The fall of LIBOR and the rise of SOFR

Published on February 16, 2023 by Kamal Valecha

LIBOR: Why is it being retired?

The London Interbank Offered Rate (LIBOR) is a benchmark rate used to calculate interest in a variety of financial contracts. It has been used all over the world for decades and is seen in derivatives, commercial loans, residential loans, small business transactions and even some consumer products such as student loans.

It is an average of interest rates calculated using estimates submitted by the leading member banks in London. Each day, these banks estimate what they would be charged in the event they borrowed from other banks. USD LIBOR has been the most popular global benchmark for short-term interest rates and represents USD200tn of financial contracts and securities, of which approximately USD8.3tn worth are potentially related to securitisations.

It was highlighted in 2012 that these banks were rigging the rates, that the member banks that gave LIBOR estimates were conspiring and submitting incorrect data to achieve higher gains from the trades. Furthermore, the underlying transactions LIBOR was supposed to be based on (i.e. interbank loans) were not taking place in reality. Instead, member banks were estimating the rates at which they would lend to each other, adding further uncertainty to the estimates even if they were made in good faith. Taking all these aspects into consideration, the Financial Conduct Authority (FCA) announced in 2017 that it would discontinue this benchmark by the end of 2021.

Out with the old, in with the new

This notification prompted financial authorities across the world to begin formulating alternative benchmark rates that would succeed LIBOR. The Alternative Reference Rates Committee (ARRC) formed the Secured Overnight Financing Rate (SOFR) for USD contracts.

Parties to the Securitisations Working Group (SWG), including representatives of issuers, arrangers, servicers, underwriters, calculation agents, trustees, note administrators, investors and trust administrators (market participants), engaged in a month-long exercise, sharing their expertise and perspectives on current asset-backed securities (ABS) market operations, investor preferences and market trends, and reached unanimity on the use of SOFR in products such as ABS, MBS and CMBS.

Unlike LIBOR, SOFR tracks genuine transactions, namely overnight transactions in the Treasury repurchase agreement (repo) market. Thus, SOFR is a more factual means of calculating the cost of borrowing money, as these transactions can be traced by anybody and are difficult to fabricate.

The transition away from LIBOR benchmarks in financial markets, begun in 2017, accelerated in 2022, especially in the US. SOFR is now being used across the US structured finance market, a credit-neutral development overall, because of factors such as the modest differences between the benchmark and LIBOR. US bank regulators have guided entities under their supervision to avoid the use of LIBOR in new contracts, ahead of the scheduled end of remaining USD versions of the benchmark in mid-2023.

In 2021, the securitised-product sector, regulators and lawmakers made notable advancement in the transition from the LIBOR reference rate to its successor, SOFR. Investors in securitised products were simultaneously tussling with the challenge of the LIBOR-SOFR transition and its effect on their analysis.

What is SOFR, and how does it work?

Financial organisations price loans for individuals and businesses using the SOFR benchmark. The name's connection to "overnight finance" refers to how SOFR determines interest rates for lenders. The rates major financial institutions charge one another for overnight loans act as its foundation.

Treasury bond repos allow large financial institutions to lend money to one another. These agreements give banks the freedom to use Treasury securities as collateral for overnight loans to satisfy reserve and liquidity requirements. SOFR includes the weighted averages of the rates charged in these agreements.

SOFR and credit-spread adjustments

Credit-spread adjustments are important for understanding SOFR. One may notice differences between the published rates of benchmarks due to the different methodologies used by LIBOR and SOFR. As institutions transition, they may look to utilise credit-spread adjustments to try to better align secured SOFR rates to unsecured LIBOR rates.

Why is SOFR being adopted by lenders?

Since the mid-1980s, LIBOR has been one of the main benchmarks for loans. However, a number of scandals and concerns regarding inaccuracy as a result of manipulation have marred the history of LIBOR.

The 2008 and 2009 financial crisis exposed several of LIBOR's technological flaws, and banking regulators realised that a more reliable, risk-free reference was needed to permanently replace LIBOR.

These scandals were partially prompted by the interbank lending market deflating in recent years. With the reduced number of transactions, the index began reflecting quoted rates, rather than actual rates for transactions. Thus, the cost of borrowing could not be derived accurately from self-quoted LIBOR.

The Treasury repo market is a highly liquid market, with over USD1tn transacted daily. Evidently, it has a large amount of real transaction data it can use, as opposed to the quoted hypothetical rates, reducing the probability of SOFR being manipulated.

LIBOR vs SOFR – key differences

LIBOR transition and its effect on businesses and individuals

Numerous types of financial contracts use LIBOR as reference, and moving away from the rate could impact a variety of businesses and individuals such as the following:

• Corporate and municipal borrowers financing operations with LIBOR-based floating-rate loans and/or bonds

• End users hedging risk with LIBOR-based derivatives

• Investment banks underwriting, issuing and making markets in LIBOR-based instruments

• Investors managing portfolios of swaps, bonds and loans tied to LIBOR

• Consumers with mortgages or other loans tied to LIBOR

• Certain credit cards that use LIBOR

Transitional obstacles

Since there are trillions of dollars' worth of outstanding LIBOR-based contracts, some of which have longer maturities that extend past LIBOR retirement, switching to a new benchmark rate is challenging. Included here is the well-known three-month USD LIBOR, to which USD200tn worth of debt and contracts are linked.

Contract repricing is difficult because there are significant differences between the two interest rates. For instance, SOFR, which is essentially a risk-free rate, represents loans backed by Treasury bonds (T-bonds) while LIBOR represents unsecured loans. Furthermore, SOFR currently publishes only one rate that is solely based on overnight loans, whereas LIBOR actually has 35 different rates.

The transition to SOFR would have a significant impact on derivatives. However, it would also be very important in debt instruments such as commercial paper, consumer credit products such as private student loans, and some adjustable-rate mortgages.

How much borrowers will pay after the loan's fixed-interest period expires depends on the movement of the benchmark rate in the case of an adjustable-rate mortgage based on SOFR. Homeowners would pay a higher rate if SOFR is higher when the loan "resets".

Challenges facing the structured finance sector

As we approach the June 2023 cessation date for LIBOR, structured credit products remain uncertain as borrowers and lenders consider the recommended replacement (SOFR) and its potential economic impact. Challenges that outstanding structured credit transactions face in the light of cessation and as they measure the impact of each transaction on deal continuity include the following:

• Basis risk: One of the common issues relating to fallback provisions is that basis risk could arise between derivative hedges and cash products due to differences in triggers and/or waterfalls. This risk is aggravated in securitisations by a third factor – the assets underlying the securities. For example, if the asset replacement percentage (ARP; say, 50%) trigger occurs, 100% of the securities would convert to SOFR (plus adjustment), while only half of the underlying assets would have converted to SOFR. If either the issuer or the investors have hedged their positions, that hedge could still be pegged to LIBOR, as this ARP trigger is not a standard derivative trigger. This underlines the importance of structuring hedges to precisely match (in all respects) the cash instrument – in this case, with the swap transaction being modified to include the ARP trigger. This, of course, would be a departure from the pending ISDA protocol.

• Legacy transactions: Although concern about the treatment of legacy transactions is relevant to all LIBOR contracts, it could be more distressful in securitisations than in certain other cash products, for the following reasons:

  • Lack of ability to amend – Most securitisations are structured; therefore, any material changes to the transaction documents require approval of 100% of investors, which is highly unfeasible and improbable, as opposed to business loans, which can be amended with little effort.

  • Higher risk of value transfer – Due to the inability to amend, substantial value transfer may arise following discontinuation of LIBOR. While existing fallback provisions differ widely, one simple example of legacy fallback illustrates the potential for value transfer – trigger occurs, and LIBOR is fixed at the most recent LIBOR setting. Investors would immediately receive (and issuers pay) an off-market fixed rate, the outcome of which could be an unforeseen but ample gain or loss; preventing this is one of the ARRC’s guiding principles.

  • Accidental LIBOR exposures – Some fixed-rate securitisations may in specific situations convert during the life of the transaction to paying a LIBOR-referenced rate. Default under the indenture and extension of the security past its scheduled maturity date are two scenarios that could result in this conversion. The presence of such situations may lead to their omission from the inventory of legacy deals that require attention.

• Lawsuit risk: Potential for a lawsuit over contract disputes is increased for “tough” legacy contracts, i.e. those that mature after June 2023 with no replacement-rate provisions (fallback language) in their documentation. Mitigating the risk partly depends on the passage of key legislation; litigation risk is less of a concern for transactions issued with fallback language in place.

• Interest rate risk: Two potential transition factors that increase the interest rate risk for CLOs and other structured credit transactions are (1) the imperfect nature of the “transition hedge”, i.e. the application of the recommended spread adjustment to equate SOFR with LIBOR, and (2) a potential base-rate mismatch between assets and liabilities. Both these factors could have an economic impact on deals.

• Effect on equity and subordinate tranches: Securitisations follow the waterfall method, where cashflow for the asset pool is paid from the most senior (usually AAA/Aaa) to the most junior (equity) tranche. Thus, the junior tranches provide credit enhancement to those that are more senior. If there are impingements to asset cashflow due to managing the LIBOR cessation, they would impact the equity and subordinate tranches first. Such a phenomenon, or the market’s perception of its possible occurrence, could have adverse effects to future transactions, increasing funding costs for the issuer and even affecting the feasibility of issuance. This risk highlights the significance of a smooth, efficient transition that addresses the concerns of all major market participants.

• Structures prepared to absorb basis: It is difficult to forecast the “all-in” basis for various structured credit transactions during the transition period. However, we can estimate the amount of excess spread deterioration it would take to impact cashflow to rated liabilities. This reduction could come from a combination of more expensive liabilities and/or an asset-liability mismatch.

Is this transition specific to the US?

This transition is happening worldwide. Many other global markets are also moving away from their respective IBORs to overnight, risk-free rates. The following countries are already in the process of transitioning to alternatives:

• The UK’s leading option is the Sterling Overnight Indexed Average (SONIA)

• The European Union's leading option is the Euro Short-Term Rate (ESTR)

• Canada’s leading option is the Canadian Overnight Repo Rate Average (CORRA)

• Japan’s leading option is the Tokyo Overnight Average Rate (TONAR)

Modifying contracts for SOFR

Henceforth, all fresh contracts should clearly reference SOFR where they would previously have referenced LIBOR. Having said that, organisations need to make crucial alterations to mitigate their risk exposure to LIBOR-tagged contracts maturing after 2021.

It would be best if these contracts were renegotiated to include SOFR, but this would not always be possible. Contracts should be changed to include strong fallback language that expressly specifies how and when the benchmark rate will switch to SOFR when they cannot be renegotiated.

This is clearly no small task. The LIBOR vs SOFR transition is a huge undertaking that could be difficult to manage because not all contracts can be treated in the same way.

Conclusion

At this crucial juncture in the LIBOR transition, Americans need complete certainty regarding the rates and goods they rely on for legacy contracts. To prevent ambiguity, confusion and potential mass litigation, all borrowers and investors require a seamless transition away from LIBOR. A careful analysis of these variables, as well as cooperation and effective communication among all parties to a transaction, including issuers, sponsors, investors, rating agencies and regulators, is essential for properly planning and structuring new transactions. For each of the securitisation subclasses (ABS, RMBS, CLOs and CMBS), the LIBOR transition and fallback provisions in new and legacy deals must also be considered. The Structured Finance Association is committed to collaborating with the Committee on Financial Services of the US House of Representatives on sensible legislation that will guarantee stability for consumers and businesses throughout this significant transition. The Structured Finance Association agrees that federal legislation is the best solution. Congress has the authority to ensure a result that is as economically neutral as possible, ensuring that all US legacy contracts are treated fairly and consistently, and minimising any value transfer and confusion. The absence of comprehensive federal legislation to address the issue increases the likelihood of future market disruption, confusion and legal disputes.

How Acuity Knowledge Partners can help

We help clients run cashflow in different scenarios to assess the impact of changing the index from LIBOR to SOFR. We also provide support in including language related to this transition in legal documents.

References:

• https://www.capitalone.com/commercial/solutions/libor-sofr/

• https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1323978

• https://www.exigent-group.com/blog/libor-vs-sofr/

• https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954

• https://www.jpmorgan.com/commercial-banking/insights/the-global-move-away-from-LIBOR

• https://structuredfinance.org/wp-content/uploads/2021/04/SFA-Statement-for-the-Record-re-LIBOR-Transition-FINAL-FINAL.pdf

• https://www.msci.com/www/blog-posts/securitized-products-libor/02578632672

• https://www.kbra.com/documents/report/57326/structured-credit-libor-transition-basis-loaded

• https://www.broydpartners.com/2021/08/06/alternative-reference-rate-committee-arrc-recommended-fallback-provisions/

• https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/options-for-using-sofr-in-new-abs-mbs-cmbs-products-032921

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