LIBOR and the Loan Market

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Jeremy Moody
6 years ago
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1 LIBOR and the Loan Market Moderator: Panelists: Ellen Hefferan, Executive Vice President of Operations and Accounting LSTA Diane Carleton, Credit Services Executive, Senior Vice President - Bank of America Merrill Lynch Meredith Coffey, Executive Vice President of Research and Regulation - LSTA Jeanne Naughton-Carr, Managing Director and Senior Managing Counsel BNY Mellon LSTA Operations Conference April 24, 2018

2 LIBOR Transition What s the Problem? What s the Proposed Solution (SOFR) What are the Problems with the Proposed Solution Ways to Tackle the Problems 2

3 The Fundamental LIBOR Problem in Words Over $200 trillion of financial contracts are tied to LIBOR LIBOR is increasingly fragile, banks do not want to submit LIBOR quotes, and LIBOR potentially will cease after YE2021 So Does there need to be a replacement rate? must assume that there will be What should it be? highest probability is SOFR What are some of the issues? SOFR (overnight, secured) is very different from LIBOR (term, unsecured) How do we get there? A lot of phased work What is our timeframe? End of 2021 for everything completed How do we operationalize all this? TBD 3

4 The Fundamental LIBOR Problem in Pictures $200 TRILLION OF LIBOR BASED CONTRACTS There is massive reliance on a small, fragile and potentially shrinking base rate Priced off $500 million of daily Interbank (LIBOR) trading 4

5 What Might Replace LIBOR? Potentially SOFR $754 SOFR SOFR Daily Trading Around $750 Billion Daily LIBOR Transaction Volume Around $500 Million $197 O/N Bank Funding $79 Effect. Fed Funds $13 $0.50 $0.34 $ mo T- Bill 3-mo LIBOR 3-mo AA CP 3-mo A2/P2 CP Many asset classes rely on LIBOR, with combined exposure of $200 trillion-plus ($4 trillion for syndicated loans) There is little trading in the inter-bank funding (LIBOR) market like $500M daily in 3M LIBOR Globally, policymakers and markets have looked for IBOR replacements All rates identified are overnight rates, because that is where actual transactions are Sterling Sonia Euro Eonia (maybe) Yen TONAR CHF SARON US has selected SOFR for US$ Swaps A combination of 3 Treasury repo rates Very deep, very liquid But very different from LIBOR Source: ARCC, LSTA 5

6 Comparison of LIBOR and SOFR LIBOR Unsecured Reflects bank cost of funds(ish) Widens to reflect COF in stress periods Term structure Established and well understood Not liquid, deep, transparent $500 million of daily trading Easily manipulated In millions of long-dated contracts SOFR Secured Risk-free rate Will not widen in periods of credit stress Overnight (to begin) New and not well understood Will be liquid and deep Over $700 billion of daily trading Will not be easily manipulated Not in contracts yet 6

7 SOFR Should be Lower than LIBOR, But Mo LIBOR vs 3-Mo Compounded Secured Overnight Funding Rate 7 LIBOR vs. OIS Bps LIBOR SOFR % M LIBOR 3M OIS Nov-14 Mar-15 Aug-15 Dec-15 Apr-16 Aug-16 Source: FRBNY, St Louis Fed Jan-17 0 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Source; ARRC Based on historical data calculated by FRBNY, 3M SOFR should be modestly lower than 3M LIBOR However, in periods of credit stress, LIBOR gaps out and bank COF widens while SOFR is flat or may decline 7

8 Actual Initial SOFR Behavior Early Days: O/N SOFR vs. O/N LIBOR O/N LIBOR O/N SOFR (published) O/N SOFR (revised) 1.75 Rate (%) Apr 3-Apr 4-Apr 5-Apr 6-Apr 7-Apr 8-Apr 9-Apr 10-Apr11-Apr12-Apr13-Apr14-Apr15-Apr16-Apr17-Apr SOFR publication began April 3, 2018 SOFR was volatile around quarter-end (like many repo rates) SOFR has since been more stable, but is above O/N LIBOR *There was a slight snafu in early publishing, which created a 1-2 bps differential in several days* Source: FRBNY, WSJ 8

9 What Do We Need to Do to Prepare for Transition (Across Asset Classes) The ARRC is focused and working hard on fixes! The ARRC (Alternative Reference Rates Committee) was launched in 2014, focusing on developing a replacement rate for derivatives (which was seen as the biggest systemic risk) In 2017, it identified SOFR as the swaps replacement rate In 2018, it reconstituted itself to also focus on cash markets (syndicated loans, FRNs, mortgages, consumer loans, securitizations, CLOs, etc.) The LSTA is a member of the ARRC and co-chairs the CLO and Business Loans Working Group There is concerted effort to develop solutions that work across asset classes 9

10 What Do We Need to Do to Prepare for Transition (For Loans) Developing robust (and improving) fallback language Better amendment language Hardwired fallbacks? Developing a term structure SOFR is overnight only now LIBOR has a term structure; participants say they need 1-month, 3-month terms Developing a credit spread adjustment SOFR should be lower than LIBOR Should SOFR have a Credit Spread Adjustment (CSA)? If so, should it be Static (e.g., calculated once?) Dynamic (e.g., recalculated as bank credit risk changes?) Operationalize all this! Do it before the end of 2021!! 10 10

11 Polling Question #1 Has your institution begun to discuss operational concerns regarding the upcoming transition of LIBOR to another rate? A. Yes, we are so immersed in these discussions that I now dream about SOFR B. Yes, we are now beginning to have the conversation C. No, we haven t begun to discuss this D. SOFR, so what?... 11

12 Case Study # 1: Lending /Servicing Today and in 2022 TODAY To Establish a loan contract: LIBOR + Margin LIBOR is an unsecured rate and incorporates a bank cost of funds concept Use the LIBO Rate that is set two (2) Business Days prior to the commencement of the new contract. Margin set forth in the Credit Agreement LIBO Rate London Interbank Offered Rate for deposits in applicable currency is set by the ICE Benchmark Administration and published by ICE at approximately 11:00 am London time on such day (or EARLIER..) To establish a loan contract: SOFR (secured risk-free rate) +/- Credit Spread Adjustment (to reflect bank cost of funds ) + Margin Establish where and when SOFR rates and applicable Credit Spread Adjustments will be published E.g. Published on page on Thomson Reuters screen same day/one day prior to the beginning of the new contract at 11:00 AM ET. Complication will spread be dynamic or static? Or will spread be added to or subtracted from the margin by each bank? Either create separate fields within all systems that will utilize this rate and spread or one field that will incorporate both SOFR and the Credit Spread Adjustment. Fields will be needed for overnight as well as term rate (e.g. 30 and/or 90 day). System must be flexible enough to accommodate multiple term rates. Build feeds from provider in order to populate the rates and spreads systemically on a daily basis. This cannot be a manual process. Margin is established in the Credit Agreement Expect to have LIBOR and SOFR as dual options for a period of time. Revise credit documentation to reflect SOFR and Credit Spread Adjustments. 12

13 Case Study # 2: Multi-Currency Facilities Today and in 2022 TODAY 2022 (or EARLIER..) just got complicated LIBOR is published for five different currencies: US Dollar Euro British Pound Sterling Japanese Yen Swiss Franc Maturity Lengths (Terms) US SOFR (secured risk-free rate) +/- Credit Spread Adjustment EURO Eonia (unsecured rate) +/- Credit Spread Adjustment? Pound Sterling Sonia (unsecured rate) +/- Credit Spread Adjustment? Japanese Yen (TONAR?) (unsecured rate) +/- Credit Spread Adjustment? Swiss Franc SARON (secured risk-free rate) +/- Credit Spread Adjustment? Establish when and where currency rates will be available/published (realistically will be published at different times and places) 2 days prior, 1 day prior, day of (may vary among rates) Process all separately Build feeds from provider(s) in order to populate the rates systemically on a daily basis. This cannot be a manual process. Expect to have LIBOR and alternate currency rates available during the transition period Revise credit documentation to reflect the additional rates, rate settling and optionality within the rates. 13

14 Case Study # 3: Settlement Today and in 2022 TODAY Funding Memo includes: Current contract details (LIBOR + Margin) on existing Borrowings Purchase Price: Delayed Comp calculations Buyer pays the interest accrued during the Delay Period at the Average LIBO Rate (cost of carry) Seller pays interest and accruing fees allocable to the Delay Period (case study #1) Average LIBO Rate means for the Delay Period (i) the sum of all the individual LIBO Rates for each day in the period from (and including) the date two (2) Business Days before the Commencement Date and to (but excluding) the date that is two (2) business Days before the Delayed Settlement Date (ii) divided by the total number of days in the period. averagelibor.com is a website established as a service to the loan trading market to calculate the average London Interbank Offered Rate (LIBOR) for a given period of time (or EARLIER..) just got complicated Operations will calculate the delayed compensation based on the new rates Because the cost of carry will include SOFR +/- Credit Spread Adjustment but NOT the margin it will be necessary to have 3 separate fields. There will be a need for platform(s) to calculate Average SOFR +/- Credit Spread Adjustment and the Average Rates for each of the additional currencies +/- Credit Spread Adjustments, as applicable, in order to account for the Cost of Carry element. 14

15 Polling Question #2 What can you do? A. Bring an awareness of the LIBOR transition to your operational team B. Speak with your treasury / custodian to see if they are aware of issues that need to be addressed C. Ask your accountants and tax colleagues to join the LSTA LIBOR accounting and tax working group D. All of the above 15

16 It is Possible that LIBOR Won t End Shortly After End 2021 But You Have to Take Action As If Is! 16

2021: A Benchmark Odyssey

2021: A Benchmark Odyssey January 2018 Andrew Bailey announced the FCA s intention to withdraw its support for LIBOR last July. In November it was confirmed that the banks participating in LIBOR have agreed