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LIBOR – What to Do Now

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LIBOR – What to Do Now LIBOR – What to do Now New York Wednesday, November 28, 2018 History of LIBOR and the Transition Away From LIBOR Stuart M. Litwin Co-Head, Structured Finance Practice [email protected] +1 312 701 7373 + 1 212 506 2389 Brief History • When I first started practicing law in the 1980s, LIBOR often really was match funded – Fallback provisions in loan agreements and indentures were originally designed to deal with short-term disruption in the LIBOR market – They were never intended to address a situation where LIBOR may disappear forever • The setting of LIBOR was managed by the British Bankers Association (“BBA”). Each business day the BBA calculated the rates based on submissions by individual panel banks for each applicable currency • Starting in 2012, there were allegations of misconduct in the setting of LIBOR • In 2013, U.K. Financial Conduct Authority (“UK FCA”) selected Intercontinental Exchange Group (“ICE”) to be the LIBOR administrator – Goal of this transfer was to bring more transparency and oversight to the calculation of LIBOR 3 What Is The Current Problem With Libor? • There has been a continued decline in the degree to which banks fund themselves in the London interbank market • As that decline continues, U.S. (and other) regulators are concerned there will be insufficient trading volume and liquidity to support the use of LIBOR as a benchmark interest rate • Quotations used by ICE today to calculate ICE LIBOR are not based on actual transactions, but “expert judgment.” • UK FCA reported in late 2017 that all LIBOR panel banks have agreed to continue to supply quotations through the end of 2021 – UK FCA will no longer require LIBOR submissions after 2021 • Other Problems with LIBOR – Pending and potential litigation – LIBOR spreads have widened compared to other benchmarks 4 Why LIBOR Matters • LIBOR stands for London interbank offered rate – Interest rate at which banks offer to lend funds to one another in the international interbank market – LIBOR was designed to reflect how much it costs banks to borrow from each other in specified currencies for specified periods of time • LIBOR is the benchmark reference for determining interest rates for a multitude of debt and derivative instruments – It is also used as a benchmark rate for mortgages, corporate loans, government bonds and a myriad of structured finance instruments • Combined exposure for various asset classes that rely on LIBOR exceeds $199 trillion – Derivatives are $190 trillion of this 5 U.S. Regulators Response • Federal Reserve Board and the Federal Reserve Bank of New York convened a joint committee (Alternative Reference Rates Committee – the “ARRC”) to identify a replacement rate • Committee wanted a “risk-free” rate – a theoretical rate of return on an investment with no risk of financial loss • The ARRC identified the Secured Overnight Financial Rate (“SOFR”), which is the cost of overnight loans that use U.S. government obligations as collateral 6 LIBOR vs SOFR Issues • Participants in the lending and securities markets have raised objections to SOFR – SOFR is a risk free rate, LIBOR is not, so SOFR likely will be a lower rate than LIBOR • LIBOR widens in periods of stress; SOFR likely will not • SOFR is likely more volatile at quarter end – SOFR is an overnight rate, and changes daily. LIBOR is typically quoted for 1 or 3 months • Need a term rate • Compounding vs a simple average – ISDA plans to create fallbacks based on both • Market participants are generally assuming that market forces will develop into a “one month SOFR rate” and a “three month SOFR rate – SOFR is backward looking. LIBOR is forward looking. Need to be able to set a rate for the next period – Probably will need spread adjustments if we move to SOFR • Static adjustment on conversion date or dynamic adjustment that reflects changes in spreads between SOFR and other LIBOR equivalents? – Will there be any effects on ratings in a shift to SOFR? For example, are past LIBOR assumptions correct for volatility and basis risk for underlying assets? • Fed believes that SOFR will be less volatile than LIBOR • Need CFTC and IRS regulatory help to grandfather legacy deals and avoid having amendments trigger clearing and margin, tax recognition • Do you no longer have hedge accounting if only one of your assets or your hedge changes its benchmark, or they don’t change precisely together? 7 LIBOR vs SOFR Issues • In response to concerns raised by participants in the loan markets, in November 2017 the ARRC announced: – Its membership would be expanded to include participants in the cash market (corporate loans, mortgage loans, securitizations, etc.) • LSTA, SIFMA and SFIG are now members – It would work to develop a SOFR-based rate that is forward-looking and is a term rate • But that rate would still be risk-free (and therefore lower than LIBOR) • That rate wouldn’t be introduced until after there was enough experience using SOFR in the derivatives market – ARRC originally estimated date would be Q2 of 2021 (!) – In March 2018, ARRC instead promised the rate by the end of 2021 – The Committee said it might have a “demonstration” rate before then 8 Changes to LIBOR Before 2021 • Changes to LIBOR (April 25, 2018 paper by ICE Benchmark Administration) – ICE will transition to a “Waterfall methodology,” in which panel banks provide quotations in the following order of priority. • Level 1: Transaction-based • Level 2: Transaction-derived (can use historical data and linear interpolation) • Level 3: Expert judgment – Will be complete by the first quarter of 2019 – Not clear whether LIBOR quotes will indicate whether they are primarily Level 1, 2 or 3 9 Recent Developments • The Federal Reserve Bank of New York began publishing the SOFR rate every day since April 2018 – Calculation of SOFR appears very much to be a black box • Fannie Mae’s and MetLife’s SOFR transactions • SFIG is working on a “Green Paper” that highlights important issues and suggests some possible model language for structured finance deals 10 What Will Happen to LIBOR After 2021? • Continued use of LIBOR even after 2021: • Some market talk about keeping LIBOR • Could be done by ICE (which is certainly motivated to continue to publish LIBOR rates), assuming that banks will continue to supply LIBOR quotations after 2021 – ICE Benchmark Administration wants to publish LIBOR rates after 2021 – “alongside the alternative risk-free rates that are being developed” – No guarantee that LIBOR will continue to be published – requires voluntary support from the banking industry – Efforts by ICE to get licensing fees • Could be done by a new non-European private sector source – U.S. regulators have expressed a preference for a rate published by the public sector – Need to comply with the EU Benchmarks Regulation • BUT the Fed is adamantly against any use of any LIBOR type rate – Fed says it’s an unstable rate that poses systemic risks – Might still be helpful for Legacy Transactions 11 Legacy Deals • Remember that most fall-back provisions in existing loan agreements and indentures were originally designed to deal with short-term disruption in the LIBOR market – These provisions never were intended to address a situation where LIBOR may disappear forever • Types of fallback provisions: – Often there’s a “waterfall”: • First look at a screen or publisher (e.g., Bloomberg, Reuters, Telerate, Wall Street Journal) ceases to publish the applicable LIBOR • If the screen rate is “not available,” get quotes from a group of reference banks in the London interbank market • If that doesn’t work – Loans often use prime - prime is significantly more expensive than LIBOR, so borrowers won’t accept this on a long term basis – Sometimes loans use a lender’s cost of funds rate. Lenders don’t want to disclose their cost of funds or get into disputes about it – Securities transactions often use the last LIBOR quote (if LIBOR is gone forever, this results in a fixed rate deal) 12 Legacy Deals • Two issues in legacy transactions: – When has LIBOR become “unavailable”? – What happens next? • When has LIBOR become “unavailable”? – What if there is still a quote on the screen? • ICE says it plans to continue to quote LIBOR, but it won’t be based on real transactions – “Zombie LIBOR” • What if banks continue to quote LIBOR, but not based on real transactions – This is the same as the securities markets for thinly traded securities • How difficult will it be for trustees to get quotes? Will they do so? – Probably the most likely bit of trustee litigation – ICE efforts to collect licensing fees from users 13 Legacy Deals – Amending? • Amending the LIBOR definition – Some deals just have a “Rating Agency Condition” – Some have a “no adverse effect” or “no material adverse effect” standard, often with a legal opinion – Lots of deals can’t be amended without unanimous consent 14 Legacy Deals • Do investors have much incentive to push for a different benchmark in legacy deals? Would they approve an amendment? – It’s economically good for investors if LIBOR spreads widen. LIBOR spread over overnight swaps has widened in recent months – It’s terrible if interests rates increase but their deals convert to a fixed rate • Is this going to be a “Train Wreck”? 15 Who will get hurt in Legacy Deals? • Trustees are in the worst position • Sponsors will want to try to amend when they can – Does it make sense to wait until there’s actually a problem? 16 Basic Issues in New Deals • What is the “trigger” that requires or permits a new benchmark rate? • What benchmark rate will be selected? • Spread adjustments • How to assure investors aren’t harmed • Who makes the decisions? 17 Some Questions About Spread Adjustments • Static? • Dynamic? • Only transitional? • Different for different Lenders? – In syndicated loans, will all lenders require approval? – Will borrowers get to approve? • Will investors in securities transactions get to approve? – Not really practical – Can they have a right to object? Difficult to decide what happens then.
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