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Why is LIBOR going away?

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 repo 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, but 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.

How to prepare

Real estate companies buying property with debt must stop taking new loans using LIBOR and start using SOFR or another robust alternative, or make sure new agreements address the change from LIBOR to another benchmark rate once LIBOR will cease to exist.

With the LIBOR phase-out impacting the economic substance of existing loans, borrowers, at a minimum, should review existing loans, assess the impact and begin discussions with lenders.

Consider working with lenders on a path forward, inform your 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.

Originally published by Commercial Observer