November 19, 2019 - On Thursday, some 600 members attended the LSTA’s “The End of LIBOR: The Big Picture” webcast, a reference presentation intended help folks quickly come up to speed on i) Why LIBOR is ending, ii) what is the anticipated replacement rate (SOFR), what are its variants and how do they behave, iii) status and key steps for replacing LIBOR loans with SOFR loans and iv) key resources. Our next LIBOR webcast – “Demystifying the LSTA’s SOFR Concept Credit Agreement” – will take place on December 3rd. Our goal is more, better and faster education for LSTA members. In addition to webcasts, we also will be hosting a weekly live LIBOR Q&A call Monday afternoon at 3PM (ET) starting November 25th. Members can email or dial in with LIBOR questions and we’ll do our best to answer them. The dial-in information is: 1-866-546-3377/599 578 2187. International dial-in attendees can email Donna Murray (firstname.lastname@example.org) for a local dial-in number. In conjunction with these LIBOR calls, the LSTA also will be developing and publishing FAQs.
But, back to Thursday’s presentation. While we covered some familiar ground, we also did want to highlight new analysis around fallbacks (which is discussed on slide 20 of the End of LIBOR presentation). In effect, we identify four practical considerations for hardwired fallbacks (which dictate the terms of LIBOR fallbacks at the origination of a credit agreement) and amendment fallbacks (which create a streamlined amendment approach to determine a replacement rate). The four considerations are i) Optionality, ii) Executability, iii) Economic Certainty, and iv) Market Impact.
Optionality: There certainly is more optionality in the amendment approach. The borrower maintains the optionality to select the replacement rate (and possible spread adjustment) and the lenders maintain the optionality to reject the rate. However, we believe market participants should weigh the diminishing value of optionality against the other three characteristics.
Executability: The amendment approach generally requires, at LIBOR cessation, for the borrower and agent to identify a replacement rate and a spread adjustment. The required lenders then have a five-day negative consent period. While this might work for a handful of loans after LIBOR cessation, in reality there are over ten thousand syndicated loans with maturity dates after December 31, 2021, according to Bloomberg and Refinitiv. They will not all get amended in a short time after LIBOR cessation. In contrast, the hardwired approach is much more executable.
Economics: In the amendment approach, it is not clear what the post-transition economics will be. A powerful borrower may be likely to push terms in its favor, while an underperforming borrower may be at the mercy of lenders. In contrast, because the hardwired approach dictates the transition terms (SOFR plus a spread adjustment) at the origination of the loan, the economics will be modelable.
Market Impact: In the amendment approach, the future cash flows of the loans are unknown because the rate will be negotiated. In turn, a loan with such uncertain cash flows may well trade at a discount in the secondary market to “hardwired” loans, whose future cash flows are more certain.
For these reasons, we believe it is better for loan market participants to move to hardwired fallbacks as soon as they can. We have heard several gating issues as to why market participants remain on the amendment approach. First, they feel they don’t have clarity around the economics of SOFR and, second, they are concerned that SOFR hasn’t been operationalized.
In fact, both these concerns are being addressed. First, as the presentation demonstrates (slides 12-15), we do have a view on the level and behaviors of the various SOFRs. Second, at LIBOR cessation, there will be a spread adjustment to make LIBOR and SOFR more comparable. Critically, ISDA has been working on a spread adjustment for derivatives. On Friday, November 15th, ISDA announced the results of their final consultation and the methodology by which they will calculate their spread adjustment (five-year median). Moreover, ISDA reiterated that Bloomberg would be publishing this spread adjustment beginning around year-end 2019 so people could understand the economics. Thus, at year-end 2019, we should have a good sense of the economics of a loan that transitions from LIBOR to SOFR. On the operations front, the LSTA and the ARRC’s Business Loans Operations Working Group has been working hard to develop recommended conventions and compounding calculation methodologies for SOFR Compounded in Arrears. The conventions are targeting a January 2020 publication date, which should help jumpstart the actual SOFR systems build.