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Market Update

What happens now to LIBOR loans and hedges?

Date:
June 30, 2023

Summary

As we enter the month of July, we pass the June 30 date which represents the sunset of LIBOR and the discontinuation of its use in CRE loans. Chatham is fielding questions from a variety of CRE market participants (including many borrowers, lenders, and brokers) on what this event will mean for their loans and interest rate hedges. This FAQ provides a guide to common questions and the key considerations that CRE market participants should bear in mind going into the transition.

Key takeaways

  • On June 30, one-month LIBOR ceased to be published by ICE, making it unavailable for loan and derivative contracts that would otherwise reference it as an index rate.
  • Loans indexed to LIBOR will convert to an alternative rate based on their documented fallback language, which may differ from lender-to-lender and loan-to-loan.
  • Legacy Freddie Mac and Fannie Mae LIBOR ARMs will convert to New York Fed 30-Day Average SOFR. Most non-Agency lenders are converting to Term SOFR. Some have or will convert to Daily Simple SOFR to facilitate reduced hedging costs.
  • To account for the historical difference between LIBOR and SOFR, lenders will typically apply a “spread adjustment”. In many cases that adjustment will be 11.448 basis points for legacy one-month LIBOR loans.
  • Absent any action, most LIBOR interest rate hedges will revert to SOFR Compounded in Arrears (with the 11.448 spread adjustment), though in many cases borrowers are proactively amending these trades to Term SOFR, as may be required by loan agreements.
  • Loans and other legacy LIBOR contracts with no defined fallback language or those that contain fallback language that is not workable, will be covered by the Adjustable Interest Rate (LIBOR) Act.
  • Conversions of hedges from LIBOR to SOFR will often result in a change in the hedge's value. The magnitude of the change may be small and will depend on the specific terms of the hedge and whether a spread adjustment is applied.
  • Chatham can assist borrowers in understanding the economic impact of loan and hedge transitions and provide context for broader practice in the market and with specific lenders.

Disclaimer: This piece discusses language in loan agreements and derivatives contracts related to LIBOR transition. This language is often nuanced and subject to interpretation. Nothing in this piece should be treated as legal advice.

FAQs

What happened on June 30?

On June 30, LIBOR’s administrator, ICE Benchmark Administration (IBA) ceased publication of the different tenors of USD LIBOR, including one-month LIBOR. This cessation follows an announcement by the IBA’s regulator, the Financial Conduct Authority (FCA) in March 2021 that LIBOR would no longer be a representative rate beyond this date.

If I had a LIBOR loan outstanding on June 30, what happened to it?

Most “legacy” LIBOR loans have “fallback” language which contemplates LIBOR cessation and provides a framework for replacing LIBOR with an alternative base rate. This language may be written in different ways — it may be fairly specific or it may simply give discretion to the loan parties to choose an alternative rate. Substantially all outstanding LIBOR debt in the CRE space has converted to some version of SOFR, a rate that measures the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Most bank, lifeco, debt fund, and CMBS loans converted to one-month Term SOFR; Agency loans converted to New York Fed 30-Day Average SOFR.

Loans that do not have fallback language or that have language which relies on certain fallback mechanisms that pre-date the contemplation of permanent LIBOR discontinuation will be covered by the Adjustable Interest Rate (LIBOR) Act. In general, this act will provide that LIBOR in such loans was replaced with one-month Term SOFR.

In most loans, the transition from LIBOR to SOFR also included a “spread adjustment” to account for the historical difference between LIBOR (a credit sensitive rate) and SOFR (a risk-free rate). The spread adjustment for one-month LIBOR loans recommended by regulatory bodies in the U.S. is 11.448 basis points. We are observing that most loans are using this spread adjustment, or something very close to it.

If I had a LIBOR interest rate hedge outstanding on June 30, what happened to it?

LIBOR-indexed interest rate hedges (including caps and swaps) which were outstanding on June 30 automatically converted to the ISDA fallback rate. For hedges of one-month LIBOR, this fallback rate will be SOFR Compounded in Arrears plus an 11.448 basis point credit spread. The exception to this is interest rate caps on Agency loans. These caps were documented with provisions distinct from standard ISDA terms and depends on whether the underlying loan was a Fannie Mae or Freddie Mac loan, the dealer bank providing the cap, and the vintage of the cap.

When will the new fallback rate in my legacy LIBOR contract be effective?

The SOFR based fallback rate for a loan or hedge will become effective for the first index reset observation past June 30. Many loan and hedge index rate resets occur on the first of the month but include a one to two business day observation lookback. In practice, for example, a loan resetting on July 1 will use the index rate observed on June 29. LIBOR was still available and representative on June 29 and, for this reason, many loans/hedges won’t incorporate the new SOFR based fallback rate until their August interest period.

What fallback documentation should I expect to receive on my legacy LIBOR hedge?

In many cases you may not receive any documentation. The standard ISDA fallback language in trades executed after January 2021 operates automatically, with no additional documentation required. Trades executed pre-January 2021 which don’t include this language will be covered by the Adjustable Interest Rate (LIBOR) Act, which also operates automatically without any need for additional documentation.

We have seen some situations where dealer banks asked our clients to execute an amendment or other document which explicitly acknowledges the fallback (even though this isn’t necessary) or have sent notices confirming the fallback. Additional documentation will be required if the hedge is being further modified beyond its documented fallback language.

It looks like it may be common for the version of SOFR used in loan fallbacks to not match the version of SOFR used in caps and swaps. Should that concern me?

Most loans replaced LIBOR with New York Fed 30-Day Average SOFR (for Agency debt) or one-month Term SOFR (other non-Agency debt). Absent any action, derivatives replaced LIBOR with SOFR Compounded in Arrears and include the spread adjustments discussed above. In practice, these rates are highly correlated but often do not match perfectly. Please see our write-up here for more information on the basis between these two rates.

Borrowers evaluating this mismatch should first consider whether the derivative was a hedge required by the lender. If so, the lender may dictate that the loan and hedge be modified to bring the fallback rates in line (often by amending the derivative). If not, the borrower should consider if they are comfortable with a slight mismatch between the loan and the derivative index. In many cases, a borrower may decide that the slight mismatch is tolerable, particularly considering the transaction costs that may be involved in further amending the loan/derivative to bring them precisely in line with one another.

Borrowers who are applying hedge accounting to their caps and swaps should consider whether a mismatch in index will allow continued hedge accounting. Whether hedge accounting can continue will depend on the specific changes to the derivative and hedged debt, how the designation memo was written, and whether the hedging relationship is eligible for optional relief under ASC 848 Reference Rate Reform (ASC 848). Companies should consider the need to document changes to the hedging program, the need to change to effectiveness testing methodology, and the need to document optional elections under ASC 848. Chatham can assist with the accounting considerations related to LIBOR transition.

Are there circumstances where I should look to further modify my loan or interest rate hedge beyond what's specified in the contract's existing fallback provisions?

We have been working with many borrowers to further amend legacy loans and/or interest rate hedges beyond the provisions already covered in these documents. These situations typically arise due to one of the following:

  • The counterparties to a loan want an amendment that more explicitly identifies that it has been converted to a SOFR loan.
  • A borrower with a hedge wants to or is being required by their lender to conform the hedge precisely to the version of SOFR used in the loan..

Please note that these modifications may continue to be made after June 30.

What are Fannie Mae and Freddie Mac doing with their legacy LIBOR loans and required hedges?

Per FHFA guidance, legacy Freddie Mac and Fannie Mae LIBOR ARMs will convert from LIBOR to New York Fed 30-Day Average SOFR after June 30. This conversion will also include a 11.448 basis point spread adjustment, so a borrower would transition from paying one-month LIBOR + spread to New York Fed 30-Day SOFR + 11.448 basis points + spread.

Treatment of interest rate caps on Fannie Mae and Freddie Mac loans is varied. Distinct approaches have been taken for different caps depending on i) whether the underlying loan is a Fannie Mae or Freddie Mac loan, ii) the dealer bank providing the cap, and iii) the vintage of the cap. Please contact us if you’d like us to review a specific hedge.

What are non-Agency lenders doing with their legacy LIBOR loans and required hedges?

This depends very much on the lender. Many lenders used any loan amendment, modification, or extension to transition a loan from LIBOR to SOFR prior to June 30. Loans that hadn't been amended have now converted to SOFR (as the next rate-reset date after June 30) using either the loan fallback language or as a result of the Adjustable Interest Rate (LIBOR) Act.

Similarly, treatment of existing interest rate hedges differs from lender to lender. Some lenders have expressed willingness to accept a mismatch between the version of SOFR used on the loan and the version of SOFR on the hedge. Others are requiring their borrowers to modify their hedges above and beyond the provisions in the hedge fallback language to ensure that the loan and the hedge match perfectly.

Is a 11.448 basis point credit spread adjustment appropriate?

The 11.448 basis point credit spread adjustment that U.S. regulatory bodies recommend and that is accepted as “market standard” is based on the five-year historical difference between one-month LIBOR and one-month SOFR Compounded in Arrears. This spread adjustment does not match the spot differential between one-month LIBOR and different SOFR variants. This spread adjustment may not be “neutral” on an expected value basis, whether looking at a loan coupon before and after the loan is transitioned from LIBOR to SOFR or the mark-to-market value of a derivative before and after a transition.

How will the conversion impact the value of my hedge?

Converting a hedge from LIBOR to SOFR + spread adjustment will, in most cases, change the mark-to-market value of a hedge by a modest amount — sometimes in the borrower’s favor, sometimes to their detriment. This change may require a payment to or from the borrower to their derivative counterparty. The size and direction of this change in value will depend on the specific economics of the hedge and market conditions at the time.

What happens if my loan and hedge transition to different rates?

The “default” fallback provisions in loans and hedges will result in a mismatch between the type of SOFR to which a loan converts (one-month Term SOFR, New York Fed 30-Day Average SOFR, Daily Simple SOFR) and the type of SOFR to which a hedge converts (SOFR Compounded in Arrears). These mismatches will typically be modest and will not prevent the hedge from providing effective protection against higher interest expenses on the loan due to rising rates. However, lenders may not be comfortable with this mismatch and may ask borrowers to further amend hedges to precisely match the associated loan, and some borrowers may prefer to make these amendments themselves.

What is the Term SOFR hedge execution basis and how should I think about transitioning my debt and any associated hedge?

Term SOFR is the most common variant of SOFR used in non-Agency loans. There is now a liquid market for caps, swaps, and other derivatives indexed to SOFR. However, regulators have prohibited dealer banks that provide these hedges to CRE borrowers from hedging their own risk using Term SOFR derivatives. This prohibition on dealer banks from using Term SOFR in the interbank market has driven a “one-way” market for Term SOFR hedges, resulting in an execution “basis” for Term SOFR hedges. This is most often felt by CRE borrowers executing Term SOFR swaps. This basis can add two to five basis points to the swap rate depending on the swap tenor and the dealer bank.

Chatham has worked with borrowers to structure around this execution basis. In some cases, we’ve worked with borrowers to negotiate a loan transition to an alternative version of SOFR to help lower the cost on the conversion of the associated swap.

How can Chatham help?

Chatham can be a resource for a borrower that is transitioning a loan and/or hedge from LIBOR to SOFR (or that is considering doing so). We can assist by:

  • Reviewing loan and hedge documents to explain how the loan/hedge transition language will work in practice.
  • Helping quantify any change in the value of a hedge because of a transition from LIBOR to SOFR and negotiating with a hedge provider to ensure the value transfer is appropriately treated (including, in some cases, a payment from the hedge provider to the borrower).
  • Negotiating the economics associated with an early amendment of a hedge prior to June 30. This includes helping to structure around or minimize the impact of the Term SOFR basis.
  • Providing color on how a lender spread adjustment (whether 11.448 basis points or something else) compares to the actual forward-looking basis between LIBOR and SOFR for a given remaining life of a loan or hedge.
  • Sharing color on how we’ve seen your lender handle LIBOR transition with the broader market.


Need help transitioning your loan or hedge?

Contact a Chatham expert

Disclaimers

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.

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