LIBOR transition considerations for non-bank lenders

In a piece published in August, we noted that U.S. prudential regulators have encouraged banks to cease entering into new LIBOR-based loans and derivatives (with limited exceptions) by the end of 2021. Based on discussions with bank lenders and hedge providers, we believe that LIBOR debt and derivative originations to commercial borrowers will all but disappear come December 31. Because debt funds and other non-bank lenders are not prudentially regulated, we’re hearing from our clients and industry partners that there are several open issues and questions.

Trends in LIBOR alternative lending and hedging markets

Bank lenders, Agencies, lifecos, and CMBS originators have all largely transitioned away from LIBOR for new floating-rate loan originations. Interest rate hedges indexed to SOFR (including interest rate swaps and interest rate caps) are now largely available to CRE borrowers. According to the Alternative Reference Rates Committee’s (ARRC) recently released Year-End Progress Report, following the CFTC’s “SOFR First” initiative:

• Volume and liquidity in SOFR swaps have increased 600% since March 2021 (up 80% during November alone)
• Almost all Floating Rate Notes and floating-rate Agency MBS are now solely based on SOFR
• Overall SOFR interest rate swap volume has increased to approximately 40% of the market measured on a risk-adjusted basis
• There is very little syndicated lending based on credit-sensitive rates

This report also suggests that the ARRC members will be looking for more standardization in securitization markets in 2022, with securitization markets moving to SOFR following the Agencies’ transition over the course of 2020 and 2021.

In a related release, the CFTC’s Market Risk Advisory Committee’s Interest Rate Benchmark Reform Subcommittee released a “SOFR First” User Guide for Exchange-Traded Derivatives Transactions, where they noted that LIBOR market activity could decrease beyond the end of this year, potentially resulting in increased LIBOR transaction costs. The subcommittee encouraged market participants to consider voluntarily converting LIBOR-based positions to SOFR-based positions.

As discussed in our summary of LIBOR alternatives in CRE loans, we’ve not yet seen a “consensus” replacement index, with several SOFR-based indices being observed, as well as some non-SOFR alternatives like BSBY. Most loans are using New York Fed 30-Day Average SOFR, Daily Simple SOFR, or Term SOFR. Term SOFR seems to be gaining the most momentum, with quick adoption by many lenders since the CME Group began publishing it in April and the ARRC formally endorsed it in July. Many lenders originating loans with the other SOFR structures are including language in the loan that will permit them to convert to Term SOFR post origination if that becomes the market standard. We have heard anecdotes of bond buyers in the CMBS market expressing concern about Term SOFR as volumes in the SOFR futures markets (from which Term SOFR is derived) are still growing. Given regulators have suggested that Term SOFR have a limited scope of use, Term SOFR may not be the preferred rate for all market participants.

Adoption of alternative rates by debt funds/non-bank lenders

Adoption of LIBOR alternatives has been slowest in the debt fund/non-bank lending space, with many such lenders still originating LIBOR-indexed loans, even as we reach the end of 2021. This isn’t surprising, as these lenders are not subject to prudential regulation and may not have the same restrictions preventing them from lending over LIBOR in 2022. Further, most of these lenders have viewed their decision to pivot away from LIBOR as hinging on the transition of their own funding sources, and warehouse/repo/subscription line lenders have only recently started providing guidance on how they expect these products to transition from LIBOR.

From our vantage point, we’ve started to see many debt funds/non-bank lenders make the transition on new originations. Looking at the caps we purchase on loans for these lenders (which is a lagging indicator as they reflect loan closings, not quotes in term sheets), 24% of loans closed month-to-date in December (as of December 17) have been indexed to a LIBOR alternative, compared to 5% in November and 4% in October.

On another relevant note, as laid out in CME’s Term SOFR FAQs (see page 3), a lender looking to lend over Term SOFR must obtain a CME Term SOFR license. In speaking with the CME, we understand that there are many lenders and other market participants seeking these licenses and can expect potential delays in obtaining them. Lenders looking to use Term SOFR and comply with CME terms would be well-advised to begin this application process sooner rather than later.

Funding source transition

Non-bank lenders have only recently started receiving guidance on how their funding sources will transition, but this guidance has raised more questions. Chief among these is whether they should immediately transition their legacy LIBOR loans in conjunction with the transition of their funding sources. Doing so would eliminate any basis risk between loan income and funding costs but would also require time and expense with borrowers. LIBOR and SOFR have historically tracked closely (with LIBOR tending to increase in times of tightening credit conditions even while SOFR falls), which may make this basis risk tolerable, particularly for loans with shorter remaining terms.

Providers of repo/warehouse/subscription lines are also asking for spread increases when converting a line from LIBOR to SOFR to reflect the historical basis between LIBOR and SOFR (with LIBOR typically exceeding SOFR-based rates). Many providers have been leading with an 11.448 bps increase (in line with ARRC recommendations based on the historic 5-year median difference between LIBOR and SOFR) or 10 bps for simplicity. The current spot differential between 1-month LIBOR and 1-month Term SOFR rates is only ~5 bps, and the expected difference between the two in the short-term (based on forward curves) may range between these two amounts. This leaves non-bank lenders that want to pass along this spread adjustment to their borrowers to either explain this difference (which may not be intuitive) or eat the difference. In situations where a lender’s funding source transitions to SOFR but the lender may prefer to leave legacy loans indexed to LIBOR, a basis swap can be used to mitigate basis risk. In the few conversations we've had on this topic, we've seen limited interest in this due to potential margin requirements and other trading costs.

Interest rate caps and LIBOR transition

With interest rate caps on SOFR largely available to CRE borrowers, availability of hedges for new SOFR-indexed loan originations is no longer a concern. The primary discussions we’re having with lenders center around availability of caps for LIBOR loans that close in 2022 and caps on legacy LIBOR loans that a lender may elect to transition to SOFR in the coming year.

Based on the requests for cap pricing we’re seeing, some non-bank lenders may still be originating LIBOR-indexed loans in early 2022. We are also seeing LIBOR-indexed loans that were scheduled to close this month getting pushed to next year. Conversely, we’re also seeing some loans that were originally quoted over LIBOR being shifted to SOFR after signing of the term sheet but prior to closing. Irrespective of the situation, lenders should understand one important point: LIBOR caps will not be available for new loan closings beyond the end of 2021. While there will be some availability of LIBOR caps for pre-existing LIBOR debt (particularly in conjunction with loan extensions), banks’ regulators have made it clear that derivatives on LIBOR, with few exceptions, should not be sold post 2021. Lenders should be aware of this and understand that any LIBOR loan originated in 2022 will need to be hedged with a SOFR cap.

We have been fielding many questions related to LIBOR cap fallbacks and how they will occur in connection with LIBOR loan conversions. Since January 2021, standardized cap documentation published by the International Swaps and Derivatives Association (ISDA) provides that LIBOR-indexed caps will automatically fall back to SOFR compounded-in-arrears upon LIBOR’s cessation or declaration that it is no longer representative, which regulators have announced will occur on June 30, 2023. This fallback process is consistent across all LIBOR caps purchased after January 25, 2021, as well as those that have been modified through adherence to ISDA’s IBOR Fallbacks Protocol. CRE loans, on the other hand, contain a variety of fallback triggers, many of which may allow for a lender to use its discretion to call for a LIBOR fallback prior to June 30, 2023. This gives rise to the risk of a loan falling back to a LIBOR alternative before the related interest rate cap falls back, which consequently creates basis risk and an imperfect hedge. Many debt funds are still deciding how to handle this and we’ve proposed the following considerations:

• LIBOR-indexed Interest rate caps purchased on or after January 25, 2021, will include standard fallback language which will automatically make them transition to a SOFR-based rate (though not necessarily the precise SOFR rate in the underlying loan) at the end of June 2023 at no cost to the lender or borrower.
• LIBOR-indexed caps that a lender wants transitioned prior to that date or to a SOFR-based rate that precisely matches the SOFR rate used in the loan will need to be restructured, which will require cost to the borrower and/or lender, in the form of both fees from the dealer bank and legal fees.
• LIBOR has historically tracked SOFR closely and may rise when SOFR falls when credit markets tightening; a LIBOR cap is still likely to be a good hedge for SOFR exposure (if somewhat less precise).
• The decision on how to handle the cap is less consequential if the cap is well “out-of-the money” (i.e., it has a strike rate much higher than current LIBOR) or if the underlying loan has a floor on the index that is well above current LIBOR and SOFR.

As we approach the end of LIBOR originations as we know them, and you have questions on these themes or any others, please reach out to your Chatham representative with any questions.