What will happen to LIBOR loans and hedges on June 30?

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 is happening on June 30?
• If I have a LIBOR loan outstanding on June 30, what will happen to it?
• If I have a LIBOR interest rate hedge outstanding on June 30, what will happen to it?
• 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?
• Are there circumstances where I should look to proactively modify my loan or interest rate hedge ahead of June 30?
• What are Fannie Mae and Freddie Mac doing with their legacy LIBOR loans and required hedges?
• What are non-Agency lenders doing with their legacy LIBOR loans and required hedges?
• Is a 11.448 basis point credit spread adjustment appropriate?
• How will the conversion impact the value of my hedge?
• What happens if my loan and hedge transition to different rates?
• What is the Term SOFR hedge execution basis and how should I think about transitioning my debt and any associated hedge?
• How can Chatham help?

What is happening on June 30?

On June 30, LIBOR’s administrator, ICE Benchmark Administration (IBA) will cease publishing the different tenors of USD LIBOR, including 1-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 have a LIBOR loan outstanding on June 30, what will happen 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 – but substantially all outstanding LIBOR debt in the CRE space will convert 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 will convert to 1-month Term SOFR; Agency loans will convert to NY 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 will be replaced with 1-month Term SOFR.

In most loans, the transition from LIBOR to SOFR will also include 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 1-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 have a LIBOR interest rate hedge outstanding on June 30, what will happen to it?

LIBOR-indexed interest rate hedges (including caps and swaps) which are outstanding beyond June 30 will automatically convert to the ISDA fallback rate. For hedges of 1-month LIBOR, this fallback rate will be SOFR Compounded in Arrears plus an 11.448 basis point credit spread.

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 will replace LIBOR with NY Fed 30-Day Average SOFR (for Agency debt) or 1-month Term SOFR (other non-Agency debt). Absent any action, derivatives will replace 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.

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 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 proactively modify my loan or interest rate hedge ahead of June 30?

We have been working with many borrowers to proactively amend legacy loans and/or interest rate hedges in advance of the June 30 LIBOR discontinuation date. These situations typically arise due to one of the following:

• The loan is otherwise being amended or modified and the lender is using that exercise to transition the loan from LIBOR to SOFR. In many cases, the lender may require that the hedge be amended at the same time (particularly if the hedge is an interest rate swap).
• The lender is proactively transitioning a portion of its loan book prior to June 30 to avoid having to transition its entire book on that date.

Transitioning a cap or a swap prior to June 30 may involve a change in value of the instrument which may be in the borrower’s favor or to their detriment, resulting in them making or receiving a payment to the hedge provider, respectively.

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 NY 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 1-month LIBOR + spread to NY Fed 30-Day SOFR + 11.448 basis points + spread.

As of February 28, neither Fannie Mae nor Freddie Mac have communicated broadly to the market (either directly or through their seller-servicer network) how they intend for legacy LIBOR caps on these ARMs to be treated. Based on our discussions with Freddie Mac, Fannie Mae, and their advisors/seller-servicers they intend to cause these interest rate caps to transition from 1-month LIBOR to some version of SOFR (likely NY Fed 30-Day Average SOFR or SOFR Compounded in Arrears) with a spread adjustment, but have not determined the exact terms or timing of these transitions.

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

This depends very much on the lender. Many lenders are using any loan amendment, modification, or extension to transition a loan from LIBOR to SOFR prior to June 30. Loans that are not transitioned by that date will need to convert to some version of SOFR, either by virtue of 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 5-year historical difference between 1-month LIBOR and 1-month SOFR Compounded in Arrears. This spread adjustment does not match the spot differential between 1-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 (1-month Term SOFR, NY 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 expense 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 2-5 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.
• Help quantify any change in the value of a hedge as a result 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.