You Say LIBOR, I Say SOFR – Looming Deadline Poses Risks for Borrowers and Lenders

On June 30, 2023, the curtain will come down on the last act of the drama surrounding the demise of??the London Interbank Offered Rate, the lending reference rate known as LIBOR — or will it? Lenders and borrowers have had over ten years to understand and implement a transition to a new interest rate.??The sheer scale and complexity of the LIBOR transition, however, has left many issues unresolved and poses risk to both sides of credit transactions.

How We Got Here

Lenders widely adopted LIBOR, which was initially based on a broad survey of overnight transactions among banks, because it was a proxy for their cost of funds determined on a broad and impartial basis.??As more banks found alternatives to the overnight funding market, liquidity in the original LIBOR market declined and the rate became based on the judgment of individual traders about the state of the market, independent of actual deals. Groups of traders famously manipulated the quoted rates, leading to regulatory action, criminal prosecutions and a loss of confidence in LIBOR.

Discussions about replacing LIBOR began in 2012 and, in 2014, the Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to develop alternatives.??ARRC, which now has over 300 members, made a series of recommendations about preferred alternative reference rates and the mechanics of adjusting existing lending relationships. In 2017, the Financial Conduct Authority, the U.K. Regulator overseeing the banks making LIBOR submissions, announced that it would no longer require submissions after 2021.??Subsequent FCA actions set June 20, 2023 as the end date for LIBOR quotations in US Dollars (Quotes in other currencies ended at the end of 2022).

In 2017, ARRC identified the Secured Overnight Financing Rate (SOFR) as the preferred replacement for??LIBOR. Federal banking regulators??issued supervisory guidance encouraging banks to stop entering into new contracts that use LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.??Regulators noted that new LIBOR issuances after that date “would create safety and soundness risks.”??In March 2022, Congress enacted the Adjustable Interest Rate (LIBOR) Act, which imposes SOFR as the replacement reference rate on credit transactions, but with many exceptions. The Fed followed up with regulations implementing the Act’s requirements last December.??

Given the volume of transactions denominated in LIBOR, which the Fed estimated as $200 trillion in US Dollars and $370 trillion globally at the inception of the transition, lenders have made impressive progress in the transition to SOFR.??An ARRC survey in December 2022 found that 94% of lenders had identified their LIBOR exposures and 90% of borrowers had been contacted by their lenders about the transition.??

But the survey painted a distinctly different picture of the syndicated loan market.??Less then half of the syndicate lenders responding indicated that they had been contacted by a lending agent or contacted an agent themselves, and only 30 percent of syndicated lenders indicated that they had received a significant number of amendments from an agent. JPMorgan estimated that, as of January, fully 80% of the leveraged loan market, representing $1 trillion in principal and $1 billion in annual interest, had not yet been transitioned from LIBOR. Commentators have cited a falloff in 2022 in refinancing and related activity, which would otherwise present opportunities to implement a??transition, for the logjam in the syndicated loan market.

Economic Consequences of the Transition

Disputes about the economic effects of the transition from LIBOR present another obstacle. Most market participants and regulators have acknowledged the need for an additional credit spread for LIBOR-denominated loans transitioning to SOFR, known as a “credit spread adjustment” (CSA). Fundamental differences between LIBOR – a forward-looking, unsecured rate — and SOFR — a backward-looking, secured rate — mean that (1)??SOFR is generally lower than LIBOR and (2) in periods of market disruption, LIBOR is likely to increase, whereas SOFR is likely to remain flat or decline. ARRC has recommended a CSA based on the the median five year historical difference between the two rates.?

The Loan Syndication and Trading Association estimates that only about one-third of outstanding credit agreements currently contain so-called “hardwired fallback” language, which contain a predetermined successor rate (usually Term SOFR) and the ARRC-recommended CSA.??The majority of deals either require the agent bank and the borrower to agree on a rate, with the other lenders retaining a negative consent right, or require affirmative lender consent with 90 days notice.??

Some borrowers have attempted to tilt the economics of their deal in their favor by proposing a successor rate with a below-market CSA (or, in some cases, no CSA at all). The consequences of a failure to agree on these terms before the June 30 deadline are uncertain.??The LIBOR Act is unlikely to provide a solution, since it applies only to agreements that would cease to function if the reference rate is unavailable.??Almost all corporate credit agreements provide for the use of some alternative rate in the event LIBOR is unavailable, although these clauses were designed to operate only in a period of temporary disruption.

Many of these agreements provide for the use of the Federal Funds rate (plus a CSA)or a bank’s prime in the event LIBOR is unavailable.??This is likely to be a much higher rate than either LIBOR or SOFR.??The FCA has released a proposal for comment under which it would continue to issue “Synthetic LIBOR” through 2024.??This would most likely be equivalent to SOFR plus a CSA, and thus very similar to the ARRC recommendation.??Synthetic LIBOR would not, however, be considered a rate “representative” of market conditions, and thus not a true substitute for LIBOR under the terms of many credit agreements.??Use of any or all of these rates would depend on interpretation of credit agreement language that is largely untested and rarely, if ever, interpreted by the courts.??LIBOR itself is likely to become more volatile as the deadline date approaches and the portion of the market actually using the rate shrinks.

Mitigating Risk as the Deadline Approaches

The Federal Financial Institutions Examination Counsel (FFIEC) has issued guidance that reviewed the risks posed by the LIBOR transition, including:

? Operational difficulty in quantifying exposure;

? Financial, valuation, and model risk related to reference rate transition;

? Inadequate risk management processes and controls to support transition;

? Consumer protection-related risks;

? Limited ability of third-party service providers to support operational changes; and,

? Potential litigation and reputational risk arising from reference rate transition.

As the deadline date approaches, multiple commentators have noted the possibility of a last-minute logjam of amendments that overtaxes lenders and their counsel. Any rate transition will require an amendment that will need to address (in addition to the rate itself) numerous administrative issues, including the rate transition date and the mechanics of interest computation and accrual.?Borrowers seeking to forecast their working capital needs will be particularly interested in the computation details of SOFR, since it will not reflect current market rates in the same way as LIBOR.

Given the degree of uncertainty surrounding the remaining non-transitioned credits, agent banks must take steps to implement transition amendments as quickly as possible.??Participant banks should assess their credit and interest rate exposure in the event credits are not transitioned by the June 30 deadline. Lenders should ensure that their process is transparent and that borrowers are kept informed of their intentions.??Managed correctly, lenders should be able to remove all suspense from LIBOR’s last act.

ARRC maintains a website devoted to the LIBOR transition at https://www.newyorkfed.org/arrc.

Fred Egler is an independent consultant who is advises on operational risk issues at financial institutions, including banking, securities and insurance.??He can be reached at?[email protected].