LIBOR: The World s Biggest Number in Transition

Transcription

1 LIBOR: The World s Biggest Number in Transition Panelists: David Bowman Federal Reserve Ming Min Lee Oliver Wyman Ann Battle ISDA Meredith Coffey LSTA Jennifer Earyes Navient Mack Makode Under Armour

2 Polling Question #1 How comfortable are you with your firm s level of readiness for the LIBOR transition? [select from a scale of 1 to 10] 1) Not aware of the transition 2) Its on our Radar 3) Just getting started on planning 4) Planning, but unsure of implications 5) Fully aware of implications and plan in motion

3 Polling Results #1

4 LIBOR Developments The ARRC Second Report was published in March 2018 and contained estimates of showing that the typical daily volume of transactions underlying to 3-month USD LIBOR was about $500 million or less. Data presented by Vice Chairman Quarles recently (chart to the right) further demonstrates how few transactions there are. IBA is publicly seeking to convince banks to continue submitting past end 2021 (the date that the UK Financial Conduct Authority has persuaded banks to agree to continue submitting until). If successful, this could gain more time, but will be difficult to accomplish and also risks falsely encouraging market participants to believe that LIBOR is stable over the long-term. On July 12, Andrew Bailey noted that FCA could find that LIBOR was not representative, which under the EU Benchmark Regulations would trigger a prohibition on use of LIBOR in new debt and swap contracts by EU supervised entities (this would include LCH). Any further bank departures would make LIBOR even less representative.

5 Estimated USD LIBOR Exposures Table 1: Estimated USD LIBOR Market Footprint by Asset Class 1 At the same time, the ARRC Second Report also contained updated estimates of exposure to US dollar (USD) LIBOR. USD LIBOR is estimated to be referenced in $200 trillion worth of financial contracts (equivalent to 10 times US GDP). Most of this exposure (95 percent) is in derivatives, but USD LIBOR is also referenced in an estimated: o o o o $3.4 trillion business loans $1.8 trillion in floating rate debt $1.8 trillion in securitizations. $1.3 trillion retail mortgages and other consumer loans (private student loans) Over-the-Counter Derivatives Exchange Traded Derivatives Business Loans 2 Consumer Loans Bonds Securitizations Volume (Trillions USD) End 2021 End 2025 After 2030 Interest rate swaps 81 66% 88% 7% 5% Forward rate agreements % 100% 0% 0% Interest rate options 12 65% 68% 5% 5% Cross currency swaps 18 88% 93% 2% 0% Interest rate options 34 99% 100% 0% 0% Interest rate futures 11 99% 100% 0% 0% Syndicated loans 1.5 Nonsyndicated business loans 0.8 After % 100% 0% 0% 86% 97% 1% 0% Nonsyndicated CRE/Commercial mortgages % 94% 4% 2% Retail mortgages % 82% 7% 1% Other Consumer loans Floating/Variable Rate Notes % 93% 6% 3% Mortgage -backed Securites (incl. CMOs) Collateralized loan obligations Asset-backed securities Collateralized debt obligations Share Maturing By: 57% 81% 7% 1% 26% 72% 5% 0% 55% 78% 10% 2% % 73% 10% 2% Total USD LIBOR Exposure: % 92% 4% 2% 1 Source: Federal Reserve staff calcuations, BIS, Bloomberg, CME, DTCC, Federal Reserve Financial Accounts of the Unites States, G.19, Shared National Credit, and Y-14 data, and JPMorgan Chase. Data are gross notional exposures as of year-end The figures for syndicated and corporate business loans do not include undrawn lines. Nonsyndicated business loans exlucde CRE/commercial mortgage loans. 3 Estimated maturities based on historical pre-payment rates

6 Contractual Fallback Language The Second Report also presented the results the ARRC s research in to contract language in cash products referencing USD LIBOR. While derivatives covered by the ISDA definitions would require the calculation agent to poll an unspecified set of banks if LIBOR is not published and do not specify what contracts should pay if banks do not respond to the poll, most cash products have further fallbacks. However, in most cases they are problematic and were not intended for a permanent LIBOR stop: Floating Rate Notes Typical contract language would direct the calculation agent to first poll a sample of banks (similar to the ISDA fallback language) and then convert to fixed-rate at the last published value of LIBOR if quotes are not received. Corporate Loans Typical contract language appears to name the Prime Rate or the Effective Fed Funds Rate + a spread as the fallback if LIBOR was discontinued. Securitizations Agency MBS allow Fannie Mae and Freddie Mac to name a successor rate if LIBOR was permanently discontinued, but typical contract language in other securitizations would require a poll of banks and then convert to fixed-rate at the last published value of LIBOR if quotes are not received. Mortgages and Other Consumer Products Typical contract language in mortgages gives the noteholder the ultimate authority to name a successor rate if LIBOR was permanently discontinued, although it is unclear if the spread can be adjusted. Other consumer loans may be more varied but thus far seem to have similar flexibility.

7 LIBOR and Financial Stability in One Picture $200 Trillion of USD LIBOR-Based Contracts Priced off $500 million or less of underlying daily transactions

8 Alternative Reference Rates Committee (ARRC 2.0) The Alternative Reference Rates Committee (ARRC) was originally convened in November 2014 by the Board of Governors and Federal Reserve Bank of New York (FRBNY) and charged with: Identifying one or more alternative USD reference rates that both fit the needs of the market and meet standards of best practice. Developing plans for the voluntary adoption of these rates. Identifying best practices for contract robustness. The ARRC selected the Secured Overnight Financing Rate (SOFR), developed its Paced Transition Plan to promote use of SOFR, and worked with ISDA on contract robustness. The ARRC was then reconstituted ( ARRC 2.0 ) in March to facilitate the much wider interest in mitigating risks related to LIBOR following Andrew Bailey s July 2017 speech. ARRC Members AXA JP Morgan Chase & Co. Bank of America LCH BlackRock MetLife Citigroup Morgan Stanley CME Group National Association of Corporate Treasurers Deutsche Bank PIMCO Federal National Mortgage Association TD Bank Federal Home Loan Mortgage Corporation The Federal Home Loan Bank of New York GE Capital The Independent Community Bankers of America Goldman Sachs The Loan Syndications and Trading Association Government Finance Officers Association SIFMA HSBC Wells Fargo Intercontinental Exchange World Bank Group ISDA Ex Officio Members Board of Governors of the Federal Reserve Federal Reserve Bank of New York Bureau of Consumer Finance Protection Office of Financial Research Commodity Futures Trading Commission Office of the Comptroller of the Currency Federal Deposit Insurance Corporation Securities and Exchange Commission Federal Housing Finance Agency Treasury Department

9 ARRC 2.0 s Expanded Scope of Work The ARRC's NewWorking Group Structure ARRC (Version 2.0) Derivatives (Current ARRC Members) Cash Products Support Paced Transition Market Structure Term Rate Floating Rate Notes Business Loans/CLOs Securitizations (MBS, CMBS, ABS) Mortgages/ Consumer Loans Regulatory Issues Legal Group (includes redocumentation) Tax and Accounting Outreach ISDA Working Group SIFMA/ISDA CCPS and SEFs Official Sector ARRC Coordinates with the FSB Official Sector Steering Group and International Currency Working Groups

10 The ARRC s Paced Transition Plan is Ahead of Schedule 1. Infrastructure for futures and/or OIS trading in the new rate is put in place by ARRC members. Anticipated completion: 2018 H2 ARRC members already trading futures and OIS 2. Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR. Anticipated completion: by end 2018 CME began SOFR Futures on May 7 3. Trading begins in cleared OIS that reference SOFR in the current (EFFR) PAI and discounting environment. Anticipated completion: 2019 Q1 LCH offered SOFR OIS and basis swap clearing on July 16, CME to offer this year 4. CCPs begin allowing market participants a choice between clearing new or modified swap contracts (swaps paying floating legs benchmarked to EFFR, LIBOR, and SOFR) into the current PAI/discounting environment or one that uses SOFR for PAI and discounting. Anticipated completion: 2020 Q1 5. CCPs no longer accept new swap contracts for clearing with EFFR as PAI and discounting except for the purpose of closing out or reducing outstanding risk in legacy contracts that use EFFR as PAI and discount rate. Existing contracts using EFFR as PAI and the discount rate continue to exist in the same pool, but would roll off over time as they mature or are closed out. Anticipated completion: 2021 Q2 6. Creation of a term reference rate based on SOFR-derivatives markets once liquidity has developed sufficiently to produce a robust rate. Anticipated completion: by end of 2021 The ARRC has also released consultations on fallback language for Syndicated Loans and Floating Rate Notes, with responses due November 8, and expects to make final recommendations by the end of year.

11 Secured Overnight Financing Rate (SOFR) SOFR began production on April 3. Following a restatement of initial data in the early days of publication, the process has been smooth. SOFR continues to trade in the mid-range of other available overnight Treasury repo rates. SOFR volumes reliably remain between $700 and $800 billion on a daily basis, marking it as representing the single largest rates market at a given maturity in the world. 2.5 SOFR Relative to Other Repo and Policy Rates Billions USD 800 $754 billion Daily Volumes in U.S. Money Markets Secured Overnight Financing Rate DTCC GCF Treasury Repo Rate BNYM Median Triparty Treasury Rate IOER Rate ON RRP Rate $197 billion Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Feb-17 Aug-17 Feb Secured Overnight Financing Rate (SOFR) Overnight Bank Funding Rate $79 billion Effective Federal Funds Rate Est. $13 billion $1.1 billion $343 million $132 million 3-month T- bills 3-month GSIB wholesale funding 3-month AA nonfinancial CP 3-month A2/P2 nonfinancial CP

12 SOFR is not economically or functionally equivalent to LIBOR Nature of Rate LIBOR SOFR Currency Consistent approach for all five currencies USD only; timelines and approaches for other currencies may differ Tenor Available for 7 tenors Only overnight rates are available Approach for term rates being considered Credit premium Unsecured rate that includes term bank credit risk Secured near risk-free rate; does not include bank credit risk Source Based on survey of banks Transaction-based (repo market) Timing of publication 11am GMT across all currencies 8:00 8:30am EST (12 12:30pm GMT)

13 SOFR-LIBOR spreads vary significantly over time 3M LIBOR vs. 3M forward-compounding SOFR proxy 1 Avg. delta: 36bps Max. delta: 460bps Treasury repo rate is a component of SOFR, and is used as proxy for SOFR prior to SOFR publication in April M rate calculated based on a geometric average of the overnight rate over a 90 day period on a forward looking basis Source: Thomson Reuters, Federal Reserve Bank of New York, Oliver Wyman analysis

14 Disorderly transition (e.g. application of existing contractual language) may have real economic impact Product Loans Floating rate notes (FRN) Securitizations Derivatives Example legacy fallback Falls back to prime rate or alternative base rate, such as the Federal funds effective rate Fixed at LIBOR for previous interest period Agency Mortgage Backed Securities (MBS): Government-sponsored enterprises may be asked to name successor rate Other securitizations: Fixed at LIBOR for previous interest period Mean of rates quoted by major banks in New York City 1 Mortgages Noteholder names successor rate 2 Illustrative impact on: $200BN Corporate Loan portfolio LIBOR loans converted into ABR [prime] loans Illustrative impact: $1MM 3-yr floating rate note LIBOR FRN converted into fixed rate (based on last available rate) 1. ISDA is developing new fallback language that will be proposed as a change to definitions used for ISDA Master Agreements 2. The New Landscape, David Bowman, , bps or $5.5BN USD 3M LIBOR Jan 2007 Issued: 536 bps Jan 2003 Issued 138 bps Increase in interest payments by borrowers Jul 2007 Fallback triggered 536 bps $1MM 3-year FRN Jul 2003 Fallback triggered 111 bps Fixed: 111bps Difference in Difference Difference in total in total $54k $54k total interest interest interest payments payments 34% 34% payments Fixed: 536bps $69k $69k 60% 60% Indexed to LIBOR Fixed

15 LIBOR is deeply entrenched in a corporate s treasury function Areas with LIBOR-dependencies Key interfaces Financial Instruments Treasury Management Processes Bilateral Loans Syndicated Loans Floating rate notes Funding Management Real Estate Derivatives Loans Surplus Management (Investments) Risk Management (e.g. Currency and Interest Rates) Cash and Working Capital Management Financial contracts Intracompany agreements Investment policies Agreements Terms & Conditions Banks Investors Rating Agencies Affiliates Customers / Suppliers Treasury Infrastructure (integrated / standalone) Treasury Management System / Enterprise Resource Planning System Trading Platform Cashflow Forecasting Tool Risk Management System Hedge Accounting Payments System Service Agreements Vendors

16 Polling Question #2 Which, if any, products and processes in your organization use LIBOR? [select all that applies] 1) Derivatives 2) Syndicated loans 3) Bilateral loans and/or credit facilities 4) Intra-company transactions 5) Issued floating rate notes 6) Benchmark for deposits 7) Fair value valuations 8) I do not use LIBOR in any way

17 Polling Results #3

18 IBOR Fallbacks: ISDA s Work Form of Amendments. To account for any permanent discontinuation of relevant IBORs, amendments to the floating rate options in Section 7.1 of the 2006 ISDA Definitions for any such IBORs will take the form of: a statement identifying the objective triggers that would activate the selected fallbacks; and a description of the fallback that would apply upon the occurrence of that trigger, which will be the relevant RFR adjusted using methodologies to account for (i) the fact that the RFR is an overnight rate and (ii) the various premia included within the IBOR. ISDA conducted a marketwide consultation to determine the methodology for calculating the adjustment described in the second bullet above. Responses are currently under review. ISDA will also publish a protocol to facilitate inclusion of the amended definitions (i.e., the definitions with fallbacks) into existing derivatives contracts (as amendments to the 2006 ISDA Definitions apply to transactions entered into on or after the date of such amendments only).

19 IBOR Fallbacks: Looking Forward Later : Supplemental consultations on the term and spread adjustments for USD LIBOR, EUR LIBOR, EURIBOR and HIBOR. Exact timing is uncertain and contingent on sufficient trading developing in the fallback rates (i.e., SOFR for USD LIBOR, HONIA for HIBOR and the rate ultimately selected by the EUR RFR Working Group for EUR LIBOR and EURIBOR). ISDA and the FSB OSSG to discuss potential implementation of fallbacks for other benchmarks. 2019: Fallbacks for GBP LIBOR, JPY LIBOR, JPY TIBOR, Euroyen TIBOR, CHF LIBOR and BBSW expected to be implemented in 2006 ISDA Definitions and expected launch of protocol to include the amended definitions in existing derivatives contracts (exact timing contingent on time required for a vendor build and for legal and regulatory approvals) Onward: Fallbacks for USD LIBOR, EUR LIBOR, EURIBOR, HIBOR and other benchmarks (TBD) expected to be implemented in 2006 ISDA Definitions and expected launch of protocol to include the amended definitions into existing derivatives contracts.

20 IBOR Fallbacks: Looking Forward Key Next Steps for Implementation of fallbacks for GBP LIBOR, JPY LIBOR, JPY TIBOR, Euroyen TIBOR, CHF LIBOR and BBSW Review and analysis of responses to consultation on spread and term adjustments hope to complete by end of 2018 RFP process for vendors interested in publishing adjustments Review and comment period on approach(es) to be implemented Vendor build Drafting of amendments to the 2006 ISDA Definitions and protocol to include the amended definitions in existing transactions Public sector/regulatory reviews Publication of amendments to the 2006 ISDA Definitions and protocol expected second half of 2019

21 Polling Question #3 For which purposes, if any, does your company use LIBOR-based derivatives: (check all that apply) 1) Fair value hedge 2) Cash flow hedge 3) Currency risk hedge 4) Hedge loans through interest rate swaps

22 Polling Results #3

23 US Syndicated Loans LIBOR Fallback Consultation What is LIBOR Fallback language? Legal drafting in credit agreements that details the steps taken to replace LIBOR if it ceased or was deemed to no longer be an appropriate reference rate. It answers the question If LIBOR ceased tomorrow, to what rate would my loan fall back? What are the four components of LIBOR fallback language for syndicated loans? Trigger What event precipitates a transition from LIBOR to the new reference rate? (An example of a trigger is LIBOR being discontinued.) Replacement Reference Rate What is the new reference rate for the loan? (For LIBOR-based loans, the new reference rate may well be SOFR.) Spread Adjustment Because LIBOR and SOFR are different rates, there may need to be a spread adjustment to make them more comparable. What is the mechanism to determine that rate? Amendment Process Some variants of fallback language require amendments. What are the ARRC s two proposals for loan fallbacks? An Amendment approach that is similar to the fallback language that has been introduced in syndicated loan agreements in the past year. A Hardwired approach that anticipates the transition from LIBOR and sets all the terms for that transition at the origination of the credit agreement (thus avoiding the need for an amendment).

24 Syndicated Loans Consultation - Amendment Approach Largely follows the fallback language that has developed in the syndicated loan market About 69% of 2018 syndicated loans use a structure where the Borrower and Administrative Agent select a rate with Required Lenders having an objection right (Xtract, September 2018) What are the elements? Triggers Mandatory triggers around LIBOR cessation, unannounced stop to LIBOR, change in quality of LIBOR, regulatory announcement that LIBOR is no longer fit for purpose Opt-in trigger if loans are being done with a new reference rate Replacement Reference Rate Alternate benchmark rate agreed between Borrower and Administrative Agent, considering term SOFR and spread adjustments Spread adjustment Agreed to between Borrower and Administrative Agent, considering market convention and recommendation by ARRC or the Fed Amendment language Required Lenders get objection rights for mandatory triggers

25 Syndicated Loans Consultation Hardwired Approach Hardwires all decisionmaking about fallbacks at origination of credit agreement What are the elements? Triggers Mandatory triggers around LIBOR cessation, unannounced stop to LIBOR, change in quality of LIBOR, regulatory announcement that LIBOR is no longer fit for purpose Opt-in trigger if loans are being done with SOFR plus spread adjustment Replacement Reference Rate A waterfall of rates that moves from most similar to LIBOR to least similar to LIBOR Step 1: Forward looking Term SOFR; if that doesn t exist, go to Step 2: Compounded SOFR; if that doesn t exist, go to Step 3: Overnight SOFR Spread adjustment A waterfall of spread adjustments The LIBOR-SOFR spread adjustment selected, endorsed or recommended by the Relevant Governmental Body (i.e. ARRC or the Fed); if not available, go to The LIBOR-SOFR spread adjustment selected by ISDA Amendment language If either the rate or spread adjustments do not exist, the Hardwired approach flips to an Amendment approach

26 Weighing the Fallback Proposals There are pros and cons to each approach Amendment Approach Terms are not predetermined so may require many loans to be amended in short amount of time; may be challenging to execute across market quickly Does not rely on terms that do not currently exist (like forward looking Term SOFR) Either borrower or lender might be winner or loser depending on when in the credit cycle transition occurs Similar to what the loan market has already developed / is familiar with Leverages loans unique amendment flexibility Hardwired Approach Avoids amendments (in most cases); should be able to be executed in short period of time Some rates do not exist, but are expected to exist by transition Less susceptible to gamesmanship because terms are determined at origination Inclusion will be a bigger change to current practice More closely aligned with other cash products

27 Polling Question #4 What is most important to you in the structuring of products based on new rates? (select one) 1) Visibility into cash flows 2) Having a variety of tenors 3) Ability to hedge rates 4) Having a transparent/robust benchmark

28 Polling Results #4

29 5 Actions to Take Now 1. Take Inventory Understand where LIBOR exists within your organization. 2. Do Your Homework Educate yourself about SOFR and its behavior relative to LIBOR. 3. Assess the Impacts Assess firm-wide exposure to understand the impacts & challenges. 4. Get Fallback Language Your LIBOR contracts need to address replacement rates. 5. Get Involved Get feedback from your fellow AFP members & check out the ARRC website.

30 Taking Inventory & Assessing Impacts There are several risks that need to be managed during the transition. Business Operations Contracts Reputation New Product Readiness Business Processes Understand Legal Obligations Readiness to Transition Hedging Data & Technology Requirements Implement Fallback Language in New Contracts Communication with Clients / Customers / Investors Pricing & Cost of Funds Accounting Models & Financial Reporting Amend Existing Contracts Advocacy / Industry Engagement

31 Polling Question #5 How comfortable are you with your level of readiness for the LIBOR transition? (on a scale of 1 to 5) 1) I still don t believe it will happen 2) It will happen, but won t be concerned until ) I will start preparing for it now 4) I have started, but continue to review 5) I have it under control

32 Polling Results #5

33 For More Information Ann Battle, Assistant General Counsel ISDA David Bowman Assistant Director Federal Reserve Board Tom Hunt, CTP Director Treasury Services AFP Ming Min Lee Partner Oliver Wyman Meredith Coffey EVP Research and Regulation LSTA