03 Feb SOFR and the LIBOR Loan Market
This is part one of a three-part series, each looking at a different aspect of the cessation of LIBOR and transition to SOFR. This part covers the size of the LIBOR-linked loan markets and the different fallback and consent language in the Credit Agreements of each type of LIBOR-linked notes. The transition to SOFR from the LIBOR-linked Loan Market will be a challenge without proper planning.
Size of LIBOR-Linked Assets & Derivatives
Most of the banking industry say they’re prepared for the December 2021 phase-out of LIBOR. SOFR (The Secured Overnight Funding Rate) is the benchmark favored by Regulators & The Fed as the Alternate Base Rate.
The Alternative Replacement Rate Committee, Second Report (published: 2018) estimated $200 trillion outstanding Syndicated Loans, mortgage loans, Floating Rate Notes & Loans total roughly $8.3 trillion and ~$190 trillion notional amount are derivative contracts.
Table 1 below shows a detailed breakdown of the cash market and derivatives. 
NOTE:
The total LIBOR-Linked assets & Derivatives outstanding is $199 trillion. 82% of the total outstanding will mature prior to December 2021.82% is a dollar amount-weighted figure:
note at the bottom CLO’s with $400 billion outstanding only 26% will mature by December 2021, or $100 billion maturing by December 2021. The total weighted amount maturing by December 2021 is $161.6 Trillion out of a total outstanding $199 Trillion. Therefore, 161.6/199 = 81.5%.
As securities and swaps mature, hopefully, issuers will use a SOFR benchmark issuance. (More about that in Part Two of this Series).
Fallback Language
Every Floating Rate Loan includes Fallback Language in case the benchmark index stops being quoted. Fallback language will differ regarding how to determine a new benchmark and who (borrower or lender) consents to the new benchmark rate. The typical floating-rate business loan language calls for an Alternate Base Rate being the higher of Fed Funds + Spread or the Prime Rate. But each type of loan agreement has its own language, summarized in the table below.
Table 2 below shows the fallback language, in layman’s terms, by type of instrument
Proposed Fallback Language as of November 2019
On November 15, 2019, the ARRC recommended updated fallback language all the different instruments: Floating Rate Notes, Bilateral Business loans, Syndicated Loans, Securitizations, Adjustable Rate Mortgages & Derivatives.
This updated language is a two-step process, with two triggers: a pre-cessation trigger and a permanent cessation of LIBOR trigger. The highlights of the language follow below.
Event Triggers
Regarding event(s) that trigger a change in the base rate, ARRC proposes a two-step trigger process.
- An official statement from a regulator will evidence a Pre-cessation trigger that LIBOR is no longer reliable.
- A Permanent cessation trigger when the administrator has stopped providing the index to the public.
N.B.: ISDA & ARRC agree on the permanent cessation language. ISDA is currently considering adding a pre-cessation trigger.
Replacement Index & Spread Adjustment
Upon the second trigger, the ARRC will propose SOFR as the replacement Index and a corresponding spread adjustment applied to SOFR to preserve the economics of the transaction.
Consent to Fallback Language
Each product type has its own consent language to adopt a fallback rate
- For derivatives, ISDA consents to new fallback language (ISDA Master Agreement)
- For the cash products: mortgages, consumer loans, and floating-rate loans require the note holder’s consent
- Securitized product & Syndicated Loans require unanimous consent
- Bilateral business loans require both borrower and lender to agree
Table 4. Consent Approval by Product and Dollar Amount /Outstanding
Issues Specific to Consent Language
Loans use one of two approaches to their fallback consent language: Hardwired and Amendment approach.
Hardwired Approach
The Hardwired approach says when LIBOR rates are no longer offered by the market, the contract falls back to the new benchmark plus a spread adjustment.
Amendment Approach
Most loans use the “amendment” approach which requires:
- the borrower to identify a replacement rate and propose a spread adjustment.
- The lenders have 5 days to object to the proposal.
- If lenders reject the proposed rate, the loan could fall back to a Prime-based rate while the agent and borrower submit a new proposed rate.
- And so on.
The Amendment approach is flexible by requiring borrower or both borrower & lender consent. But when two counterparties are at odds, the negotiation can go on and on, disagreements happen. and this leads to poor execution and market disruption.
The Problem with the Amendment Approach
There are over 10,000 U.S. dollar LIBOR loans outstanding according to Bloomberg. If the noteholders don’t consent or the bilateral instruments can’t agree, there is a clause, but it’s not Santa. The Consent clause can force borrowers into a Prime-based rate for some time period.
- N.B.: Prime Rate is 5% versus SOFR @ 1.75% as of this writing (January 2020)
Forcing borrowers to a Prime index could impact market liquidity and uneven market availability.
- They can price the hardwired loans.
- The amendment loans will trade cheap to hardwired loans.
With 10,000 loans and $10 trillion outstanding, it seems more likely players are keeping a keen eye on the indices.
The GSE’s have approved SOFR. ISDA has approved SOFR. While the future holds the key, today it looks like SOFR it will be.
Adjusted Spread Will Be Announced Soon
Today, we have 20 months of SOFR rates published by the FRBNY. The FRBNY has been publishing indicative compound SOFR and forward-looking term SOFR for nearly a year and, as the timeline shows, the FRBNY plans to publish official compound SOFR rates in early 2020. You can view the SOFR rates published at the NY Fed here, every day.
ISDA will publish their indicative spread adjustments for LIBOR fallbacks in 1Q20. This means that, for derivatives at least, we will soon know both SOFR and the spread adjustment for contracts that fallback from LIBOR. The economics will be clear.
Administrative Loan Tasks
Re-paper the legacy loans and the new benchmark/spread language in place. New loans being made between today and December 2021 should be a SOFR-Linked asset.
So far, $250 Billion of SOFR-linked notes since October 2018. Government Sponsored Entities (GSE’s) issued much of those assets. We’ll look at this further in the next blog.
Operational & Technological Tasks
By now operations and IT groups know the amount of LIBOR linked products on their books.
Then, they need to make it operationally possible to
- Calculate cash flows and reset rates properly for SOFR-Linked Notes
- Know which assets will set in advance or arrears
- Know which assets will pay simple interest and which will pay compound interest
- Be able to price the SOFR-Linked notes in between interest payments so they can make an orderly market.
Add SOFR to Risk Reporting. Monitor spread between SOFR and Fed Funds, SOFR and LIBOR, etc. In Part Three, we cover the spread between Fed Funds and SOFR in when we discuss pricing. For now, it’s an observation–and one of the few we have. It shows SOFR versus another liquid, tradable rate.
- Liquid, yes. But overnight.
Summary & Conclusions
- LIBOR will stop being quoted regularly in less than 2 years, December 2021.
- 82% of the current outstanding products linked to LIBOR mature by the Cessation date
- If the borrower’s intention is to replace debt maturing prior to the cessation date, it’s best to have the new benchmark/spread adjustment set up. (i.e., new loan docs, a new language, and consent).
- Banks are running SOFR, Fed Funds LIBOR & Treasury rates side to side. This way they can track all the spreads and run scenarios to solve for the adjusted spread to the benchmark.
This week we sized up the LIBOR-Linked products, looked into the proposed fallback language & compared it to consent language for each product.
Next week, we’ll look at the SOFR futures market & SOFR issuance and see if an easy transition is possible.