May 31, 2018 - In the past week, both the LSTA and Bill Dudley, President of the Federal Reserve Bank of New York, exhorted finance professionals to pay attention to the potential end of LIBOR. While we recognize that Mr. Dudley speaks with more gravitas, below we highlight of the Fed speech and dive into the LSTA’s loan takeaways.
Mr. Dudley discussed what happened to LIBOR in the financial crisis (alleged manipulation, billions of dollars of fines and jail terms) and why LIBOR doesn’t work today: “The essential problem with LIBOR is the inherent fragility of its ‘inverted pyramid,’ where the pricing of hundreds of trillions of dollars of financial instruments rests on the expert judgement of relatively few individuals, informed by a very small base of unsecured interbank transactions.” The solution? Much hard work from many individuals in the official and private sector – and a transition to a new rate, SOFR, by the end of 2021.
The LSTA’s lecture, which was paired with Loan and LIBOR FAQs, focused more narrowly on the impact of LIBOR cessation on the syndicated loan market. We noted that LIBOR’s end is not a regulatory diktat. As Mr. Dudley vividly explained, LIBOR might cease because banks do not particularly like making LIBOR submissions and the regulators will not compel banks to make submissions after the end of 2021. Indeed, even if one thinks there’s a 75% chance of LIBOR continuing in perpetuity, one must still prepare because the downside risk of being wrong is so high. So what to do?
Step One: Prepare your documents. As this related LSTA missive reports, even if you’re not 100% certain of the LIBOR replacement rate, you still can set up your credit agreements to transition to a new rate more easily. (And, by the way, all this year’s repricings and refinancings may be a good time to update your fallback language.)
Step Two: Know your replacement rate. For US dollar loans, the replacement rate likely will be SOFR – the Secured Overnight Financing Rate – which is a combination of three existing treasury repo rates. The good thing about SOFR is that it is real, deep, robust and hard to manipulate. The bad thing about SOFR is that, while its underlying repo rates have existed for a long time, SOFR itself just began being published in April. Thus, something we are all familiar with (LIBOR) may be replaced by something that we simply don’t know (SOFR). And, indeed, SOFR isdifferent: It is a secured, risk-free overnight rate, whereas LIBOR is an unsecured term rate. That said, SOFR futures already have begun to trade on the CME and a SOFR term curve will quickly develop. Meanwhile, market experts are developing an additional “credit spread adjustment” or “CSA” to minimize the difference between unsecured LIBOR and secured, risk-free SOFR.
Step Three: Be aware of other, related products that may need to transition from LIBOR. For instance, a LIBOR-based loan may have a LIBOR-based hedge, and may be in LIBOR-based CLOs. Ideally, one is thinking about transitioning all these products.
Step Four: Operationalize. While picking a replacement rate and getting the correct language in documents is key, so is having operations that can handle a new rate. We recommend that everyone begin to think about the operational changes that a transition to SOFR may require.
Step Five: Engage! The LSTA is a member of the U.S. Alternative Reference Rates Committee and co-chairs the ARRC business loans and CLOs committee. We are developing reference materials on our website (www.lsta.org), FAQs for members that have questions. If we all work toward this, the transition can be done.