The End of LIBOR: Final Countdown
The LIBOR transition will significantly impact the following LIBOR-based financial instruments:
- Existing loans transitioning to a replacement benchmark
- Existing caps/swaps that should transition to the same replacement benchmark of
- the associated loans (but often remain unchanged); caps/swaps will transition to a different benchmark on the LIBOR end date absent proactive borrower efforts
- New loans utilizing a new benchmark
- New caps/swaps utilizing a benchmark different from the associated loans
These likely have significant financial impacts on borrowers that have not been recognized in the urgency presented for the transition.
Limited Term SOFR Use
At last month’s meeting, ARRC discussed the risks associated with widespread use of Term SOFR outside of limited targeted recommendations.
In April 2021, ARRC recommended that the vast majority of new contracts directly reference actual SOFR (e.g. Daily Simple SOFR and 30-Day Average SOFR) and not Term SOFR. Instead, ARRC mentioned that Term SOFR might be useful for legacy contracts.
In its report on interest rate benchmark reform from June 2021, the Financial Stability Board (FSB) stated that risk-free derived term rates (e.g. Term SOFR) are not as robust as the underlying overnight risk-free rates (e.g. Daily Simple SOFR). The report further stated that utilizing derived term rates would not reduce the risks and vulnerabilities in the financial system currently in existence under the LIBOR regime.
Notwithstanding the foregoing, our experience has been that Term SOFR is frequently utilized in the LIBOR transition for commercial loans (see ‘Historical Benchmark Replacements” below).
In August 2021, ARRC recommended the use of Daily Simple SOFR and 30-Day Average SOFR for loans in cases where a party wishes to hedge in the most efficient and transparent manner since caps/swaps are typically based upon Daily Simple SOFR. In addition, ARRC supports the use of Term SOFR for derivatives in borrower hedged loan transactions utilizing Term SOFR so as to ensure that related financial instruments are based upon parallel benchmarks. FSB also mentioned that term rates should only be used in certain segments of the loan market where hedging needs are limited.
In practice, loans have frequently utilized Term SOFR while, inconsistently, caps/swaps have transitioned to Daily Simple SOFR through the use of the ISDA Protocol. A parallel mismatch will occur on the LIBOR end date through inaction as the Federal Reserve’s benchmark replacement for loans will be Term SOFR while the benchmark replacement for caps/swaps will be Daily Simple SOFR.
As a result of this mismatch of benchmark replacements in hedged transactions, borrowers will be presented with potential shortfalls in cash flows between the loans and associated caps/swaps.
Historical Benchmark Replacements
In our general experience, use in new contracts, as well as legacy contracts transitioning from LIBOR, had been effectuated as follows:
2020 (& Before)
LIBOR → LIBOR → Bank Selected Benchmark
2021 & 2022
LIBOR → LIBOR → Bank Selected Benchmark [a few banks]
LIBOR → Term SOFR [most banks]
LIBOR → Daily Simple SOFR/30-Day Average SOFR [upon borrower pushback]
LIBOR → Term SOFR
LIBOR → Daily Simple SOFR
Federal Reserve Approved Benchmarks
Set forth below are the Federal Reserve-approved benchmarks:
|Daily Simple SOFR|
|Commercial Loans||Term SOFR|
|GSE Loans||30-Day Average SOFR|
|Consumer Loans||Term SOFR (over a 1-year period)|
However, these approved benchmarks did not become effective until earlier this week.
Query whether the parties are afforded the benefits of the liability releases under the Adjustable Interest Rate (LIBOR) Act for LIBOR transitions occurring prior to this week.
For new contracts and existing contracts currently being amended, LIBOR should be transitioned to Daily Simple SOFR or 30-Day Average SOFR. This is particularly critical for hedged transactions.
For existing contracts previously amended that do not reflect the foregoing but instead reflect the historical benchmark replacement changes, this should be quickly rectified.
As the summer LIBOR end date approaches, it is highly recommended that ample sunblock be on hand to prevent being further burned during the final LIBOR transition, with LIBOR and SOFR benchmark rates expected to be extremely volatile by June as a result of the transition.
 Often, Term SOFR is ironically defined in the LIBOR transition documents as ‘SOFR’ although it is not an actual SOFR rate.
 For concerns relating to the ISDA Protocol, see the Client Alert entitled ‘ISDA 2020 IBOR Fallbacks Protocol’ dated October 20, 2020.
 Also see ‘Significant Financial Ramifications” in the Client Alert entitled ‘LIBOR Transition: Potential Higher Interest Rates and Resultant Job Cuts’ dated July 1, 2021.
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