New LIBOR hedge fallbacks take effect: now what?

Legacy LIBOR hedge fallback definitions

If you are counterparty to an interest rate hedge (cap, swap, etc.), your bank may have contacted you about LIBOR transition and “the ISDA Protocol.” International Swaps and Derivatives Association (ISDA) documents govern most interest rate hedges, with the notable exception of caps on floating-rate Freddie Mac and Fannie Mae loans. ISDA’s 2006 Definitions serve as reference points and the foundation of this documentation. Prior to their recent amendment, the 2006 Definitions only contemplated temporary unavailability, rather than wholesale discontinuation, of LIBOR and other benchmarks, and called for the parties to poll a group of banks for quotes on their interbank lending rates in the event LIBOR was not available.

New LIBOR hedge fallback definitions and the ISDA Fallbacks Protocol

Out of concern that banks would be unwilling to quote on a permanently discontinued rate, or that any quotes may not be representative of actual interbank lending rates, ISDA conducted a series of public consultations and incorporated feedback into an amended set of 2006 Definitions that provide as follows, for USD and GBP LIBOR:

1. The Secured Overnight Financing Rate (SOFR), compounded over the relevant tenor (e.g., one month), will replace USD LIBOR as the floating rate of the affected hedge. For more detailed information about SOFR, please read: SOFR: An end user’s guide.
2. The Sterling Overnight Index Average (SONIA), compounded over the relevant tenor, will replace GBP LIBOR as the floating rate of the affected hedge. For more detailed information about SONIA, please read: SONIA: An end user's guide.
3. To reflect the credit risk premium inherent in LIBOR but absent from SOFR and SONIA, these replacement floating rates will be adjusted with the addition of a static spread adjustment for each, calculated as the five-year median of historical differences between the relevant LIBOR and compounded SOFR or SONIA; this will constitute the all-in fallback rate.
4. The occurrence of certain specified “pre-cessation triggers” will set the date of determination of this spread adjustment, and LIBOR’s ultimate cessation will set the date of transition itself.

Barring specific negotiations to the contrary, the revised 2006 Definitions apply automatically to all hedging transactions executed on or after January 25, 2021. They can also be applied to pre-existing hedges if the parties adhere to the ISDA 2020 IBOR Fallbacks Protocol or enter into a one-off bilateral agreement (i.e., borrower and hedge bank, to the extent they are willing to incorporate these terms outside of the ISDA Protocol).

For more detailed information about ISDA’s new LIBOR fallbacks, please read: ISDA’s IBOR Fallbacks Supplement and Protocol for U.S. CRE Investors.

Regulatory backdrop: LIBOR (most likely) lives on

As the revised 2006 Definitions take effect, the current administrator of LIBOR, ICE Benchmark Administration (IBA), closes its December 2020 public consultation regarding whether to publish one-month and three-month USD LIBOR through June 30, 2023, rather than December 31, 2021, as previously expected. While we won’t know when IBA will cease to publish LIBOR until they release the results of this consultation, which closes on January 25; many treat it as a foregone conclusion that the extension will be granted. Global regulators have publicly supported the consultation and the idea of an extension, which Randy Quarles, the Fed’s vice-chair of supervision, also suggested at a Senate banking committee hearing prior to the release of the consultation. In their statement regarding the IBA consultation, the U.S. prudential regulators (Fed, FDIC, OCC) also encouraged banks to cease entering into new LIBOR-based contracts on or before December 31, 2021.

Risks in transition

There are a number of business risks inherent in LIBOR transition, whether under the legacy 2006 Definitions (i.e., polling) or the revised 2006 Definitions (i.e., SOFR or SONIA with spread adjustment):

1. Loan agreements most likely address LIBOR transition differently than the revised 2006 Definitions (or may not address it at all), potentially resulting in a mismatch in fallbacks and consequent introduction of economic risk. To be clear, this risk also exists to the extent you do not incorporate ISDA’s revised 2006 Definitions into your hedging transactions because the existing polling fallback is unlikely to match the fallbacks in your underlying loan instruments.
2. For new trades, hedge banks may not be willing to accept any approach to fallbacks other than the approach laid out in the revised 2006 Definitions.
3. For existing trades, hedge banks may insist on adherence to the Protocol in order to continue to offer new hedges to a given borrower.

What to do

ISDA has stated that they intended the new fallbacks to serve as a one-size-fits-all safety net, rather than the primary means of transition. From that perspective, Chatham recommends that commercial real estate borrowers take a proactive approach to LIBOR transition.

Specifically, if your lender or hedge provider asks you to adhere to the ISDA Protocol, Chatham recommends you consider the following:

1. For CRE borrowers with caps from non-lender banks: If you plan to purchase or have purchased a cap from a bank that is not your lender, Chatham recommends you approach your lender to see if they will require you to adhere to the ISDA Protocol or otherwise incorporate the terms of the revised 2006 Definitions.
   1. If they want you to do so, Chatham can help you adhere.
   2. If they won’t require you to do so, Chatham can help you evaluate the pros and cons to adhering, which likely are different for a short-dated, out-of-the-money cap, than a longer-dated cap at a low strike relative to current LIBOR expectations.
2. For CRE borrowers who have executed swaps with lender banks: If you plan to execute or have executed a swap with your lender, we recommend that you approach your bank relationship manager to request that the bank align your loan and hedge fallbacks so as to minimize or eliminate the economic risk of a mismatch. For new USD swaps, we also recommend calculating the floating leg by considering SOFR as published by the New York Federal Reserve, which can be found on Chatham’s website, rather than on the fallback rate referenced in the revised 2006 Definitions and as published by Bloomberg. While these rates likely will match closely, they are not the same and will exhibit different liquidity profiles over time.

Please reach out to your Chatham team to discuss the best way to evaluate any risk in transition and approach your lender and/or hedge bank. This could include trading out of a LIBOR-based position and into another position before the “safety net” of the ISDA fallbacks take effect under the legacy or revised 2006 Definitions. We can provide direction as the market evolves and we invite you to monitor our LIBOR Transition Real Estate Insights for updates.