December 13, 2018 - LIBOR is somehow simultaneously both a pressing issue and a slow-motion market upheaval. A first step to avoiding the upheaval scenario is the development of fallback language across cash asset classes. (Fallback language answers the critical question “If LIBOR disappeared tomorrow, to what rate would my contract fall back?” Is it Prime? Is it SOFR? Is it the last fixed rate? Is it nothing?!).
To expedite the development of standard and workable fallback language, in September the Alternative Reference Rates Committee (“ARRC”) released a consultation on syndicated loan and FRN LIBOR fallbacks, and last Friday it posted the responses. (And, if that were not enough for a December Friday, the ARRC also released a bilateral loan and a securitization consultation.) Below, we recap the main questions in the loan consultation and provide aggregated market feedback and our interpretation of the results. This feedback will inform the ARRC recommendation on LIBOR fallbacks for syndicated loans.
As background, there are three major components to loan fallback language: 1) What is the trigger that initiates the transition from LIBOR to the new reference rate? 2) What is the new reference rate? 3) What is any spread adjustment to make the new reference rate and LIBOR more equivalent?
Triggers: ISDA has announced two “cessation” triggers for LIBOR: Either the i) LIBOR administrator or ii) the administrator’s regulator or insolvency authority says that LIBOR has or will cease. In addition to these two “cessation” triggers, loans and FRNs have suggested three additional “pre-cessation” triggers: i) an unannounced stop to LIBOR for five days, ii) enough banks drop out that the administrator invokes its “insufficient submissions” policy, or iii) the relevant regulator says that LIBOR is no longer fit for purpose and may not be used. Market feedback on triggers to initiate the transition was straightforward – in effect, “more is better”: 68% of respondents wanted to keep all these triggers. In addition, 73% wanted optional “opt-in” triggers that allowed an existing loan to transition to term SOFR if two or more public loans had used term SOFR. The idea here is that folks want to transition before LIBOR is too enfeebled or when term SOFR becomes a viable alternative. In particular, the opt-in trigger permits market participants to reduce their book of LIBOR loans prior to cessation.
The Fallback Approach: One of the foundational questions in the consultation was, “What type of LIBOR fallback mechanism would the market want?” To date, the loan market has used an “amendment approach”, which requires i) the agent and borrower to determine that a LIBOR discontinuance event has occurred, ii) they then develop a replacement rate (and potentially a spread adjustment to make the LIBOR and the new rate more equivalent), and iii) the bank group (often) gets a negative consent vote. While this uses loans’ amendment flexibility, it is different than what every other cash market is likely to do, which is a “hardwired approach”. In the hardwired approach, if a trigger event occurs, the LIBOR fallback language first looks to a “Forward Looking Term SOFR” (plus a spread adjustment). If that doesn’t exist, then it falls back to Overnight Compounded SOFR (plus a spread adjustment). If neither exists, the hardwired approach falls back to the amendment approach.
At first blush, respondents appeared split on the preferred approach: 46% of respondents identified the hardwired approach as the ultimate preferred approach, 41% preferred the amendment approach, while 14% answered “both”. But perhaps there is more commonality than it appears. Respondents’ comments suggested that, while the amendment approach might be most workable today, once more information is available – like more details about term SOFR and the spread adjustment – the market would prefer to use the hardwired approach.
The Fallback Rate: Respondents definitely want a forward looking term SOFR: 90% wanted this rate as the first fallback rate in the hardwired waterfall. The issue is that term SOFR does not yet exist; it will have to be developed and modeled off swaps trading. The next stage of the waterfall is compounded overnight SOFR; 94% agreed this is the appropriate second stage. Importantly, 70% of respondents said that this rate should be compounded in arrears. This means that the interest rate would not be known at the beginning of the period and would have to be calculated and accrue every day. Respondents acknowledged that i) this may be the right approach but ii) it could involve significant operational changes. The LSTA is engaging members to scope out the operational challenges. (Note that there was a third fallback to overnight SOFR, but market participants pushed back on this approach and it likely will be removed.)
The Spread Adjustment: SOFR is a secured rate and is expected to be lower than LIBOR. To minimize value transfer, there needs to be a spread adjustment to make SOFR more equivalent to LIBOR. Who determines this? 91% of respondents said that the ARRC should publish a spread adjustment for cash markets. While ARRC has indicated a willingness to do this, if they do not, then 21% said the ISDA fallback should be used regardless, while 64% said the market should use the ISDA spread adjustment if the fallback rate matches. Critically, 100% of the respondents said that both SOFR and the spread adjustment must be published on screens. There should be no calculations by loan market participants.
In the “Challenges” Category: Respondents reiterated that while “compounded in arrears” may be the correct second stage of the waterfall, it comes with considerable operational challenges. They also noted that this consultation was for US dollar loans; multicurrency loans will face their own challenges with other fallback rates, spreads and times. In addition, market conventions – like holidays – and documents will need to adjust. Finally, if loans and hedges fallback to different rates – and it is clear that swaps will not be falling back to forward looking term SOFR – there will be basis risk (though respondents were mixed on how important basis risk is).
Next Steps: While there is a lot to do, ARRC is busy doing it. The ARRC Business Loans Working Group, which is co-chaired by the LSTA and ABA, is taking this feedback to help develop a LIBOR fallback recommendation for US dollar syndicated loans. Meanwhile, the LSTA is engaging with its members to understand all the challenges of falling back. For more information, please contact email@example.com (for general policy issues), firstname.lastname@example.org (for legal/documentation issues) or email@example.com (for operational issues).