London Interbank Offer Rate (LIBOR) is dying a slow but predictable death. After serving as a bedrock of the modern financial system for over 30 years, it is all set to be discontinued by the end of 2021. Interest rates on close to $200 trillion of commercial contracts routinely reset based on this benchmark in the U.S. alone, as per the IMF’s Global Financial Stability Report for 2019. These instruments cover practically every aspect of our financial system, including corporate loans, bonds, mortgages, student loans, and asset-backed-securities. What happens to these outstanding contracts after 2021? We do not have precise answers to this $200 trillion question, and that creates a host of legal, valuation, and financing uncertainty for businesses and individuals alike. Corporate America needs to wake up to this reality to avoid a wholly anticipated crisis.
LIBOR indicates the rate at which large banks are “willing” to borrow from each other in the wholesale funding market in a specific currency for a given maturity. The rate is estimated daily based on quotes received from a panel of 15-20 banks for each currency; banks do not have to transact at their quoted price necessarily. Thus, LIBOR is a rate where banks do not have to put their money where their mouth is! This divergence creates incentive conflicts: banks can strategically provide misleading quotes to benefit themselves.
In a Wall Street Journal article in April 2008, Carrick Mollenkamp writes, “Some banks don’t want to report the high rates they’re paying for short-term loans because they don’t want to tip off the market that they’re desperate for cash.” These scrutinies intensified in 2012 with additional allegations that banks are colluding in the LIBOR market to benefit themselves on their holdings of LIBOR-based contracts. CFTC took enforcement action against Barclays Bank in 2012. Other prominent names such as UBS, Deutsche Bank, RBS, Société Générale, and Rabobank either paid fines or settled the case with regulators. A critical economic attribute of a benchmark rate is to ensure that it is manipulation-proof, especially by one of the contracting parties. Over time it was clear that LIBOR has lost the most sacred character of a benchmark rate: its reliability.
In the meantime, regulators around the world began their search for a replacement. This task fell upon The Alternative Reference Rates Committee (ARRC) in the U.S. They are recommending the use of the Secured Overnight Financing Rate (“SOFR”) as the alternative to LIBOR. SOFR is an overnight repo-rate, the rate at which large institutions borrow money in the overnight lending market backed by the collateral of U.S. treasury. Thus rates in the LIBOR benchmark reflects the banking sector’s credit risk, whereas SOFR is a risk-free rate. Additionally, SOFR only gives the rate for overnight maturity, as against a range of maturities covered by LIBOR. Due to these differences, it is not possible to simply replace LIBOR with SOFR in existing contracts.
What should be the correct adjustment after LIBOR’s demise? The transition from LIBOR to SOFR must take into account the fact that LIBOR contains a credit risk premium for banks, which is absent from SOFR. Similarly, contracts based on longer maturity LIBOR benchmark, say a 3-month or 6-month LIBOR, must account for the fact that SOFR is only an overnight rate. Hence, a term premium must be added to SOFR before it replaces LIBOR in such contracts. These are not easy tasks. Credit risk premium and term premium change over time, and even in the best of times, there is disagreement on the best ways to estimate them. Absent a precise method to do so, contracts tied to LIBOR must be renegotiated between various contracting parties before transitioning to SOFR or any other benchmark rate. The impact of this uncertainty will be felt across the economy unless, of course, we take actions before it is too late.
For the CFOs of Corporate America, this transition poses challenges on three critical fronts: disclosure policy, risk management strategies, and financing decisions. In its July 12, 2019 staff statement, the Securities And Exchange Commission (SEC) issued some guidelines on disclosure of this risk to investors. They recommend that companies keep their investors informed about the progress toward risk identification and mitigation arising out of their post-2021 LIBOR-linked obligation, and the anticipated impact of this transition on the company. Several companies have LIBOR-linked liabilities on their balance sheets that extend far beyond 2021. CFOs need to begin their work on taking stock of these liabilities and disclosing their potential valuation impact right away. We are yet to see meaningful disclosure on this front, even from companies that have considerable LIBOR-linked obligations beyond 2021. Investors hate surprises.
While disclosure policies will undoubtedly help in managing investor expectations, it cannot be a substitute for active risk management. CFOs need to work on a fallback language in their existing contracts to remove ambiguity in determining interest rates if LIBOR is not available. There are some fallback provisions in existing debt contracts, too, but they come from a time of active LIBOR market. After the discontinuation of LIBOR, existing fallback provisions may lose their relevance. For example, in one of APPLE’s floating-rate note contracts, the fallback rule states that if LIBOR benchmark is not available, then the rates will be decided based on quotes provided by four major reference banks in the LIBOR market. But if the LIBOR market ceases to exist, such a rule may end up with a lot of ambiguity and legal challenges by investors. CFOs need to think in terms of a new reference rate or renegotiate the deal before it is too late.
Related, CFOs have to assess the implications of this change for hedge accounting rules. Derivatives contract used by a firm to hedge an existing exposure should be sufficiently negatively-correlated with the underlying exposure it proposes to hedge. The transition from LIBOR to SOFR will present challenges in estimating and establishing this correlation, partly because of the lack of historical data on instruments linked to the alternative rate.
Finally, companies should proactively make modifications to their corporate financial policies. As a starter, it makes sense to avoid entering into new contracts linked to LIBOR. Perhaps a shift towards a fixed-rate debt may not be a bad idea in the short run. If firms have convertible or callable bonds, linked to LIBOR, CFOs must analyze the implication of LIBOR’s demise on the incentives to call these bonds.
Beyond its implications for individual companies, LIBOR’s demise can play havoc with the smooth functioning of debt markets. Imagine a financial institution that has entered into an intricate web of LIBOR-linked contracts on both sides of its balance sheet. If parties on different sides of the contract do not agree on a standard method of replacement, it can destabilize the entire financial markets. Insurance companies, pension funds, and banks are all vulnerable to such destabilizing forces.
The recent spike in SOFR has compounded these concerns. By getting rid of quotation-based LIBOR benchmark, regulators hope to avoid manipulation. They most likely are right. But the market-based substitute in the form of SOFR comes with its baggage: market-based measures are inherently more volatile. On September 17, 2019, SOFR increased to a whopping 5.25%, far exceeding its previous day’s value of about 2.5%. In a recently published Bloomberg article, ARCC’s chairman Tom Wipf makes a compelling case for using average SOFR over a period to mitigate these volatility concerns. The use of average values will undoubtedly help, but such adjustments make the task of transitioning from LIBOR to SOFR even more complicated: not only do the contracting parties need to agree on adjustments for credit and term premium when they change from the LIBOR benchmark to SOFR, but they also have to decide on the averaging period.
LIBOR’s demise look certain. The risks that come with it remain uncertain, however. The best way to deal with a certain event with uncertain impact is to prepare ahead of time.Follow me on Twitter. Check out my website.