As LIBOR deadlines come into focus, crafting fallback language and vetting SOFR become top priorities for businesses and regulators.
Businesses across the globe are preparing to say goodbye to LIBOR with a move to a new benchmark that has been called a “seismic shift” for many financial institutions.
There is still plenty of time left on the countdown clock with a termination date set for the end of 2021. However, there is still a sizable job ahead in making a smooth transition given the fact that LIBOR is entrenched in pricing trillions of dollars of financial products globally. First introduced in the mid-1980s, the benchmark is used to set rates on everything from securities, student loans and credit cards to adjustable-rate and interest-only real estate loans. LIBOR landed on the chopping block after a massive rate manipulation scheme was uncovered in 2012 involving some of the top banks in Britain.
According to a recent Deloitte webcast on LIBOR transition preparedness, many financial institutions have already rolled up their sleeves, jumped into analyzing the impact, and have begun creating a transition strategy. U.S. regulators also are expected to increase issuance of more formal guidance and requests in 2019 in an effort to drive more tangible progress. Two issues front and center in those efforts are the rise of SOFR as a viable replacement, as well as the need to create fallback language and re-papering in current and future loan documents for loans that have maturities beyond 2021.
Although the initial work has been occurring within banks and other financial institutions, there is growing interest from the corporate sector that need to know what benchmark rates will be tied to, as well as what they need to do to create fallback language in contracts and loan agreements. Specific to commercial real estate, a number of participants in the CMBS securitization sector have responded to the request for public commentary issued by the Federal Reserve Bank’s Alternative Reference Rates Committee (ARRC).
The Mortgage Bankers Association (MBA) also has published a primer that addresses potential transition issues ahead for commercial mortgage market participants that use LIBOR-based reference indices in their operations. Some of the recommendations include:
- Identify and assess existing LIBOR exposure in their portfolios;
- Prepare adequate contract fallback language for new floating rate loans being closed today;
- Join the Federal Reserve ARRC email distribution for key LIBOR transition updates;
- For those companies with international floating rate portfolios, manage international implications of a replacement index.
Contract Fallback Language
Generally, there is significant focus on removing transition risk and making sure existing contracts are appropriately amended. Companies and financial institutions need to create draft language for new contracts that reference LIBOR to ensure that contracts will still be valid and usable once LIBOR is no longer available. Some key points regarding fallback language include:
- ARRC and its sub-committees are still developing guidance for fallback language considerations.
- Proposed fallback language has to be tailored to individual products. However, there is a desire to create some consistency in language.
- Final recommendations for contract language from ARRC are expected in the next couple months. Potentially, there could be more rigorous fallback language.
Preparing for SOFR
It’s not official, but SOFR (the Secured Overnight Financing Rate) appears to have the lead in becoming the replacement benchmark in the U.S. Bloomberg recently noted the one-year anniversary of the introduction of SOFR with an article highlighting the headwinds and tailwinds facing the possible LIBOR replacement. One of the chief concerns surrounding SOFR is a pattern of recent volatility. Meanwhile, some of the positives fueling momentum for SOFR as a viable replacement include:
- Futures and swaps trading continues to grow and establish a track record. Bloomberg notes that swaps transactions tied to SOFR reached a one-month record high of $13.1 billion of notional value in March.
- Organizations have been issuing SOFR-linked debt since last July, with sales dominated by government-sponsored entities such as Fannie Mae and the Federal Home Loan Banks.
- Some bond issuers have successfully sold securities linked to the rate. For example, Mizuho Americas issued its first SOFR-linked Certificate of Deposit in the U.S. in February with a $200 million, floating rate CD.
It will be a busy year for those financial institutions focused on LIBOR transition. Most of the heavy lifting of the transition is being performed by financial institutions likely to be most directly impacted by the shift. According to Deloitte, global banks and investment banks have taken the lead in preparedness for the transition, with activity that is trickling down to national, regional and local banks depending on their size, scale and exposure levels.