April 20, 2022 - Last week, LSTA’s Meredith Coffey and Tess Virmani hosted LevFin Insights’ Kerry Kantin and Covenant Review’s Ian Walker in a discussion about what three months of SOFR loan originations have taught us – and what we’ve got left to do. (Spoiler: A lot.) We encourage members to view the webcast and slides (here), but also offer a few fast takeaways below.
The first twenty minutes of the webcast focus on level setting and new SOFR loan originations, including volume, pricing and credit spread adjustment (“CSA”) trends. Specifically, the transition from doing 90% LIBOR loans in 4Q2021 to 90% SOFR loans in 1Q22 (slide 5) moved more smoothly than many anticipated; to be fair, this was largely due to years of work by the thousands of SOFR gnomes (webcast speakers included) who scrutinized SOFR’s economics and operations and developed the loan documentation that facilitated transition. While it wasn’t a surprise that new institutional loans largely flipped to CME Term SOFR – after all, banking regulators said that banks should not originate new LIBOR loans after year-end – incremental loans also largely flipped to Term SOFR (right chart on slide 5). The few loans that were done in LIBOR often were add-ons that needed to match the terms of the existing LIBOR loans to maintain fungibility. (Conversely, some add-ons were done in SOFR, and the existing loan flipped from LIBOR to SOFR to maintain fungibility.)
While originating new SOFR loans moved smoothly, the debate intensified on an economically “neutral” transition. Because the SOFR curve is lower and flatter than LIBOR (slide 11), maintaining economic neutrality requires either a credit spread adjustment (“CSA”) or a higher margin on a SOFR loan. As slide 6 illustrates, the type of CSA – a 10/15/25 bps curve, 10 bps flat or no CSA at all – fluctuated during the quarter depending on whether lenders or borrowers had the upper hand. (Lenders generally want a CSA; borrowers generally do not.) CSAs continue to evolve and might disappear by LIBOR cessation.
All things considered, the loan market did a good job of originating some $400 billion – including pro rata and IG – of SOFR loans in 1Q22. But that is a drop in the bucket of the roughly $5 trillion of syndicated SNC loans that may need to be remediated by LIBOR’s cessation on June 30, 2023. As slide 8 demonstrates, there are four ways to remediate: i) refinance directly into SOFR before June 30, 2023 (and control your fate), ii) fallback from LIBOR to SOFR before June 30, 2023 (via fallback language), iii) fallback from LIBOR to SOFR on June 30, 2023 (via fallback language) or iv) don’t fallback and flip from LIBOR to ABR (aka Prime) and pay a lot more if there is no fallback language whatsoever.
As slide 9 illustrates, while there is a wide spectrum of fallback language in existing loans, 65% will need some form of amendment to transition. For loans that transition at LIBOR cessation, slide 10 demonstrates how the variations of fallback language will work. ARRC hardwired fallback language is clear: a loan will fall back to Term SOFR+ARRC CSAs and only requires conforming changes. For ARRC amendment fallbacks, the language is fairly clear: it’s likely Term SOFR and likely the ARRC CSAs with a negative consent amendment. For other kinds of fallback language, it’s not terribly clear and it behooves parties to read their credit agreements very closely. This message returns on slide 12 with fallback “early opt-ins”, which permit companies to shift to a replacement rate before LIBOR fully ceases. Again, the ARRC hardwired language is clearest: the loan would switch to Term SOFR+ARRC CSA with the negative consent of required lenders. The ARRC amendment fallback is clearish: Term SOFR, likely with the ARRC CSA, with the affirmative consent of required lenders. The non-ARRC fallback language (“Everything Else”) is less clear because language is less consistent and may be more discretionary.
Regardless of the form of fallback, the bottom line is clear: It is a good idea to transition to a replacement rate before LIBOR cessation because there is $5 trillion of loans to remediate and the queue is going to get very crowded by mid-2023.