Are you prepared for the disappearance of LIBOR?
The clock is winding down on the last days of LIBOR, forcing commercial real estate professionals to take a closer look at mortgages and loan docs that will be impacted when the key benchmark is phased out by the end of 2021.
The demise of LIBOR (the London InterBank Offered Rate) could have a much bigger impact that many people realize. The benchmark is entrenched in pricing trillions of dollars of financial products globally. A group of British banks first created LIBOR in the mid-1980s as a source to set interest rates for derivatives. It has since evolved into a key benchmark to set bank rates all over the world: on securities, student loans, credit cards and mortgages – including adjustable-rate and interest-only real estate loans in the United States
LIBOR landed on the chopping block after a massive rate manipulation scheme was uncovered in 2012 involving some of the top banks in Britain. In the wake of the scandal, the Financial Conduct Authority – the U.K.’s main regulatory agency – announced that it would phase out LIBOR and plan for a transition to “alternative benchmarks” by the end of 2021.
Commercial real estate owners, investors, and lenders need to make sure they are not caught off guard when this change goes into effect. New loan documentation has begun to touch upon illegality of the use of LIBOR in anticipation of that end date. However, many older mortgage documents (pre-LIBOR scandal) contain boilerplate language regarding benchmarks for determining interest rate calculations. Many of these documents don’t anticipate what happens when LIBOR is no longer available.
Example of New Language
1.7.5 Inability to Determine Rates. If (a) Administrative Agent determines that (i) U.S. Dollar deposits are not being offered to banks in the London interbank eurodollar market in the amount of any proposed or existing advance of the Loan at the time of determination for terms equal to one (1) month, or (ii) adequate and reasonable means do not exist for determining the LIBOR Daily Floating Rate for proposed or existing advances of the Loan (in each case with respect to clause (a)(i) above, "Impacted Advances"), or (b) Administrative Agent or Required Lenders determine that for any reason the LIBOR Rate does not adequately and fairly reflect the cost to such Lenders of funding the Loan, Administrative Agent will promptly so notify Borrower and each Lender. Thereafter, the obligation of Lenders to make or maintain advances of the Loan at the LIBOR Rate shall be suspended, in each case until Administrative Agent (upon the instruction of Required Lenders) revokes such notice. During the period of such suspension, all proposed advances and all amounts from day to day outstanding which are not past due, shall bear interest at the Base Rate.
Notwithstanding the foregoing, if Administrative Agent has made the determination described in subsection (a)(i) of this Section 1.7.5, Administrative Agent, in consultation with Borrower and the affected Lenders, may establish an alternative interest rate for the Impacted Advances, in which case, such alternative rate of interest shall apply with respect to the Impacted Advances until (1) Administrative Agent revokes the notice delivered with respect to the Impacted Advances under subsection (a) of the first sentence of this Section 1.7.5, (2) Administrative Agent or Required Lenders notify Administrative Agent and Borrower that such alternative interest rate does not adequately and fairly reflect the cost to such Lenders of funding the Impacted Advances, or (3) any Lender determines that any Law has made it unlawful, or that any Governmental Authority has asserted that it is unlawful, for such Lender or its applicable Lending Office to make, maintain or fund Loan advances whose interest is determined by reference to such alternative rate of interest or to determine or charge interest rates based upon such rate or any Governmental Authority has imposed material restrictions on the authority of such Lender to do any of the foregoing and provides Administrative Agent and Borrower written notice thereof.
It remains to be seen whether regulatory agencies and market participants believe that LIBOR, or LIBOR fallback language in loan documents, could or should be replaced. If so, the broad Treasuries repo financing rate may be one likely replacement. If that is the case, new credit agreement language would have to be developed for that LIBOR replacement.
Although everyone is still waiting for firm guidance on what happens next, it is important to take preemptive steps. Start reviewing your inventory of loan documents and loan abstracts to get a clear picture of which properties could be affected by the phasing out of LIBOR in 2021. Some of the key provisions that rely on LIBOR include Illegality Clauses, Inability to Determine Rates Clauses and Increased Costs Clauses.
The good news is that companies do have ample time to prepare for the arrival of libor alternatives. In addition, if you have documents with LIBOR language, there are resources that can help you manage the transition away from LIBOR. CREModels regularly reviews loan documentation and performs sensitivity analysis for pre- and post-LIBOR instruments and their affects to the underlying collateral cash flows.
EDITOR’S NOTE: See our update on this topic: “Libor Replacements in Real Estate: Introducing SOFR“