LIBOR Transition FAQs | Husch Blackwell LLP
With the phase-out of LIBOR by the end of 2021 and its prevalence in business loans, adjustable rate mortgages, variable rate notes, securitized products and derivatives, almost all lenders and borrowers will be affected. Husch Blackwell’s lawyers have put together answers to frequently asked questions about the LIBOR transition.
What is LIBOR?
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which the world’s major banks lend each other on the international interbank market for short-term loans, published daily by the Intercontinental Exchange (ICE). The Alternative Reference Rates Committee (ARRC) considers that outstanding contracts referencing US dollar LIBOR, including business loans, variable rate mortgages, floating rate notes, securitized products and derivatives total nearly $ 200 trillion.
When will LIBOR rates stop being published?
The ICE and the Financial Conduct Authority (FCA) recently announced that most US Dollar LIBOR holdings will continue to be published until June 30, 2023, extending the previously announced deadline of December 2021.
When should lenders stop making LIBOR-based loans?
The Federal Reserve Board of Governors, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) issued a statement on November 30, 2020 encouraging banks to abandon LIBOR as soon as possible. , but in any event by December 31, 2021. The agencies believe that entering into new contracts using LIBOR as the benchmark rate after December 31, 2021 “would create security and soundness risks and will review practices bank accordingly ”. The ARRC suggests that lenders abandon new loans that reference LIBOR by June 30, 2021.
What should be included in new loan documents executed in 2021?
The joint statement released by the Federal Reserve Board, OCC and FDIC said new contracts entered into before Dec.31, 2021 should either use a benchmark rate other than LIBOR or have strong fallback language that includes a clearly defined alternative benchmark rate after LIBOR is discontinued. .
Do the agencies impose a specific replacement for LIBOR?
In its joint statement of November 6, 2020, the Federal Reserve Board, OCC, and FDIC noted that the agencies did not intend to recommend a specific credit-sensitive rate to be used in place of LIBOR. The agencies recommended that financial institutions “use for their loans any benchmark rate that the bank deems appropriate to its funding model and the needs of its customers.”
What are the possible replacement rates for LIBOR?
Many existing loan documents include a fallback to the prime rate if LIBOR ceases to be available. The ARRC proposed “hard-wired” replacement rate arrangements that would use the Guaranteed Overnight Funding Rate (SOFR) as a replacement for LIBOR. The ARRC was established by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in 2014 to develop best practice recommendations in identifying potential alternative benchmarks for LIBOR.
What are the possible mechanisms to replace LIBOR?
- Loan documents can take an “amendment approach” whereby the lender can amend the documents to replace LIBOR, if necessary, subject to the borrower’s consent rights, as negotiated between the parties.
- The ARRC has promulgated a suggested “hard-wired” language that provides for automatic replacement of LIBOR by SOFR upon certain triggering events.
What is SOFR?
The Guaranteed Overnight Funding Rate (SOFR) represents the interest rate that banks charge each other when making loans backed by US Treasury bills. The SOFR is a daily overnight rate, released by the Fed each morning. SOFR can include:
- The “SOFR term” would function similarly to LIBOR, in that it would be a forward-looking rate representing a projection of what the daily SOFR would be at some date in the future. The term SOFR is not yet available as an index and will not be until a more active swap market exists for the daily SOFR.
- “Simple Daily SOFR” or “Overdue SOFR” is a “backward” rate based on the SOFR Daily Rates that occurred prior to the relevant interest payment date, and would be an average of the SOFR Daily Rate for each day during the previous period (for example, a month).
How are LIBOR and SOFR different?
LIBOR is currently published as a forward rate (one month, three months, etc.), while SOFR is not. LIBOR is supposed to represent a bank’s cost of capital, while SOFR measures the rates applicable to short-term secured funding.
How does ARRC’s “hard-wired” approach work?
ARRC’s hard-wired approach uses a three-step cascade to determine the LIBOR replacement rate. Once an event triggering the need to replace LIBOR occurs, the lender will replace LIBOR in the following cascade:
Step 1: SOFR term plus the corresponding spread adjustment. As noted above, the SOFR term is not yet an available rate, although it may become available before the end of LIBOR.
2nd step: Daily Simple SOFR plus the corresponding spread adjustment. If Term SOFR is not available, Daily Simple SOFR (aka SOFR in Arrears) plus a spread would be used.
Step 3: If SOFR is not available, the borrower and lender select a replacement rate, similar to an “amendment approach”.
Note: a language can be included to “climb the cascade” to return to step 1 (SOFR term) if this tariff becomes available later.
How will the spread adjustment be determined when using SOFR?
Since SOFR is an overnight guaranteed rate, it has historically been a lower rate than LIBOR. Therefore, a “spread adjustment” will be required when converting to an SOFR based rate. The ARRC recommends using a spread adjustment based on a five-year historical median between LIBOR and SOFR.
What would trigger the conversion of LIBOR to SOFR?
In the wired language of the ARRC, announcements from relevant regulatory agencies and industry bodies indicating that LIBOR will no longer be released would trigger the switch from LIBOR to SOFR. The lender and the borrower can also choose an “early opt-in” which would allow an earlier switch to SOFR.
What if my existing loan documents already provide for the lender to select a replacement rate when LIBOR is no longer available?
The ARRC recommends in its best practice guidelines that the lender disclose its intended selection to affected parties at least six months in advance of the date a replacement rate would come into effect.
Additionally, lenders should consider adding more robust fallback language if there is a possibility of modifying loan documents.
What should a lender consider now?
- Prepare for LIBOR termination by including robust alternate language in new loan documents (whether changes or new credit facilities).
- Review the existing loan portfolio to ensure that proper rate transition language is included for all loans.
- Prepare internal operations for transition to SOFR, if applicable.