Life After LIBOR

LIBORs days are numbered. 970 days or so, to be exact. 

LIBOR is the London Interbank Offered Rate, the index for most floating rate real estate loans.  LIBOR comes from that rate at which 18 major banks in the UK would lend to each other for short term loans.. These 18 banks are on a formal panel to submit, daily, their suggested rate for interbank lending (not the rate that these banks actually lend to each other, but on what they think such a loan rate ought to be).

Due to well-publicized financial scandals in 2012 among a few of these banks, the marketplace has lost confidence in LIBOR, and in 2017, UK regulators stated that after December 31, 2021, no banks would be required to submit daily LIBOR rates. Meaning, effective January 1, 2022, LIBOR could completely go away.

In 2017, no one really focused on this since the affected loans were three-year terms. Now in 2019, most new construction and bridge loan terms go beyond the potential LIBOR end date.

So, how do banks change their loan structures and documents to accommodate a different way to charge interest during the term of the loan? Should borrowers be concerned? Banks need to keep options open, but also need to come up with a comparable rate. And what is a fair, comparable rate?

The Leading Candidate is…

The Secured Overnight Funding Rate (SOFR) is a potential alternative rate.  First, it is an existing, published rate with a track record. Second, it is based on actual transactions occurring daily. Different from LIBOR, though, there is only a daily term, not monthly. Also, SOFR is collateralized by U.S. Treasuries; LIBOR is unsecured lending.

In the U.S., much of the official discussion on LIBOR transition is facilitated by the Alternative Reference Rate Committee (ARRC), a group of market lender participants convened by the Federal Reserve to opine on a comparable replacement. 

SOFR is viewed as the preferred alternative rate by the ARRC.  The ARRC and the Federal Reserve will not officially mandate that banks switch to SOFR; the issue is currently in discussion within industry working groups as to what should be done, when, and what will it look like.

Changes to Loan Documents

In the meantime, what should be the “fallback” language in loan documents to handle a potential disappearance of LIBOR? The answer is a work in progress, and banks are grappling with the big picture as well as the minutiae of changing horses midstream.

Experts agree that any language should address two major points:

  • What is the trigger event or date that must occur for there to be a change? It could be a group of several “mini-events” like “half of the 18 banks no longer quote LIBOR daily” or if the Federal Reserve issues a statement that definitively declares LIBOR dead. The idea is that the Lender does not want to assume the responsibility of determining the trigger event but wants to be able to point to someone else.
  • What replacement rate is used? There is SOFR, and – details – there are variations of SOFR. Hint: using the last published LIBOR rate might not be a good idea; if LIBOR is becoming a scarce commodity, the last few published rates might be sky high.

Other Relevant Issues for Borrowers

  • If SOFR – or whatever replacement rate – differs from LIBOR, what agreed-upon adjustments should be made to the rate to reflect fundamental differences in risk found in LIBOR vs. the replacement?Should the spread over the new index also be subject to adjustment?  Will lenders solely push upwards on any index or spread changes?
  • Should the LIBOR transition be “hardwired” into the loan documents today, or should lenders create an “amendment clause” that provides for an open-ended process for the borrower and lender to re-negotiate what rate and new spread to use?

So Where Does it Land Right Now?

So far, banks are all over the board on what the fallback language should look like. Ask five banks for their thoughts and borrowers will get five very different answers, from “don’t worry, LIBOR isn’t going away” to “we are going to protect ourselves at all costs with higher rates.”

ARRC will issue recommended language “soon” but until then, borrowers need to be aware of the potential pitfalls buried in their loan documents that had been casually perused in the past.