Phase-Out of LIBOR: Impact on Floating Rate Loans and Derivatives; Implementing Alternative Reference Rates

Transcription

1 Presenting a 90-minute encore presentation featuring live Q&A Phase-Out of LIBOR: Impact on Floating Rate Loans and Derivatives; Implementing Alternative Reference Rates WEDNESDAY, JANUARY 3, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Cheryl I. Aaron, Senior Counsel, Michael Best & Friedrich, Washington, D.C. Mark Heimendinger, Of Counsel, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla. James S. Toscano, Shareholder, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 LOCAL ROOTS. BROAD REACH. SM Phase-Out of LIBOR Mark E. Heimendinger Lowndes, Drosdick, Doster, Kantor & Reed, P.A All rights reserved. Lowndes, Drosdick, Doster, Kantor & Reed, P.A.

6 Phase-Out of LIBOR Mark E. Heimendinger Lowndes, Drosdick, Doster, Kantor & Reed, P.A. LOCAL ROOTS. BROAD REACH. SM 2017 All rights reserved. Lowndes, Drosdick, Doster, Kantor & Reed, P.A.

7 Reasons for the Phase-out - Background LIBOR rate fixing scandal Wheatley Review published September ICE Benchmark Administration took over administration of LIBOR February 2014 Alternative Reference Rates Committee convened November 2014 ICE Benchmark Administration LIBOR Roadmap published March Secured Overnight Financing Rate (SOFR) chosen by ARRC to replace LIBOR Andrew Bailey announcement July

8 Reasons for the Phase-out Current Official Views While no one is mandating an end to LIBOR, it may simply not exist after the end of 2021 IOSCO Principles for Financial Benchmarks 4 Desire for a truly transactions-based reference rate 5 Need for a reference rate that encompasses a robust market Desire for an overnight, nearly risk-free rate that is highly correlated with other money market rates Why overnight? There currently is not enough date to produce a robust term rate Desire for a rate that covers multiple money market segments that allows for future evolution 8

9 Reasons for the Phase-out Dissenting Views? Conflict between creating the perfect reference rate vs. good enough Currently around $160 trillion in transactions quoted in U.S. dollar LIBOR with approximately 90% of that made up by derivatives 6 Jeffrey Sprecher of ICE stated in October that LIBOR will be difficult to replace and SOFR doesn t address term rates 7 CME chief executive Terry Duffy has said he expects LIBOR to continue to be used alongside the new rates after Nearly 80% of the 164 respondents to a recent Bank of America Merrill Lynch survey released in October believe that LIBOR should continue 9 9

10 Timeline - Paced Transition Plan 10 Infrastructure for futures and/or Overnight Index Swaps (OIS) trading in the new rate is put into place by ARRC members (2 nd half of 2018) Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR (end of 2018) Trading begins in cleared OIS that reference SOFR in the current Effective Federal Funds Rate (EFFR) Price Alignment Interest (PAI) and discounting environment (end of 2018) CCPs begin allowing market participants a choice between clearing in new or modified swap contracts (swaps benchmarked to EFFR, LIBOR and SOFR) into current PAI and discounting environment or one that uses SOFR for PAI and discounting (1 st quarter 2020) 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. Existing legacy contracts continue to exist but roll off as they hit maturity (2 nd quarter 2020) Creation of a term reference rate based on SOFR derivatives markets once liquidity has developed sufficiently to produce a robust rate (end of 2021) 10

11 Impact on Commercial Lending Paced Transition Plan focuses on derivatives SOFR is solely an overnight rate and no replacement is anticipated until the end of 2021 Legacy fallback language contemplates a temporary unavailability of LIBOR not a permanent replacement While ISDA is taking a leading role in derivatives and is working to make sure its rate works with term products, the market participants must recognize the need to act 11

12 Impact on Commercial Lending Current fallback language is not adequate Base rate loans often more expensive than LIBOR Need for polling of reference banks Problem of value transfers (the choice of alternative rate not adequate without a spread change in light of difference between LIBOR and a risk-free rate such as SOFR) Some provide for conversion to fixed rate based on last quoted LIBOR rate if polling rates not received Wait and see or act now? If you wait until the end of 2021 it may be too late. ARRC s term reference rate is not anticipated to be available until the end of 2021 ARRC is leaving this to the market no current legislative or global fix available What will the lending market be like in 2021? 12

13 Impact on Commercial Lending Review your legacy contracts Identify LIBOR-based loans with terms that extend beyond 2021 or with extension options that extend beyond 2021 Calculate exposure to this issue Identify any securitized loans first. These may not be possible to amend Review language and anticipate problems now Defeasance? Identify any loans with multiple lenders. These will take time to negotiate. Is the agent authorized to make changes or will changes require 100% lender approval? Contact and begin speaking with lenders/borrowers? 13

14 Impact on Commercial Lending Need new fallback language that is flexible enough to anticipate a new (as yet unidentified) term reference rate Clear trigger for use of replacement Flexible enough to generally identify a new accepted benchmark rate but specific enough to allow for mechanical application to allow for securitization and avoid disputes Anticipates the difference in magnitude between LIBOR and new reference rate Avoids value transfer Minimizes market disruption Is not subject to manipulation 14

15 Impact on Commercial Lending In the event that Lender determines that LIBOR cannot be determined or is no longer offered and provides notice thereof at least one business day before the interest determination date with respect to the loan interest accrual period, then, commencing with the first day of such loan interest accrual period, the interest rate will be converted to an interest rate based on the Prime Rate plus an Alternative Rate Spread. If, prior to a conversion to an interest rate based on the Prime Rate as described above, Lender has determined in its sole but good faith discretion that LIBOR has been succeeded by another floating rate index that is has an accrual period that is consistent with the loan interest accrual period, is commonly accepted by market participants in CMBS loans, has been recognized by ISDA for hedging products, and which has begun to be regularly quoted by a recognized reporting service (the Alternate Index Rate ), and Lender provides notice thereof at least one day before the interest determination date with respect to the loan interest accrual period, then, commencing with the first day of such loan interest accrual period, the interest rate will be converted to an interest rate based on the Alternate Index Rate plus an Alternative Rate Spread. Alternative Rate Spread shall mean the difference (expressed as the number of basis points) between (a) the interest rate determined in respect of the loan interest accrual period for which LIBOR was last applicable to the Loan, and (b) the Alternative Index Rate on such date. - Issues with taking a snapshot in time of LIBOR and the Alternative Reference Rate - Subject to manipulation by large participants? - Lack of perfect correlation between LIBOR and the Alternative Reference Rate likely to lead to mispricing - Perhaps focus on a stated number of multiple data points or historical average over a stated period 15

16 Impact on Securitized and Packaged Consumer Loans Approximately $1.8 trillion in outstanding securitizations that reference U.S. dollar LIBOR. 7 Typical LIBOR provision gives the lender/noteholder direct authority to pick an alternative reference rate if LIBOR becomes unavailable. Fannie mortgages, for example, simply require a comparable rate. These provisions almost universally simply call for the replacement rate and do not anticipate a change to the spread. Cannot negotiate with millions of (consumer) borrowers and, even if you could, legacy servicing and trust agreements do not accommodate this issue. As it stands, ARRC has not proposed a solution. Will the GSEs and regulators act? 16

17 End Notes 1 _libor_finalreport_ pdf see also

18 Questions? Mark E. Heimendinger Of Counsel Lowndes, Drosdick, Doster, Kantor & Reed, P.A Orlando, FL LOCAL ROOTS. BROAD REACH. SM 18

19 Phase-Out of LIBOR Cheryl I. Aaron

20 LIBOR in Derivatives Contracts LIBOR is used as a reference rate in $160 trillion (notional) of derivatives contracts In many interest rate swaps, counterparties rely on a LIBOR-based rate to hedge against the floating rate risk in a loan or credit facility The vast majority of swaps and other types of derivative products incorporate the terms of the International Swaps and Derivatives Association ( ISDA ) Master Agreement As written, the LIBOR replacement language in the ISDA Master Agreement is insufficient The 2006 ISDA Definitions create a fallback where LIBOR is unavailable, in which case the Calculation Agent can collect alternate rates from other major banks and use the arithmetic mean to determine the replacement michaelbest.com 20

21 LIBOR in Derivatives what to do now? First Step: portfolio review Examine your company s derivatives portfolio (ideally as part of a review of all financial contracts), and determine which contracts reference LIBOR Second Step: divide derivatives into 3 categories 1. Already-executed transactions that expire by the end of 2021 No need to act counterparties can rely on LIBOR 2. Already-executed transactions that expire after 2021 Amend, incorporate appropriate fallback terms, allocate associated risks/losses, and align with related loan fallback terms (as applicable) 3. Transactions that have not yet been executed Incorporate appropriate fallback terms, align with related loan fallback terms (as applicable); potentially choose alternative reference rate michaelbest.com 21

22 LIBOR Replacement Terms LIBOR fallback language in credit facilities and other financial contracts should: - Select a specific replacement rate OR (i) clearly delineate which party or parties will choose the replacement rate, and (ii) set any other parameters for the rate - Account for all scenarios in which LIBOR may go away (e.g., become unavailable, no longer be published, be unlawful to rely upon see ISDA triggers) - Set a date on which the replacement rate will go into effect under the contract - Allocate any costs / risks associated with relying on the replacement rate in lieu of LIBOR - Create termination rights and payment obligations (if no replacement rate) michaelbest.com 22

23 The ISDA Solution ISDA is in the process of creating a universal LIBOR transition solution for derivatives and other financial contracts At present, ISDA is: 1. Developing a roadmap for the transition (expected December 2017) 2. Drafting a report that will include the results of a market survey on the use of LIBOR, will identify potential transition issues for existing and new contracts, and will make recommendations for possible solutions (expected March 2018) Going forward, ISDA expects to: 1. Develop strategies related to term structures for the LIBOR replacement rate and the credit spread that will arise 2. Amend the 2006 ISDA Definitions to incorporate the fallback terms 3. Create a Protocol to incorporate the fallbacks into already-executed transactions michaelbest.com 23

24 The ISDA Solution ISDA has identified the following triggers for use of its fallback language: 1. A public statement by the ICE Benchmark Administration of its insolvency, with no successor administrator 2. A public statement by the ICE Benchmark Administration that it will cease publishing USD LIBOR permanently or indefinitely, and there is no successor administrator to continue publication 3. A public statement by the UK Financial Conduct Authority that USD LIBOR has been permanently or indefinitely discontinued 4. A public statement by the UK Financial Conduct Authority that USD LIBOR may no longer be used The trigger timing is upon cessation of USD LIBOR, not at the time of the announcement michaelbest.com 24

25 The ISDA Solution Worth the Wait? Should derivative counterparties begin negotiating / amending their ISDA Master Agreements now? Or wait until an ISDA protocol is available? - Either approach is acceptable, but the ISDA solution will likely be the most streamlined and universally-adopted - Regardless of methodology, interest rate derivatives that hedge the floating rate risk in a related credit facility must align fallback terms with the credit facility Should derivative counterparties wait until the alternative reference rate is available before amending / updating contract terms? Or choose a new rate in the meantime? - There is no need to wait for the new benchmark to be published and adopted prior to amending derivative contract terms the parties can insert fallback terms with objective standards for when and how to pick a new rate - It is not necessary to choose a new rate prior to the adoption of SOFR (discussed below), though some parties may desire the economic certainty of a set replacement rate michaelbest.com 25

26 Choosing an Alternative Reference Rate What makes a good financial benchmark? - Integrity and continuity. The benchmark should be based on an underlying market with sufficient liquidity, transaction volume and resilience - Soundness and robustness. The benchmark should have standardized terms, transparent data, and readily available historical data (IOSCO Principles) - Accountability. The benchmark should have evidence of a process that ensures compliance with the IOSCO Principles - Governance. The benchmark should have governance structures that promote its integrity - Ease of implementation. The benchmark should allow for relative ease in transitioning to the new rate, including an assessment of the anticipated demand for hedging and trading, and the potential for a term market in the underlying rate michaelbest.com 26

27 The Alternative Reference Rate Committee In 2014, FSOC recommended that U.S. regulators identify an alternative to USD LIBOR, based on perceived shortcomings Later that year, the Federal Reserve Board convened the Alternative Reference Rates Committee (ARRC) to identify a new financial benchmark that: - is based on actual transactions - aligns with the IOSCO Principles for Financial Benchmarks The ARRC is a public-private partnership, comprising representatives of the Federal Reserve, Federal Reserve Bank of NY, and various banks In June 2017, after considering six potential replacement rates, the ARRC selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR michaelbest.com 27

28 Secured Overnight Financing Rate (SOFR) What is SOFR? - Includes overnight, Treasury-backed repo transactions - All transactions take place in BNY s triparty repurchase system or are cleared on one of two Fixed Income Clearing Corporation platforms - Will be published daily at 8:30am ET based on prior day s trading activity The Federal Reserve requested public comment on its proposal to compute SOFR in August 2017 (the comment period ended on Oct. 30 th ) The Federal Reserve Bank of New York, along with the Office of Financial Research, expect to begin publishing SOFR in 2Q 2018 michaelbest.com 28

29 LIBOR vs. SOFR LIBOR is: - An index that reflects the interest rates at which banks borrow from one another overnight on an uncollateralized basis - Calculated daily in 5 currencies (USD, EUR, GBP, JPY, CHF) and for maturities ranging from overnight to 1 year - Formulated from pricing contributions by 17 panel banks (using expert judgment rather than transaction data) SOFR is: - An index that that is nearly risk-free, reflecting a broad measure of overnight U.S. Treasury repurchase ( repo ) financing transactions - Calculated based on transaction data (no subjective input) - Solely a replacement for USD LIBOR - Based on collateralized transactions in a liquid market (with about $660 billion in daily transactions) michaelbest.com 29

30 Other LIBOR Alternatives United Kingdom: The Sterling Overnight Index Average (SONIA) will replace GBP LIBOR - SONIA is administered by the Bank of England, and is based on actual transactions in the UK overnight unsecured market Japan: The Tokyo Overnight Average Rate (TONAR) will replace JPY LIBOR, JPY TIBOR and Euroyen TIBOR - TONAR is calculated and published by the Bank of Japan, and is based on actual transactions in the Tokyo overnight unsecured market Switzerland: The Swiss Average Rate Overnight (SARON) will replace CHF LIBOR - SARON is administered by the Swiss National Bank, and is a secured overnight interest rate average based on the Swiss France interbank market EU: The replacement rate for EU LIBOR and Euribor has not yet been determined michaelbest.com 30

31 The Future of Benchmarks in Derivatives Despite references to the end, demise phaseout, etc. of LIBOR, the benchmark may very well continue to exist past The UK Financial Conduct Authority did not create a requirement for ICE Benchmark Administration to stop publishing LIBOR - Instead, it will no longer compel the LIBOR panel banks to submit pricing data to the publisher after 2021 Regardless, LIBOR is no longer the reliable benchmark that it once was, and derivatives counterparties should not plan on using it past 2021 Derivatives market participants should expect the transition from LIBOR to be a massive undertaking, but with advance planning and a thorough understanding of the new reference rate, the shift may be a smooth one michaelbest.com 31

32 Thank You Cheryl I. Aaron Senior Counsel Michael Best & Friedrich, LLP michaelbest.com 32

33 The Demise of LIBOR: A Litigation Perspective James S. Toscano

34 I. Assumption is that LIBOR goes away * Given how LIBOR is determined, if the process for establishing it no longer exists, there is no objective way to calculate what LIBOR would be going forward for purposes of comparison 34

35 II. CONTRACT LAW GOVERNS Loan Credit Agreements Adjustable Rate Mortgages Home Equity Lines of Credit Auto Loans Student Loans Credit Cards 35

36 III. HOW DO CONTRACTS ADDRESS CHANGES IN LIBOR? Sampling of Provisions: Successor Provisions: LIBOR continues, but under some authority other than the ICE Benchmark Administration or is published in a different way. Provisions allowing some unilateral flexibility yet still tied to LIBOR: Allows one party some flexibility to select among LIBOR averages and indecies or to select some rate still tied in some way to the underlying LIBOR rate. Reference Bank Provisions: Provides that a specific interest rate offer from a specified private bank or the average of rates offered by several identified banks would be the replacement rate for the LIBOR rate if LIBOR is unavailable. Unilateral Selection: The creditor party is allowed unilaterally to select a comparable replacement if LIBOR is no longer available. 36

37 IV. SPECIFIC LANGUAGE FROM FORM ADJUSTABLE RATE RESIDENTIAL MORTGAGES (FANNIE MAE) If the index (a function of LIBOR) is no longer available, the Note Holder will choose a new index that is based upon comparable information. The Note Holder will give me notice of this choice. 37

38 V. WHAT IS COMPARABLE INFORMATION? Vague and Ambiguous? Interpreted Against the Drafter/Note Holder? Essential Term? Meeting of the Minds? 38

39 VI. LEVERAGE/BALANCE OF POWER Should have less of an impact on Senior Loan Market better able to monitor situation and negotiate resolution. Some Commercial Credit Agreements have fallback language that allows the Issuer to choose other indices such as the Prime Rate, Federal Funds Rate or the Treasury Repo Rate temporary fix. Those on more equal footing are more likely to work it out/be able to protect their interests. 39

40 VII. WHAT ABOUT THE INDIVIDUAL BORROWER BOUND BY UNILATERAL SELECTION PROVISION? Unlikely replacements: 1 year Treasury Index/Monthly Treasury Average Certificate of Deposit Index Constant Maturity Treasury 40

41 VIII. POTENTIAL NEW BENCH MARK Alternative Reference Rates Committee Fannie Mae and Freddie Mac 41

42 IX. WHAT TO DO? 42

43 Thank You James S. Toscano Lowndes Drosdick Doster Kantor & Reed 43