"Libor Ends" – What's Next?
The vast majority of our clients’ loans are based, one way or the other, on an index known as the London Interbank Offered Rate or “LIBOR”.
Estimates of the volume of such loans is $200-300 trillion worldwide. The index is based on rates for short term unsecured loans among banks with a subjective component as a “forward looking” index. This allowed banks to set interest rates at levels commensurate with risk and to not only compare loans among a variety of customers, but to set fixed swap rates and other derivatives and “hedge” their own lending. Well, LIBOR is ending! So, What’s next?
A few years ago it became obvious to regulators that a few banks had at times manipulated the LIBOR rates so the world financial community determined to end LIBOR by the end of 2021. That will require that a new “benchmark” index be adopted that can be used in the same way LIBOR has been used. In anticipation of the change, in the United States, the Federal Reserve Bank commissioned the Alternative Reference Rates Committee (“ARRC”) to recommend how to proceed and to propose a new index. Although banks are free to adopt other indices, ARRC determined that the Secured Overnight Funding Rate (“SOFR”) was a suitable replacement in the United States.
More recently, on November 30, 2020, the Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a statement effectively urging their regulated banks to transition to a new index as soon as possible. Being sure that the transition as it effects your loans is as smooth as possible is our prime goal because exactly how this is going to work can’t be determined.
How Will It Change?
Our clients’ current credit agreements (“Existing Agreements”) include some general language intended to accommodate the end of LIBOR. They were necessarily either an “agreement to agree” if a new index was suitable, or a “default” to converting all loans to Base Rate (“Prime Rate”) loans. ARRC has recommended replacing those terms using either a “hardwired” or an “amendment” approach.
The former specifies exactly how a transition is to work and list of options in priority order. In other words, the first of the options that is feasible will take effect. Banks can also use an “amendment” approach which would have less objective provisions and would require some additional negotiation when the time comes. For some of our late 2020 transactions, one of the banks adopted the “hardwired” approach.
There are a few issues, however. First, the good news is that SOFR does not have any subjective aspect. Instead it is a record of actual borrowings by banks with U.S. Treasuries as collateral. But as such, it is a secured “backward looking” index as opposed to LIBOR which is an unsecured “forward looking” benchmark (and as such provides some risk premium). So, as a borrower, you will not know the interest you actually owe until the end of the rate period. While SOFR doesn’t have a long history, it has generally been lower than the 1-month LIBOR rate—a good thing—but it has been much more volatile than LIBOR in part because it is a daily rate.
At right is a chart comparing 30 day LIBOR with SOFR and the “Prime Rate” (“Base” or “Reference” rate in your documents). As can be seen, LIBOR and SOFR are similar rates and as more transactions are done using SOFR, there will be a “futures” market which will allow more forward looking pricing. But what is mostly clear is that the “default” to the Prime Rate is not a good option. For example, a client which can borrow at the “Base (Prime)” rate, (some pay a small bank “spread” on top of that) could borrow at 3.25% on average as shown in the chart. That client could also likely borrow with an “all in” rate of LIBOR plus a spread of 150bp, or about half as much, at 1.65% on average.
In converting to SOFR, theoretically your all in rate could go down as illustrated in the chart but there are also provisions in the Modified Agreements for a “Spread Adjustment” which may be positive, negative, or zero. It is unclear what this will actually do but the documents do require that it be imposed in accordance with widespread market conditions so it is unlikely that any particular borrower will be treated differently than others. The key to the transition is keeping your borrowing costs as low as possible.d.
One last thing to consider. If you have used swaps to fix part of your interest rates (click here [Set up link]for more on swaps), whether because you wished to or because your credit agreement requires it, the change will obviously impact swaps that have to date been based upon LIBOR. The AARC has been working with the International Swaps and Derivatives Association (“ISDA”) in an effort to ease or at least guide the conversion and/or renegotiation of existing LIBOR swaps.
What This Means and How We Can Help
Given the “guidance” from the federal regulators cited above, this will require amendments to your credit documents to accommodate how each bank wants to handle this. For those of you with LIBOR based tax exempt notes, the indentures for those transactions will also have to be modified.
We will be able to advise you on amendments to your credit agreements and, if your financing includes tax exempts, on amendments to the documents for those transactions.
Our plan is to get the banks and tax exempt issuers to do as much as possible of this amendment work on a “global” basis so we can get everything done at about the same time and with as low a cost as possible from bank and tax exempt “bond counsel”.
Obviously, as this starts to happen, we will be vigilant to be sure that your bank is treating you properly and, more importantly, the same as other borrowers similarly situated and in comparison to other lenders.