Everyone was talking about big changes coming in 2021 during SFVegas. The talk centered around the demise of LIBOR, the use of SOFR as a replacement rate, market uncertainty and the ensuing litigation that will follow. In case you missed it, here are the basics of what’s actually going on with LIBOR’s dissolution.
The downfall of LIBOR: a brief history
The London Interbank Offered Rate (“LIBOR”) has been around for over 30 years and has set the standard for the rate banks lend to each other on a short-term, unsecured basis. Used in more than USD 350 trillion of financial transactions, LIBOR has long been depended on by virtually all major banks to set the interest rates on bonds, floating rate notes, securitizations, commercial loans, derivatives, consumer loans and more. Basically, on a daily basis, the major financial institutions in London put in their two cents on what the rate of LIBOR is, generating an average quoted rate. But in 2012, when some banks submitted fraudulent LIBOR quotes, civil and criminal litigation ensued, trust and integrity in the public market tanked, and now, LIBOR’s glory days are coming to an end.
Relatively speaking, LIBOR is based on a small number of transactions, there’s room for manipulation, and it doesn’t effectively sum up all market activity. After review, the UK’s Financial Conduct Authority (“FCA”) deemed LIBOR is an insufficient snapshot and as of 2021, the FCA is no longer requiring banks to submit quotes to determine LIBOR. Without this FCA requirement, and the general loss of market confidence in a rate set by bad players, the number of transactions in which LIBOR is based will shrink. In 2021, LIBOR will become more unreliable, undependable and essentially phased out for good.
Although actual transactions underlying LIBOR have diminished, its use as a benchmark has become ubiquitous. The gross notional value of all financial products tied to the US dollar LIBOR is around USD 260 trillion—about 13 times the US GDP. That includes USD 3.4 trillion of business loans, USD 1.8 trillion of floating-rate notes and bonds, another USD 1.8 trillion of securitizations and USD 1.3 trillion of consumer loans, including around USD 1.2 trillion of residential mortgage loans. The remaining 95% of exposures are derivative contracts, which we learned in the 2008 financial crisis have consequences for both Wall Street and Main Street.
There’s no easy path forward to a world without LIBOR and the industry is still dealing with the impact of 2012’s disarray. In the US, five states are still investigating the rigged rate of 2012 and at least USD 9 billion in aggregate settlements has already been paid.
However, the litigation risk for all participants is still high. In best-case scenarios, perhaps the financial transaction has an agreement in place that requires only two or more parties to agree to a rate where LIBOR can be substituted. Or maybe there are already terms in place where LIBOR can be substituted with a different rate reference. Monstrous litigations could rear their ugly heads though, likely where public debt offerings interest rate changes require the consent of every bondholder, which is probably impossible. Or the more probable situation where the lackluster temporary alternative LIBOR fallback language in these debt instruments (meant in the event of a LIBOR hiccup and not a catastrophic LIBOR failure) suddenly creates a fixed rate security that none of the parties envisioned or negotiated. Bondholders expecting market variable rate notes will likely be keen to litigate this unexpected outcome. Needless to say, it’s entirely foreseeable that these discrepancies and disagreements can cause cash flow and waterfall payout chaos, welcoming even more litigation.
SOFR is stepping up
The US has proposed the Secured Overnight Financing Rate (“SOFR”), also known as the “overnight treasury repo rate” to step in as the new standard rate. Collateralized by US Treasuries, SOFR is backed by the full faith and credit of the US government, making the risk almost null, versus LIBOR’s basis of unsecured bank loans. While SOFR may be safer and more reliable, it’s not without downfalls. Although most of the current uses of LIBOR have no actual need to reflect the bank funding risk implicit in LIBOR, that difference does still affect the level of the index and will need to be adjusted for in contracts that start out referencing LIBOR and then switch to SOFR. Furthermore, the calculation supporting SOFR is not an exact replacement for LIBOR. Most contracts that reference LIBOR are based off of three-month or six-month LIBOR, with some mortgages even using one-year LIBOR. But SOFR is an overnight rate—there’s no such thing as three-month or six-month SOFR. The result is an attempt to replace apples with oranges which will certainly create an administrative burden, including calculating interest on pay day.
So, now what?
While SOFR appears to be the clear front runner as the alternative risk free basis rate of choice, it is by no means a done deal. Equally there is a fiduciary duty on ABS issuers and their boards to address the issue of LIBOR’s abolition sooner than later, which is a complex task. There’s a lot to address: many issuances may be backed by assets which themselves carry a LIBOR basis rate which needs repapering, there will be swaps, liquidity facilities and guaranteed investment contracts which will also need to be amended, not forgetting considerations for Trustees and Facility Agents for any needed amendments to cash flows and deal rating confirmations from the appropriate agencies. The implications for all these factors need to be considered by the issuer before deciding on a course of action, a proposed alternative rate and consent solicitation.
Given the amount of considerations, the absence of an accepted alternative rate cannot be dusted under the carpet to be dealt with at a later date. While the abolition date at the end of 2021 may seem distant, investors will be looking for issuers to address the slew of changes sooner than later, even if that means the decision is simply to be cognizant of risk in their portfolios and to be ready to react to an adopted rate once the market has reached a complete consensus, with appropriate machinery explored and in place to make swift, efficient changes. Issuers need to review their portfolios and prepare to defend themselves against any claims that they have neglected their fiduciary duty.
We’d like to thank our legal and business partners at Perkins Coie for staying at the forefront of LIBOR updates and keeping our global network informed with the information you read in this article. Read more information about LIBOR from the experts at Perkins Coie here.
As one of the largest corporate services providers in Europe and across the globe, Intertrust is at the forefront of all processes following the ending of LIBOR. With experience and expertise in every various element that needs to be addressed, we’re happy to discuss your next steps in embracing all the changes the fall of LIBOR will bring.