Issues for LIBOR based loans that are hedged — the latest developments with respect to the LIBOR phase out
When borrowers execute interest rate swaps to hedge their interest rate risk associated with their debt financings, they are careful to make sure that the variable rate in their loan agreement (typically the London Interbank Offered Rate, or “LIBOR”) is the same as in the swap agreement in all respects—the definition of the rate, when the rates are determined and effective, etc. If there are any differences, borrowers will have an imperfect hedge—also called basis risk.
By now you have likely heard that LIBOR will be phased out by the end of 2021. So what happens to the variable rate in a loan agreement and a swap when LIBOR is replaced? Ideally, they would be replaced at the same time and with the same rate. Many astute borrowers have in fact asked their banks to assure them that this will be the case. Much to the frustration of these borrowers, we are not aware of any banks that have agreed to this request. Why is this the case when the bank is both the lender and the swap counterparty? Why can’t it agree that it will treat them the same when LIBOR is phased out? The reason is banks control neither benchmark interest rates nor the swap market. In fact, there are three different groups working on the transition from LIBOR, increasing the likelihood that different results will be reached.
The primary organization working on the transition from LIBOR is the Alternative Reference Rates Committee (“ARRC”) which is a group of private-market participants sponsored by the Federal Reserve Board that have put forth recommendations on an alternative, more robust reference rate together with transition practices. ARRC has identified the Secured Overnight Financing Rate (“SOFR”)1 as the most robust replacement rate (i.e. difficult if not impossible to manipulate). The two other organizations working on the transition from LIBOR are the Loan Syndications and Trading Association (“LSTA”) and the International Swaps and Derivatives Association (“ISDA”). These organizations serve different constituencies and may have different recommendations. LSTA and ARRC are focused on the loan market while ISDA is focused on swaps and other derivatives. As a result, loan agreements are likely to be modified in accordance with ARRC’s and LSTA’s recommendations while interest rate hedges will be modified pursuant to ISDA’s guidance. Thankfully, there has been a lot of work by these organizations to harmonize their approaches, though they still have work to do. The remainder of this article will focus on the principal areas where the potentially different results could mean the interest rates in a borrower’s loan and its swap are different, and the current status of the recommendations by the different organizations.
The first and most obvious risk is that a borrower’s loan and swap select different replacement rates. We know that ARRC selected SOFR. Where do LSTA and ISDA stand on replacement rates? The good news is that everyone agrees that SOFR will replace LIBOR. The not-so-good news is that there are different SOFRs. Taking a step back, fundamentally, LIBOR and SOFR operate very differently. LIBOR is a forward rate. Typically, LIBOR is set for 30, 60 or 90 days (called an ‘interest period’), and a borrower knows its interest rate for that interest period. SOFR is currently only an overnight rate and is reported by the Fed on its website at 8:00 AM for the previous day. See https://apps.newyorkfed.org/markets/autorates/SOFR. So borrowers will only know their interest rate after they have borrowed money. Since SOFR is currently only a daily rate, there are different methods (simple versus compound) to calculate the interest payments. A full explanation of these differences goes beyond the scope of this article, but ARRC has published a “User’s Guide to SOFR” that explains the differences and challenges with each approach.2 The important point is that the loan market and swap market may not pick the same method of calculating SOFR. The most recent guidance from ARRC provides a waterfall of replacement benchmark rates. The first fallback option recommended is “Term SOFR” which does not currently, and may not ever, exist.3 The second fallback option recommended is “Daily Simple SOFR”. ISDA on the other hand has chosen a third alternative, “Daily Compounded SOFR” also called “compounded in arrears”.4 In fairness, ARRC has acknowledged that borrowers with swaps may wish to fall back to Daily Compounded SOFR to better align with ISDA’s fallback rate.5 None of the definitions for the rates that ARRC recommends include the actual conventions for when the rates are selected etc. Further, ARRC currently believes that the loan market will likely have different conventions than those used by ISDA thereby “generating differences between the two products even if both used compounded SOFR in arrears.”6
Another risk is that even if both loan and swap agreements select the exact same replacement rate, they may not go into effect at the same time. The events that require the implementation of the new benchmark rate are called “triggers”. Currently, LIBOR will be replaced in a swap only when LIBOR ceases to exist (called a ‘permanent cessation trigger’).7 Conversely, ARRC has published recommended LIBOR Fallback language for inclusion in loan agreements that includes “pre-cessation triggers”.8 This means a loan may convert to a replacement rate before LIBOR actually goes away. ISDA, recognizing that consistency across the markets is important, recently sought market guidance on whether to implement a specific pre-cessation trigger referred to as ‘non-representativeness’—which it defined as “the date that the UK FCA states that LIBOR ‘is no longer capable of being representative” into swaps.9 This is a promising step because if ISDA in fact incorporates such a non-representativeness trigger, the mandatory fallback triggers in swaps and loans will align.10 There are other triggers included in the ARRC language, but they require the agreement of the borrower at the time the fallback rate is implemented.
On the good news front, another potential difference between the swap and loan market—spread adjustments—seems to have been harmonized. Because SOFR is a rate based on collateralized overnight loans and LIBOR is an unsecured lending rate, there needs to be an adjustment to SOFR to make the replacement rate similar to LIBOR. Clearly if they use different spread adjustments, the rates will be different. Fortunately, ARRC and ISDA have both decided to calculate the spread adjustment based on the five-year historical median difference between LIBOR and SOFR,11 meaning that this potential basis risk seems to have been eliminated.
We are just over a year away from LIBOR’s demise, and while some differences between the loan and swap market’s approaches for the benchmark replacement remain, the different groups are working hard to eliminate, or at least reduce, these differences.
1. Second Report of the Alternative Reference Rates Committee, Page 6, (March 2018), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report
2. A User’s Guide to SOFR, The Alternative Reference Rates Committee, (April 2019), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/Users_Guide_to_SOFR.pdf
3. ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans, Page 18, (June 30, 2020), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/Updated-Final-Recommended-Language-June-30-2020.pdf
4. See note 3, at 10
5. See note 3, at 19
6. See note 3, at 21
7. 2020 Consultation on How to Implement Pre-Cessation Fallbacks in Derivatives, - Page 1 -
For more information reach out to your Quarles & Brady contact or
- Anthony Marino: 414-277-5365 / Anthony.Marino@quarles.com