The Transition Away From LIBOR

The use of the London Interbank Offered Rate (LIBOR) as a benchmark rate has become ubiquitous over the last several decades. Yet LIBOR will cease to exist beyond 2021 without a single universal rate to replace it. The potential disruption has the financial markets worried and implications will be vast. Is your company prepared for this transition? Inaction is not an option.

Why isn’t LIBOR here to stay?

It became apparent after the financial crisis of 2008 that LIBOR was being manipulated by banks to make them look healthier. As a response, in 2014, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) to plan the transition away from LIBOR. After roundtables, and the meeting of an advisory group of end users across market sectors, the ARRC recommended a new rate, Secured Overnight Financing Rate (SOFR), to replace LIBOR, which the New York Federal Reserve (NY Fed) had proposed in cooperating with the Treasury Department’s Office of Financial Research. SOFR has been published by the NY Fed since April 2018 and is based on the cost of overnight borrowings through repurchase transactions collateralized with U.S. Treasury securities. Great Britain, Japan and others have also formed similar working groups and are working on their own reference rates.

LIBOR is supervised by the U.K. Financial Conduct Authority (FCA). In 2017, the FCA received commitments from banks to continue submitting LIBOR quotes through December 2021, with no assurance that LIBOR would be published beyond 2021. In 2018, the CEO of FCA reiterated that financial markets should treat the discontinuation of LIBOR as an event that will happen. With the likelihood that LIBOR would cease to exist beyond 2021, the challenge to the market is no longer to gradually move away from LIBOR by writing new contracts on alternative rates like SOFR, but to prepare for LIBOR no longer being a reference rate. It is estimated that $200 trillion of existing financial products are tied to LIBOR. Impacted financial instruments include floating-rate notes and mortgages, auto loans, securitizations, consumer loans, derivatives, among many others. Many contracts have not been drafted to deal with the pending LIBOR disappearance, including those with fallbacks to the Prime Rate, which is roughly 3 percent higher than LIBOR.

In February 2020, Fannie Mae and Freddie Mac announced that they will stop accepting LIBOR-indexed adjustable–rate mortgages by the end of 2020 and start accepting SOFR. The International Swaps and Derivatives Association (ISDA) is working on protocols that will incorporate new rates and fallback provisions through amended contracts and recently announced preliminary results of its industry consultation. However, other financial institutions currently do not have a clear path forward. Certain midsized banks have objected to the use of SOFR, touting Ameribor (American Interbank Offered Rate) as an alternative. The Securities and Exchange Commission, having identified the rate reform as a key risk, is acutely focused on the topic, as is the Treasury and the Internal Revenue Service. For financial reporting purposes, for loans that are modified prior to December 31, 2022, the change from LIBOR to another base rate will likely not result in a change in accounting treatment of loans or the related derivatives.

Will COVID-19 alter the priorities for the transition of LIBOR?

With market participants’ changing priorities as a result of the COVID-19 pandemic, and dedicating resources to more urgent matters, the transition efforts have been delayed further. Yet, despite the dislocations created by the pandemic, on March 25, 2020, the FCA reinforced the timeline of the transition from LIBOR, while the ARRC published 2020 objectives to support the transition away from LIBOR and the voluntary use of SOFR.

However, certain stimulus loan programs in the United States continue to be indexed to LIBOR.  The Main Street Lending Program acknowledged that implementing systems to issue SOFR-based loans would divert resources from challenges related to the pandemic, encouraging lenders and borrowers to include fallback contract language to be used should LIBOR cease to exist during the term of the loan, but not mandating the use of SOFR.

How to prepare for the transition away from LIBOR and into the voluntary use of SOFR

With less than two years remaining until LIBOR could be unusable, the ARRC outlined best practices and key recommended transition milestones that market participants should aim to achieve.

Real estate companies buying property with debt, refinancing existing loans or negotiating with lenders on debt modifications should stop using LIBOR and start using SOFR or another robust alternative, or include language in the new agreements to address the change from LIBOR to another benchmark rate once LIBOR will cease to exist.

For existing loans or other financial instruments, borrowers at a minimum, should review loan documentation, assess the impact and begin discussions with lenders to work on a path forward.  Borrowers should inform their organization of the transition from LIBOR, assess the accounting and tax impact, and consult with lawyers to craft language to adjust rates so that effective rates stay similar to initial agreements or to include fallback language provisions to address LIBOR becoming unavailable beyond 2021.