The London Interbank Offered Rate (LIBOR), which was created on August 15, 1969, will cease to exist after 2021. This action comes as a result of international investigations revealing efforts by some banks and traders to unfairly manipulate LIBOR. Currently, LIBOR is the relied-upon interest rate for approximately $350 trillion in outstanding financial arrangements around the world. In view of the large outstanding amount of obligations based on LIBOR and its rapidly approaching end, banks and other financial institutions in the United States and around the world are trying to develop an alternative.
At the moment, there is no easy corresponding index for LIBOR. One proposed US index is the secured overnight financing rate (SOFR), which is a daily rate. While SOFR could be adapted to the one-, three-, or six-month LIBOR time periods, it does not easily lend itself to those time periods presently. While SOFR is a market rate actually used for borrowing, unlike the situation with LIBOR––which ostensibly was the offered rates between banks––it can have more volatility than LIBOR at different time periods.
As opposed to LIBOR’s unsecured lending rate, SOFR is a rate secured by the US Treasury securities. As such, using SOFR will generally provide a lower interest rate, creating an issue for existing transactions if the same interest-rate spread margin applicable to LIBOR in an instrument is also applied to SOFR. To attempt to equalize the indices, this requires an upward adjustment known as the replacement benchmark spread to ensure comparable rates. However, creating an easy uniform market method or formula required to make the rates comparable has proved cumbersome.
Presently, the most important issue to address involves amending all existing contracts dependent on LIBOR with a maturity date after 2021. If contracts using LIBOR as the applicable rate are not amended and LIBOR no longer exists, those contracts will need a new interest-rate formula to be applied to those obligations. Although some contracts contain provisions for an alternative rate such as the prime rate or another type of base rate when LIBOR is unavailable, these alternative rates were meant for temporary reliance until LIBOR became available. If LIBOR ceases to be reported, existing language may not cover this situation neatly.
Also relevant to borrowers is the fact that, over the past few years, the prime rate has been historically higher than LIBOR, and using the same spread will result in a higher interest rate. Significantly, the end of LIBOR also affects counterparties and derivative contracts such as interest-rate swap agreements. Derivative contracts such as interest-rate swap agreements that utilize LIBOR as the floating rate for the swapped fixed-interest rate will require amendments to these contracts to account for a different floating-rate interest index once LIBOR is unavailable.
Fortunately, given the lead time for LIBOR’s demise, there has been much work already performed preparing for its expiration, particularly by the Alternative Reference Rates Committee (AARC), which was created by the Federal Reserve and the Federal Reserve Bank of New York’s board of governors. The AARC has utilized two distinct approaches. The first is referred to as the “hardwire” approach, which involves substituting a defined index such as SOFR and specifically defining the adjustment mechanism for interest-rate spreads when applied to SOFR instead of LIBOR. The second approach is to utilize “fallback” language to try and spell out the parameters of any replacement index and to determine a new spread for any new rate index without specifying either. While the AARC has extensive proposed language, that language has not yet been universally adopted. As there is still time before the end of LIBOR, language can be adopted to modify existing obligations to either shift LIBOR to a new defined alternative index or to include language similar to the fallback language proposed by the AARC.
For existing loans, it is recommended that steps be taken to modify them with either another index––or at least the fallback language––and to include any swap party in the discussion if a swap contract is part of the underlying loan transaction.
Bank regulators and the market may come up with a new standard prior to the end date of LIBOR, which will solve all these concerns. In the interim, now is the time to address issues with borrowers and counterparties so there is no uncertainty when LIBOR ends. For bankers, preliminary measures can prevent litigation with the borrower as to what constitutes a comparable index and spread. For future loans, given the impending action to eliminate LIBOR, it would be prudent not to use LIBOR and instead adopt a substitute index.
If you have any questions regarding the content of this alert, please contact Roger Cominsky, Financial Institutions & Lending Practice Area chair, at rcominsky@barclaydamon.com, or Paul Vellano Jr., partner, at pvellanojr@barclaydamon.com or another member of the firm’s Financial Institutions & Lending Practice Area.