LIBOR transition creates possible exposure to disconnection
Floating rate debt instruments for commercial real estate loans and many other forms of financing have been based for decades on an interest rate index called the London Interbank Offered Rate. If LIBOR went up or down, so would the interest rate paid by the borrower. And LIBOR rates have been quoted each business day for a range of borrowing periods, from one day to one year. In real estate, the most common borrowing period traditionally being 30 days, so LIBOR home loans are revalued every 30 days.
A decade ago, it became clear that LIBOR in part mirrors the creative writing of money traders at big banks. It did not reliably or accurately reflect actual borrowing and lending market conditions. So regulators and industry organizations decided that LIBOR was broken and the market should move towards something better.
Thus began a multiannual and surprisingly complex exercise. Its main finding so far has been a suggestion to replace LIBOR, at least in the United States, with something called the Secured Overnight Financing Rate. SOFR fluctuates daily and is determined a posteriori (in arrears) rather than at the start of each borrowing period, which is always one day. In contrast, LIBOR pricing is set at the start of each borrowing period. And it offers a range of possible loan terms of up to one year. SOFR also assumes an absolutely risk-free borrowing rate at all times, so that it will not respond to changes in the price of money driven by changes in aggregate credit risk in the financial markets as a whole. Based on these differences alone, the suitability of SOFR as a replacement for LIBOR does not seem obvious.
International banking regulators have struck harder in recent months to announce the impending demise of LIBOR, but surrogate SOFR has only gotten limited traction. More promising, private players have imagined possible replacements for LIBOR: the Ameribor rate promulgated by the American Financial Exchange; Bloomberg’s Short Term Bank Yield Index (BSBY); and the IBA Bank Yield Index.
Unlike the SOFR index, these three new possible LIBOR replacements incorporate an element of credit risk, are quoted in advance and offer a range of loan terms. They are much more like LIBOR. Regulators are generally open to these substitution rates, subject to some lingering concerns about how they might behave over time and especially under stress.
Market players need to be smart enough to understand all of this, with or without the help of regulators. The market should, over time, become familiar with one or more of these LIBOR surrogates or some other replacement index created by the private sector.
This creates a new problem. Some long-term financial structures with LIBOR-based interest rates involve two different sets of documents and relationships. Each set has its own language to deal with the once purely hypothetical possibility that LIBOR may disappear. For example, residential variable rate mortgages have a mechanism to replace LIBOR if it disappears. Many of these residential loans generate mortgage payments which in turn fund the payments to bondholders. But these bonds often have a different mechanism to replace LIBOR if it goes missing.
These differences will create some disconnect between the incoming money flow and the outgoing payments that the same cash flow has to fund. One LIBOR replacement rate may perform differently from another. The result: a risk or perhaps a pleasant surprise for institutions that make outgoing payments to bondholders. This disconnection can also create an opportunity for whoever decides on each LIBOR replacement. The result could be litigation, unexpected profit or loss, and perhaps a new product for the derivatives industry.
Perhaps identifying problems with LIBOR was relatively easy. Finding the ideal replacement for LIBOR is not so easy.