The London Interbank Offered Rate (or LIBOR for short), the benchmark interest rate that trillions of dollars of financial instruments are tied to, is slated to disappear by the end of 2021. While banks and other financial companies have started thinking through the transition to other alternative rates, LIBOR still serves as a reference rate for bank loans, bond investments, floating-rates notes as well as many consumer-based loans, including variable-rate mortgages. The end of LIBOR affects not only investors and financial institutions but also the holders of debt tied to LIBOR rates, including businesses and consumers.
Background on LIBOR
For decades, LIBOR has been the benchmark interest rate in the financial industry, but the financial crisis and its aftermath revealed its fallibility. LIBOR is calculated by averaging the rates at which the participating panel banks could borrow from each other. However, because banks are asked to estimate the rate at which they could borrow from one another as opposed to rates at which they actually borrowed, the officials responsible for providing those numbers could, and did, provide skewed estimates to maximize profits for themselves. After these manipulations were revealed to the public, confidence in LIBOR as a reference rate plummeted, and industry officials and regulators began to search for alternative rates that were more reliable. In 2017, the UK’s Financial Conduct Authority announced that it would not require panel banks to submit the rates necessary to calculate LIBOR after the end of 2021.
For a while, despite the Financial Conduct Authority’s decision to stop compelling banks’ participation, there seemed to be some belief that LIBOR may continue to exist after 2021. However, it has recently been made clear by various agencies that the chances of LIBOR’s continued publication past that point are slim to none. John Williams, president of the Federal Reserve Bank of New York, taken from his recent speech titled “LIBOR: The Clock is Ticking” stated, “Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.” Naturally, this poses an issue for the millions of financial instruments, including trillions in variable-rate residential mortgages, tied to LIBOR that have maturity dates beyond 2021. Many of these instruments have no fallback provisions in the event that LIBOR would become unavailable, or only contain provisions anticipating a temporary unavailability, leaving the parties with no practical solutions for the permanent discontinuance of LIBOR. For example, many contracts, including some variable-rate mortgages, include a fallback provision stating that the reference rate would be the most recently published LIBOR rate; if the contract matures in 2035 for example, referencing a last published rate from 14 years prior would be illogical. Michael Held, the executive vice president and general counsel for the Federal Reserve Bank of New York has characterized this lack of practical fallback provisions as “a situation that invites litigation . . . on a massive scale.” As a result, the Federal Reserve has repeatedly stressed that banks and financial institutions need to start taking steps now to transition away from LIBOR.
The Introduction of SOFR
The Alternative Reference Rates Committee (ARRC), a committee established in 2014 by the Federal Reserve to plan the transition away from LIBOR, has selected the Secured Overnight Financing Rate (SOFR) as the reference rate that should replace LIBOR. In April 2018, the Federal Bank of New York first began publishing the SOFR rate. The transition from LIBOR to SOFR presents a series of challenges stemming from the basic differences between the two rates.
Unlike LIBOR, which is an inter-bank, unsecured lending rate, SOFR is calculated by measuring the cost of overnight borrowing through repurchase (repo) transactions collateralized with U.S. Treasury securities. Because SOFR is based on actual transactions as opposed to estimates about hypothetical transactions, it is more reliable and less susceptible to manipulation. However, LIBOR generally runs higher than SOFR, oftentimes by as many as 20 basis points, leaving a simple switch between the two rates impossible, without lowering the total interest rate on the loan. Consumers and businesses may find themselves renegotiating interest rates with their lenders to cover the change in rates.
Additionally, SOFR has been the subject of criticism for its volatility on a day to day basis. For example, on September 17, 2019 the SOFR rate increased by 282 basis points from 2.43% to 5.25%. Such “SOFR surges” have not lasted more than one day but leave a warranted alarming feeling among those transitioning to SOFR.
Finally, SOFR is currently only available as a backwards-looking rate, based on the overnight rate on the Federal Reserve Bank of New York. Parties are developing estimated SOFR curves, but the lack of forward-looking predictions leaves some reluctant to rely on the new rate.
Due to the differences between the two rates and the complexities of transitioning sophisticated financial instruments from one reference rate to another, the ARRC has developed the Paced Transition Plan with specific steps and timelines designed to encourage adoption of SOFR. The committee is also working on providing draft fallback contract language for new contracts that reference LIBOR. The committee’s progress on developing this language, as well as what other steps market participants should be taking to prepare for the end of LIBOR were the subject of a roundtable meeting held in NYC on June 3, 2019.
Planning for the end of LIBOR
The first step businesses and consumers need to take is to determine what their exposure is with regard to LIBOR, i.e., how many agreements are in place that reference LIBOR and how many of them have maturity dates beyond 2021. Once this is determined, then it is a matter of contacting the other parties to the contract (where feasible) and beginning the amendment process. As the Fed and the ARRC have made clear, the process to transition from LIBOR to SOFR will likely be a long one, and it’s best that companies and consumers get started now to limit their exposure to litigation once LIBOR fully disappears.
While the process for amending contracts linked to LIBOR will necessarily vary depending on what type of agreement is at play, the ARRC has already produced recommended fallback provision language for many types of agreements. However, agreements such as syndicated business loans, complex construction or mortgage loans and derivatives, which are by their nature more complicated to amend, will require additional amendments and adjustments to language across multiple loan documents. And despite the residual lack of confidence in non-term rate SOFR that is responsible for the market inertia in terms of transitioning from LIBOR, the ARRC strongly encourages companies to start using SOFR now, as much as possible. The ARRC also emphasized that issuing debt tied to SOFR is not impossible at this juncture – Fannie Mae and Federal Home Loans Bank have issued $86 billion in various instruments tied to SOFR to date, and Goldman Sachs issued its first bond with reference to SOFR on May 20, 2019.
The ARRC and the Federal Reserve officials strongly discourage the continued use of LIBOR in new contracts, as it will only create problems in the near future. There is a continued concern by some that if banks continue to use LIBOR past 2021 the markets may be left with a sort of “Zombie LIBOR” living on in some capacity beyond 2021.
In his opening remarks, Federal Reserve Vice Chair for Supervision Randal K. Quarles warned that “history may not view [the decision to continue using LIBOR] kindly; after LIBOR stops, it may be fairly difficult to explain . . . exactly why it made sense to continue using a rate that you had been clearly informed had such significant risks attached to it.” As a testament to how seriously the Federal Reserve is taking the urgency of beginning the transition process, it was suggested that the Fed may issue MRAs – matters requiring attention- to the banks and companies that continue to drag their feet. MRAs are “call[s] for action to address weaknesses in processes or controls that could lead to deterioration in a banking organization’s soundness; may result in harm to consumers, or that have caused, or could lead to, noncompliance with laws and regulations.” If these matters go unaddressed, the Fed could issue a formal enforcement action, which derive from and carry the full weight and enforceability of law. While such drastic action remains unlikely at this stage, it is a testament to the gravity of the situation, and the need for prompt action.
Businesses and consumers should start preparing for the end of LIBOR today. By identifying your potential risk and working with your financial institutions, accountants and legal counsel to understand and plan for the end of LIBOR those most at risk will be able to avoid the headache that will likely ensue as the clock ticks closer to 2021 and the end of LIBOR.
Emily R.L. Cohen is an attorney in Harter Secrest & Emery’s Finance practice. She can be reached at 585-231-1141 and firstname.lastname@example.org. Former HSE summer clerk Autumn Young also contributed to this article.