The Alternative Reference Rates Committee (ARRC) has released its recommended fallback language for the London Interbank Offered Rate (Libor). This language indicates the rate that corporates would fall back on, should Libor become unusable after 2021.
The Loan Syndications and Trading Association (LSTA), a member of the ARRC, has issued a guidance on the Libor fallback language for syndicated loans. As the LSTA notes, many loans will be outstanding when Libor ceases, and thus it is “critical” to develop fallback language in any new loans and collateralized loan obligations (CLOs).
In the United States, the Secured Overnight Financing Rate (SOFR) is poised to replace derivatives, and may also take over for loans, CLOs and floating rate notes. Since SOFR is secured and is expected to be lower than Libor, loans that fall back to it will require a spread adjustment to make the rate more comparable to the current benchmark, the LSTA explained.
Fallback language is contingent on a “trigger”, i.e., an event that initiates the switch from Libor to a new rate (e.g., the benchmark administrator or the administrator’s regulator announcing that the benchmark will cease, or a public statement from the regulator that the benchmark is no longer representative). Fallback language also requires a replacement rate to take over for the current benchmark.
TWO TYPES OF FALLBACK LANGUAGE
The ARRC has developed two versions of fallback language for syndicated loans:
- The amendment approach: Following a trigger event, the bank group enables a streamlined amendment to replace Libor.
- The hardwired approach: Fallback language is built into the original credit agreement so that the loan can automatically convert to a new rate in the event that a trigger occurs.
The LSTA noted that both versions have their pros and cons. The amendment approach takes advantages of loans’ flexibility and doesn’t lock market participants into a rate that doesn’t actually exist yet. But it also is subject to potential manipulation depending on the economic landscape at the time of the transition. Additionally, if thousands of loans need to be transitioned at the same time, this approach might not actually be plausible.
Meanwhile, the hardwired approach would not be subject to manipulation and would likely be more workable en masse when Libor ceases to exist. But it requires participants to agree to a rate that does not yet exist. Thus the LSTA surmises that the market may choose the amendment approach until there is greater clarity on Term SOFR.
SWITCHING AHEAD OF SCHEDULE
The LSTA noted that corporates can switch loans to SOFR before the Libor cessation. For the hardwired approach, once it has been identified that a certain number of loans have used Term SOFR plus a spread adjustment, then the agent, required lenders and the borrower can switch to Term SOFR by affirmative vote. For the amendment approach, it can be determined that loans are being executed or amended to incorporate or adopt a successor rate and can elect to switch to that rate.
The ARRC is encouraging market participants to switch to SOFR for cash products ahead of Libor cessation, and has even released a whitepaper to help them do that. That makes sense; after all, SOFR is the ARRC’s preferred alternative to U.S. dollar Libor. But the ARRC also noted that SOFR has certain characteristics that could make it an improvement on Libor:
- SOFR is produced by the Federal Reserve Bank of New York “for the public good”
- The rate is derived from an active and well-defined market, which makes it difficult to manipulate or influence
- It is based on observable transactions, rather than dependence on estimates
- SOFR is derived from a market that weathered the global financial crisis, and the ARRC believes that signifies that the rate can reliably be produced in a wide range of market conditions.
“We have only a little over two and a half years until LIBOR could become unusable. It’s crucial for the safety of the financial system, and for the many firms using LIBOR, that they not wait to begin a transition. By releasing this white paper, the ARRC shows how market participants can use SOFR and transition now,” said Tom Wipf, chair of the ARRC and vice chairman of institutional securities for Morgan Stanley. “We encourage market participants to begin writing contracts using SOFR instead of U.S. dollar LIBOR.”
A treasury professional who wished to remain anonymous told AFP that the atmosphere lately has been leaning towards shifting financing away from Libor quickly—from syndicated business loans to consumer lending. “In my opinion, we’ll see consumer lending shift first on adjustable rate mortgages,” she said. “Before that can happen, I believe that GSEs need to provide guidance to lenders by including a new rate amongst the eligible rates for qualifying mortgages. To ensure the new ARM product is able to be financed without paying a high premium, it is an easy assumption that discussions are taking place.”