LIBOR rates will no longer be published until 2021

Lenders have issued both large and small lines of credit with LIBOR-based interest rates and related documents such as promissory note loans as customizable mortgages for decades, and often include LIBOR-related provisions.

Background from LIBOR

“LIBOR” (the London Interbank Offered Rate) is an average interest rate calculated from estimates by the leading banks in London. LIBOR was organized by the British Bankers Association in 1984 and served as the world’s leading benchmark for short-term interest rates (overnight to a year) with an estimated funding volume of $ 3 trillion using LIBOR.

Since the global financial crisis in 2008, the number of LIBOR-based transactions has declined. Investigations sparked by this crisis led authorities in the United States and the United Kingdom to discover that traders had manipulated LIBOR to generate banking and personal profits. Big banks were fined billions of dollars and traders were sentenced to prison terms. At the end of the calendar year 2021, the LIBOR will no longer be published.

LIBOR fallbacks

The discontinuation of the publication of LIBOR has been expected for several years, which justifies the need for “fallbacks”, ie replacements for LIBOR. In 2014 the Federal Reserve Board and the Federal Reserve Bank of New York formed the Alternative Reference Rates Committee (ARRC) to lead the transition from USD-LIBOR. The ARRC then developed the Secured Overnight Funding Rate (SOFR)based on transactions in the United States, as the new benchmark for US dollar denominated loans and securities. The Federal Reserve began releasing SOFR in 2018.

SOFR and LIBOR have some similarities, but they are also different. Both reflect short-term borrowing costs. However, SOFR is based on an average daily volume of actual transactions in the United States totaling more than $ 1 trillion, while LIBOR is based on volumes less than 1% of that amount, which is why SOFR is viewed as reducing the likelihood of attempted manipulation. In addition, SOFR is based entirely on transaction data, while LIBOR is based on transaction data supplemented by “expert judgment”. SOFR is “backwards” while LIBOR is forward-looking, so borrowers know the interest rate for a given interest period at the beginning of the period. Significantly, the SOFR is supposedly a “risk-free” rate because it is based on actual transactions in US Treasuries. However, if market transactions in Treasuries “freeze” for any reason, as it did in September 2019, interest rate setting becomes uncertain. In the event of market disruptions, the level of the minimum reserve requirement to meet cautious regulatory standards can be significantly different under SOFR than under LIBOR, as banks may refuse to grant loans and thus no transactions take place. Parties involved in financial transactions need to be aware of these differences when considering replacing LIBOR with SOFR.

The development of SOFR is only one part of a challenging shift away from LIBOR. Another component relates to financial derivatives such as transactions with interest rate swaps, e.g. LIBOR on a fixed interest rate. The International Swap Dealers Association (ISDA) has long been developing a corresponding fallback, especially since the fallbacks in the ISDA definitions from 2006 were not designed with a view to a permanent suspension of LIBOR. On October 23, 2020, the ISDA published its IBOR Fallbacks Protocol 2020 and its ISDA IBOR Fallbacks Supplement, which will come into effect on January 25, 2021. The Protocol and Supplement will provide a way for parties involved in financial transactions to replace the fallbacks of the interest rate benchmark currently involved in swap deals.

Transition and implementation

With LIBOR only a year away to end, lenders and borrowers should make serious preparations. In a joint statement, the Federal Reserve Board issued the Federal Deposit Insurance Corporation, and the Office of the Auditor have encouraged banks to turn loans from LIBOR “without delay”. While SOFR and the ISDA Fallbacks Protocol and the ISDA Fallbacks Supplement are significant fallbacks, their implementation poses challenges for lenders and borrowers.

1. Existing LIBOR-based loans may or may not have fallbacks, and even if they do, the fallbacks may be insufficient. For example, relapse prevention for an existing loan can be as simple as “a comparable replacement rate determined by the bank”. However, completely substituting SOFR for LIBOR without careful review of the loan can be risky. To illustrate, a law introduced in New York would remedy contracts that lack adequate fallbacks for the suspension of LIBOR.
2. In the case of fallback provisions, documents on existing loans may also have to be adjusted. An important consideration for lenders is whether the cost of changing the documents can or should be passed on to the borrowers, especially since the exit from LIBOR was not caused by either party.
3. An aggravating factor with both existing and new loans is whether or not the loan is a swap. Particular attention should be paid to the new ISDA fallbacks.
4. In the case of new loans, lenders can use a “hardwire” procedure in which the fallback provisions contained in the loan documents automatically take effect if the LIBOR is no longer published.
5. Alternative benchmark rates, such as the AMERIBOR operated by CBOE Global Markets, Inc. on its AFX platform, may be more suitable for some lenders, especially smaller institutions. AMERIBOR is a weighted index for unsecured overnight loans and is regulated by the Committee on Benchmark Oversight. The Federal Reserve Board has expressly recognized that AMERIBOR is an appropriate benchmark rate for banks.

Bottom line for lenders

With the LIBOR discontinuation, lenders are encouraged to:

• Take stock of their loan portfolios to identify LIBOR based loans
• Develop a plan to convey vital information to your borrowers
• Take the necessary steps to enable your systems and software to handle the LIBOR transition
• Discuss with a lawyer the actions that need to be taken, including developing new form documents