LIBOR transition – where we stand now
- December 10, 2020
Managing Partner, Chairman
Global Head of Real Estate
Kennett Square, PA
SummaryOver the past few weeks there has been a flurry of developments associated with the LIBOR transition.
While Chatham has been in ongoing communication with many of you on the details of the transition, these recent developments provide a good opportunity to step back and view the bigger picture of how the transition has progressed to date, possible paths for the transition going forward, and our guidance on how to approach decisions and planning in this rapidly changing environment.
What we know
- The Federal Reserve wants to move away from LIBOR and has used the 2012 LIBOR scandal as the reason for the change.
- SOFR is the presumptive replacement for LIBOR in the U.S. With the exception of Freddie Mac and Fannie Mae, commercial real estate lenders have not started to originate loans indexed to SOFR nor have any committed to a specific timeline for doing so beyond speculation that such loans may start in the first or second quarter of 2021.
- Similarly, the market for SOFR-indexed derivatives is still very thin, which makes it harder and/or more expensive to manage SOFR exposure on loans.
- SOFR itself has some major weaknesses compared to LIBOR:
- SOFR does not yet have a term structure. LIBOR has a well-established yield curve allowing participants to price LIBOR over a variety of terms. It is a classic chicken-and-egg problem – SOFR won’t have a term structure until the market uses it in loans and derivatives; but its lack of term structure is the reason why many are reluctant to use it as a lending index.
- SOFR is not a credit sensitive index. This could result in an index that does not consistently reflect market participants’ cost of funds in all market environments. It could be challenging for banks to price loans with a fixed spread. This was clearly on display at the start of the COVID-19 crisis; SOFR fell in line with rate cuts by the Fed as bank funding costs spiked with tightening credit conditions.
- Because of these weaknesses, there has been a push by many in the community banking sector to use AMERIBOR instead of SOFR. In fact, Chatham recently advised on the first AMERIBOR transaction.
- Legacy LIBOR contracts that mature after the LIBOR “sunset” have become a major issue. Transitioning these legacy contracts from LIBOR to SOFR will create financial winners and losers. There is currently no guarantee that in the latest fallback proposals that a borrower’s all-in rate will remain the same, that a borrower’s hedged rate will remain the same, that the value of a borrower’s hedge will remain that same, or that the loan and hedge index will be calculated consistently. It is presumed that the fear of litigation caused regulators to extend the transition period.
There have been two recent developments noteworthy for CRE borrowers:
- Regulators are taking action to address the problem of legacy contracts. On November 10, Fed Vice Chairman Randy Quarles made a statement that the Fed was working on a plan that would allow the “great bulk” of these contracts to not have to transition away from LIBOR, suggesting that LIBOR, in some form, will survive for some period beyond 2021. Dovetailing with this, on November 30, the ICE Benchmark Administration (the administrator of LIBOR) indicated that they may continue to publish LIBOR through June 30, 2023, extending its “life” an additional 18 months beyond the previously presumed sunset date of December 31, 2021.
- A New York state senator has introduced legislation that would allow for “automatic” amendments of legacy contracts to include specific LIBOR fallback provisions if the contracts don’t already have suitable language. Federal legislators are drafting similar legislation. Drafts of these “legislative fix” bills include safe harbor provisions that would limit litigation options in the event of bad outcomes when these amendments take effect. This is appealing to lenders, but we recommend borrowers view them with caution; rules that limit our clients’ ability to pursue legal remedies against mistreatment by banks concern us.
What to do
This transition is proving to be far more complicated than regulators hoped. Despite widespread pushing for lenders and borrowers to use SOFR, universal adoption by the market is still far away. The SOFR lending market for CRE is non-existent beyond the Agencies, and the LIBOR derivatives market continues to dwarf the SOFR derivatives market. The probable extension of LIBOR to June 30, 2023, provides a welcome reprieve from the urgency of addressing legacy contracts and allows market participants to focus on new originations based on SOFR, which the Fed has made clear they want to see by the end of 2021.
While there are some alarmist voices in the industry either trying to scare people into taking SOFR loans, or trying to dramatize the risk to sell services, the new extension date should help alleviate near-term pressure. As your advisor, Chatham is diligently watching and participating in the industry discussions to ensure that your financial positions are protected. For those clients with large debt portfolios, we recommend two near-term steps to consider:
- Begin to have dialogues with your lenders about alternatively indexed floating-rate loans
- Inventory your floating-rates loans and associated derivatives to understand your risks
We’re prepared to help your capital markets teams with either exercise.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0460
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