses merely substitute another industry standard such as Prime, without a precise adjustment for the spread between LIBOR and Prime.
Time will tell whether banks move to SOFR as a chosen rate for new loans or even a replacement rate until such time as LIBOR is no longer quoted.
INTEREST RATE SWAPS
As noted in the ARRC Report 2, a compelling reason to use LIBOR with commercial loans is the “ease of hedging LIBOR.” Indeed, some 95% of the LIBOR-related transactions are derivative contracts. Yet, in the same breath, ARRC noted that current International Swaps and Derivatives Association (ISDA) contract provisions dealing with the discontinuation of LIBOR were not “robust enough to prevent potentially serious market disruptions” for the approximately $115 trillion in interest rate swap contracts outstanding (not including other derivatives) at the end of 2016. But merely adopting SOFR as a replacement rate fails to address the “method for adjusting for the difference between LIBOR and the fallback rate.”
If SOFR becomes a standard commercial loan rate in the market, then ISDA will swap it. But if ISDA selects a replacement rate other than SOFR for its derivative contracts, then SOFR’s acceptance may be endangered.
Conclusion & Summary
As we noted in August, the fluid situation bears scrutiny by corporations, developers and lenders. Just as nature abhors a vacuum, financial markets revere certainty. Still, given the remaining shelf life of LIBOR and the uncertainty in the market as to the use of SOFR, it may be premature to rush to a change.
Four comforting points commend rumination rather than speed. First, LIBOR may be reported long after the sunset date in 2021. Second, a replacement rate has been identified, is being reported, and the market will decide over time whether it will gain traction and ultimately find acceptance among the financial community. Third, the vast majority of existing loans will be paid off or refinanced prior to December 31, 2021. Fourth, lenders and borrowers have ample time to amend loan documents and incorporate a mutually agreeable definitive provision on a replacement rate.
We commend the advice from a line found in Shakespeare’s Romeo and Juliet: “Wisely and slow; they stumble that run fast.”
» Molly Jeffcoat Moody and Ben Williams are attorneys engaged in an active commercial law practice at Watkins & Eager PLLC. Molly and Ben are both recognized by Chambers USA and Best Lawyers in America. Molly was selected as Best Lawyer’s 2018 Commercial Transactions /UCC Law Attorney of the Year in Jackson, Mississippi. Ben was selected as Best Lawyer’s 2018 Project Finance Law Attorney of the Year in Jackson, Mississippi. Additional information is available at www.watkinseager.com.
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