phase-out of libor: impact on floating rate loans and...
TRANSCRIPT
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Presenting a 90-minute encore presentation featuring live Q&A
Phase-Out of LIBOR: Impact on Floating
Rate Loans and Derivatives; Implementing
Alternative Reference Rates
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, JANUARY 3, 2018
Cheryl I. Aaron, Senior Counsel, Michael Best & Friedrich, Washington, D.C.
Mark Heimendinger, Of Counsel, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla.
James S. Toscano, Shareholder, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla.
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© 2017 All rights reserved. Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
LOCAL ROOTS. BROAD REACH.SM
Phase-Out of LIBOR
Mark E. Heimendinger
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
www.lowndes-law.com
© 2017 All rights reserved. Lowndes, Drosdick, Doster, Kantor & Reed, P.A. LOCAL ROOTS. BROAD REACH.SM
Phase-Out of LIBOR
Mark E. Heimendinger
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
www.lowndes-law.com
Reasons for the Phase-out - Background
LIBOR rate fixing scandal
Wheatley Review published September 20121
ICE Benchmark Administration took over administration of LIBOR February 2014
Alternative Reference Rates Committee convened November 2014
ICE Benchmark Administration LIBOR Roadmap published March 20162
Secured Overnight Financing Rate (SOFR) chosen by ARRC to replace LIBOR
Andrew Bailey announcement July 20173
7
Reasons for the Phase-out – Current Official Views
• While no one is mandating an end to LIBOR, it may simply not exist after the
end of 2021
• IOSCO Principles for Financial Benchmarks4
• Desire for a truly transactions-based reference rate5
• Need for a reference rate that encompasses a robust market
• Desire for an overnight, nearly risk-free rate that is highly correlated with other
money market rates
– Why overnight? There currently is not enough date to produce a robust term rate
• Desire for a rate that covers multiple money market segments that allows for
future evolution
8
Reasons for the Phase-out – Dissenting Views?
• Conflict between creating the “perfect” reference rate vs. “good enough”
• Currently around $160 trillion in transactions quoted in U.S. dollar LIBOR with
approximately 90% of that made up by derivatives6
• Jeffrey Sprecher of ICE stated in October that LIBOR will be difficult to replace and
SOFR doesn’t address term rates7
• CME chief executive Terry Duffy has said he expects LIBOR to continue to be used
alongside the new rates after 20218
• Nearly 80% of the 164 respondents to a recent Bank of America Merrill Lynch survey
released in October believe that LIBOR should continue9
9
Timeline - Paced Transition Plan10
• Infrastructure for futures and/or Overnight Index Swaps (OIS) trading in the new rate is put into
place by ARRC members (2nd half of 2018)
• Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR (end of 2018)
• Trading begins in cleared OIS that reference SOFR in the current Effective Federal Funds
Rate (EFFR) Price Alignment Interest (PAI) and discounting environment (end of 2018)
• CCPs begin allowing market participants a choice between clearing in new or modified swap
contracts (swaps benchmarked to EFFR, LIBOR and SOFR) into current PAI and discounting
environment or one that uses SOFR for PAI and discounting (1st quarter 2020)
• CCPs no longer accept new swap contracts for clearing with EFFR as PAI and discounting
except for the purpose of closing out or reducing outstanding risk in legacy contracts. Existing
legacy contracts continue to exist but roll off as they hit maturity (2nd quarter 2020)
• Creation of a term reference rate based on SOFR derivatives markets once liquidity has
developed sufficiently to produce a robust rate (end of 2021)
10
Impact on Commercial Lending
• Paced Transition Plan focuses on derivatives
• SOFR is solely an overnight rate and no replacement is anticipated until the end of
2021
• Legacy fallback language contemplates a temporary unavailability of LIBOR not a
permanent replacement
• While ISDA is taking a leading role in derivatives and is working to make sure its rate
works with term products, the market participants must recognize the need to act
11
Impact on Commercial Lending
• Current fallback language is not adequate
– Base rate loans often more expensive than LIBOR
– Need for polling of reference banks
– Problem of value transfers (the choice of alternative rate not adequate without a spread change in
light of difference between LIBOR and a risk-free rate such as SOFR)
– Some provide for conversion to fixed rate based on last quoted LIBOR rate if polling rates not
received
• Wait and see or act now? If you wait until the end of 2021 it may be too late.
– ARRC’s term reference rate is not anticipated to be available until the end of 2021
– ARRC is leaving this to the market – no current legislative or “global” fix available
– What will the lending market be like in 2021?
12
Impact on Commercial Lending
• Review your legacy contracts
– Identify LIBOR-based loans with terms that extend beyond 2021 or with extension options that
extend beyond 2021
– Calculate exposure to this issue
– Identify any securitized loans first. These may not be possible to amend
• Review language and anticipate problems now
• Defeasance?
– Identify any loans with multiple lenders. These will take time to negotiate. Is the agent authorized to
make changes or will changes require 100% lender approval?
– Contact and begin speaking with lenders/borrowers?
13
Impact on Commercial Lending
• Need new fallback language that is flexible enough to anticipate a new (as yet
unidentified) term reference rate
– Clear trigger for use of replacement
– Flexible enough to generally identify a new accepted benchmark rate but specific enough to allow
for mechanical application to allow for securitization and avoid disputes
– Anticipates the difference in magnitude between LIBOR and new reference rate
– Avoids value transfer
– Minimizes market disruption
– Is not subject to manipulation
14
Impact on Commercial Lending
In the event that Lender determines that LIBOR cannot be determined or is no longer offered and provides notice thereof at least one
business day before the interest determination date with respect to the loan interest accrual period, then, commencing with the first day of
such loan interest accrual period, the interest rate will be converted to an interest rate based on the Prime Rate plus an Alternative Rate
Spread. If, prior to a conversion to an interest rate based on the Prime Rate as described above, Lender has determined in its sole but good
faith discretion that LIBOR has been succeeded by another floating rate index that is has an accrual period that is consistent with the loan
interest accrual period, is commonly accepted by market participants in CMBS loans, has been recognized by ISDA for hedging products,
and which has begun to be regularly quoted by a recognized reporting service (the “Alternate Index Rate”), and Lender provides notice
thereof at least one day before the interest determination date with respect to the loan interest accrual period, then, commencing with the first
day of such loan interest accrual period, the interest rate will be converted to an interest rate based on the Alternate Index Rate plus an
Alternative Rate Spread.
“Alternative Rate Spread” shall mean the difference (expressed as the number of basis points) between (a) the interest rate determined in
respect of the loan interest accrual period for which LIBOR was last applicable to the Loan, and (b) the Alternative Index Rate on such date.
- Issues with taking a “snapshot” in time of LIBOR and the Alternative Reference Rate
- Subject to manipulation by large participants?
- Lack of perfect correlation between LIBOR and the Alternative Reference Rate likely to lead to mispricing
- Perhaps focus on a stated number of multiple data points or historical average over a stated period
15
Impact on Securitized and Packaged Consumer Loans
• Approximately $1.8 trillion in outstanding securitizations that reference U.S. dollar
LIBOR.7
• Typical LIBOR provision gives the lender/noteholder direct authority to pick an
alternative reference rate if LIBOR becomes unavailable. Fannie mortgages, for
example, simply require a “comparable” rate.
• These provisions almost universally simply call for the replacement rate and do not
anticipate a change to the spread.
• Cannot negotiate with millions of (consumer) borrowers and, even if you could, legacy
servicing and trust agreements do not accommodate this issue.
• As it stands, ARRC has not proposed a solution. Will the GSEs and regulators act?
16
End Notes
1https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/191762/wheatley_review
_libor_finalreport_280912.pdf
2https://www.theice.com/publicdocs/ICE_LIBOR_Roadmap0316.pdf
3https://www.fca.org.uk/news/speeches/the-future-of-libor
4https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf
5https://www.newyorkfed.org/medialibrary/media/newsevents/speeches/2017/Frostpresentation.pdf
6https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/Bowmanpresentation.pdf
7https://www.risk.net/derivatives/5345891/ices-sprecher-criticises-libor-replacement-push
8https://www.risk.net/derivatives/5356091/the-fraught-search-for-a-libor-fallback
9https://www.reuters.com/article/us-libor-survey-bankofamerica/many-investors-want-libor-to-stay-with-
improvements-bank-of-america-survey-idUSKBN1CV25F; see also
https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/Bowmanpresentation.pdf
10https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/OConnorpresentation.pdf
17
LOCAL ROOTS. BROAD REACH.SM
Questions?
Mark E. Heimendinger
Of Counsel
Lowndes, Drosdick, Doster, Kantor & Reed, P.A.
407-418-6271 | Orlando, FL
18
Phase-Out of LIBOR
Cheryl I. Aaron
LIBOR in Derivatives Contracts
michaelbest.com
• LIBOR is used as a reference rate in $160 trillion (notional) of
derivatives contracts
• In many interest rate swaps, counterparties rely on a LIBOR-based
rate to hedge against the floating rate risk in a loan or credit facility
• The vast majority of swaps and other types of derivative products
incorporate the terms of the International Swaps and Derivatives
Association (“ISDA”) Master Agreement
• As written, the LIBOR replacement language in the ISDA Master
Agreement is insufficient
• The 2006 ISDA Definitions create a fallback where LIBOR is
unavailable, in which case the Calculation Agent can collect alternate
rates from other major banks and use the arithmetic mean to
determine the replacement
20
LIBOR in Derivatives – what to do now?
michaelbest.com
• First Step: portfolio review • Examine your company’s derivatives portfolio (ideally as part of a
review of all financial contracts), and determine which contracts
reference LIBOR
• Second Step: divide derivatives into 3 categories 1. Already-executed transactions that expire by the end of 2021
• No need to act – counterparties can rely on LIBOR
2. Already-executed transactions that expire after 2021
• Amend, incorporate appropriate fallback terms, allocate associated
risks/losses, and align with related loan fallback terms (as applicable)
3. Transactions that have not yet been executed
• Incorporate appropriate fallback terms, align with related loan fallback
terms (as applicable); potentially choose alternative reference rate
21
LIBOR Replacement Terms
michaelbest.com
• LIBOR fallback language in credit facilities and other
financial contracts should:
- Select a specific replacement rate OR (i) clearly delineate which party or parties
will choose the replacement rate, and (ii) set any other parameters for the rate
- Account for all scenarios in which LIBOR may “go away” (e.g., become
unavailable, no longer be published, be unlawful to rely upon… see ISDA
triggers)
- Set a date on which the replacement rate will go into effect under the contract
- Allocate any costs / risks associated with relying on the replacement rate in lieu
of LIBOR
- Create termination rights and payment obligations (if no replacement rate)
22
The ISDA Solution
michaelbest.com
• ISDA is in the process of creating a universal LIBOR transition solution for
derivatives and other financial contracts
• At present, ISDA is:
1. Developing a roadmap for the transition (expected December 2017)
2. Drafting a report that will include the results of a market survey on the use of
LIBOR, will identify potential transition issues for existing and new contracts,
and will make recommendations for possible solutions (expected March 2018)
• Going forward, ISDA expects to:
1. Develop strategies related to term structures for the LIBOR replacement rate
and the credit spread that will arise
2. Amend the 2006 ISDA Definitions to incorporate the fallback terms
3. Create a Protocol to incorporate the fallbacks into already-executed
transactions
23
The ISDA Solution
michaelbest.com
• ISDA has identified the following “triggers” for use of its fallback language:
1. A public statement by the ICE Benchmark Administration of its insolvency, with
no successor administrator
2. A public statement by the ICE Benchmark Administration that it will cease
publishing USD LIBOR permanently or indefinitely, and there is no successor
administrator to continue publication
3. A public statement by the UK Financial Conduct Authority that USD LIBOR has
been permanently or indefinitely discontinued
4. A public statement by the UK Financial Conduct Authority that USD LIBOR
may no longer be used
• The trigger timing is upon cessation of USD LIBOR, not at the time of the
announcement
24
The ISDA Solution – Worth the Wait?
michaelbest.com
• Should derivative counterparties begin negotiating / amending their ISDA
Master Agreements now? Or wait until an ISDA protocol is available?
- Either approach is acceptable, but the ISDA solution will likely be the most
streamlined and universally-adopted
- Regardless of methodology, interest rate derivatives that hedge the floating
rate risk in a related credit facility must align fallback terms with the credit facility
• Should derivative counterparties wait until the alternative reference rate is
available before amending / updating contract terms? Or choose a new
rate in the meantime?
- There is no need to wait for the new benchmark to be published and adopted
prior to amending derivative contract terms – the parties can insert fallback
terms with objective standards for when and how to pick a new rate
- It is not necessary to choose a new rate prior to the adoption of SOFR
(discussed below), though some parties may desire the economic certainty of a
set replacement rate
25
Choosing an Alternative Reference Rate
michaelbest.com
• What makes a good financial benchmark?
- Integrity and continuity. The benchmark should be based on an underlying
market with sufficient liquidity, transaction volume and resilience
- Soundness and robustness. The benchmark should have standardized terms,
transparent data, and readily available historical data (IOSCO Principles)
- Accountability. The benchmark should have evidence of a process that ensures
compliance with the IOSCO Principles
- Governance. The benchmark should have governance structures that promote
its integrity
- Ease of implementation. The benchmark should allow for relative ease in
transitioning to the new rate, including an assessment of the anticipated
demand for hedging and trading, and the potential for a term market in the
underlying rate
26
The Alternative Reference Rate Committee
michaelbest.com
• In 2014, FSOC recommended that U.S. regulators identify an alternative
to USD LIBOR, based on perceived shortcomings
• Later that year, the Federal Reserve Board convened the Alternative
Reference Rates Committee (ARRC) to identify a new financial
benchmark that:
- is based on actual transactions
- aligns with the IOSCO Principles for Financial Benchmarks
• The ARRC is a public-private partnership, comprising representatives of
the Federal Reserve, Federal Reserve Bank of NY, and various banks
• In June 2017, after considering six potential replacement rates, the ARRC
selected the Secured Overnight Financing Rate (SOFR) as its
recommended alternative to USD LIBOR
27
Secured Overnight Financing Rate (SOFR)
michaelbest.com
• What is SOFR?
- Includes overnight, Treasury-backed repo transactions
- All transactions take place in BNY’s triparty repurchase system or are cleared
on one of two Fixed Income Clearing Corporation platforms
- Will be published daily at 8:30am ET based on prior day’s trading activity
• The Federal Reserve requested public comment on its proposal to
compute SOFR in August 2017 (the comment period ended on Oct. 30th)
• The Federal Reserve Bank of New York, along with the Office of Financial
Research, expect to begin publishing SOFR in 2Q 2018
28
LIBOR vs. SOFR
michaelbest.com
• LIBOR is:
- An index that reflects the interest rates at which banks borrow from one another
overnight on an uncollateralized basis
- Calculated daily in 5 currencies (USD, EUR, GBP, JPY, CHF) and for maturities
ranging from overnight to 1 year
- Formulated from pricing contributions by 17 panel banks (using “expert
judgment” rather than transaction data)
• SOFR is:
- An index that that is nearly “risk-free,” reflecting a broad measure of overnight
U.S. Treasury repurchase (“repo”) financing transactions
- Calculated based on transaction data (no subjective input)
- Solely a replacement for USD LIBOR
- Based on collateralized transactions in a liquid market (with about $660 billion in
daily transactions)
29
Other LIBOR Alternatives
michaelbest.com
• United Kingdom: The Sterling Overnight Index Average (SONIA) will
replace GBP LIBOR
- SONIA is administered by the Bank of England, and is based on actual
transactions in the UK overnight unsecured market
• Japan: The Tokyo Overnight Average Rate (TONAR) will replace JPY
LIBOR, JPY TIBOR and Euroyen TIBOR
- TONAR is calculated and published by the Bank of Japan, and is based on
actual transactions in the Tokyo overnight unsecured market
• Switzerland: The Swiss Average Rate Overnight (SARON) will replace
CHF LIBOR
- SARON is administered by the Swiss National Bank, and is a secured overnight
interest rate average based on the Swiss France interbank market
• EU: The replacement rate for EU LIBOR and Euribor has not yet been
determined
30
The Future of Benchmarks in Derivatives
michaelbest.com
• Despite references to the “end,” “demise” “phaseout,” etc. of LIBOR, the
benchmark may very well continue to exist past 2021
- The UK Financial Conduct Authority did not create a requirement for ICE
Benchmark Administration to stop publishing LIBOR
- Instead, it will no longer compel the LIBOR panel banks to submit pricing data to
the publisher after 2021
• Regardless, LIBOR is no longer the reliable benchmark that it once was,
and derivatives counterparties should not plan on using it past 2021
• Derivatives market participants should expect the transition from LIBOR
to be a massive undertaking, but with advance planning and a thorough
understanding of the new reference rate, the shift may be a smooth one
31
Thank You
michaelbest.com 32
Cheryl I. Aaron
Senior Counsel
Michael Best & Friedrich, LLP
202.595.7934
The Demise of LIBOR:
A Litigation Perspective
James S. Toscano
I. Assumption is that LIBOR goes away
* Given how LIBOR is determined, if the process
for establishing it no longer exists, there is
no objective way to calculate what LIBOR
would be going forward for purposes of
comparison
34
II. CONTRACT LAW GOVERNS
• Loan Credit Agreements
• Adjustable Rate Mortgages
• Home Equity Lines of Credit
• Auto Loans
• Student Loans
• Credit Cards
35
III. HOW DO CONTRACTS ADDRESS
CHANGES IN LIBOR?
Sampling of Provisions: • Successor Provisions: LIBOR continues, but under some authority other than
the ICE Benchmark Administration or is published in a different way.
• Provisions allowing some unilateral flexibility yet still tied to LIBOR: Allows
one party some flexibility to select among LIBOR averages and indecies or to
select some rate still tied in some way to the underlying LIBOR rate.
• Reference Bank Provisions: Provides that a specific interest rate offer from a
specified private bank or the average of rates offered by several identified
banks would be the replacement rate for the LIBOR rate if LIBOR is
unavailable.
• Unilateral Selection: The creditor party is allowed unilaterally to select a
comparable replacement if LIBOR is no longer available.
36
IV. SPECIFIC LANGUAGE FROM FORM
ADJUSTABLE RATE RESIDENTIAL
MORTGAGES (FANNIE MAE)
If the index (a function of LIBOR) is no longer available, the Note
Holder will choose a new index that is based upon comparable
information. The Note Holder will give me notice of this choice.”
37
V. WHAT IS “COMPARABLE INFORMATION?”
• Vague and Ambiguous?
• Interpreted Against the Drafter/Note Holder?
• Essential Term?
• Meeting of the Minds?
38
VI. LEVERAGE/BALANCE OF POWER
• Should have less of an impact on Senior Loan Market –
better able to monitor situation and negotiate resolution.
• Some Commercial Credit Agreements have fallback
language that allows the Issuer to choose other indices
such as the Prime Rate, Federal Funds Rate or the
Treasury “Repo Rate” – temporary fix.
• Those on more equal footing are more likely to work it
out/be able to protect their interests.
39
VII. WHAT ABOUT THE INDIVIDUAL BORROWER
BOUND BY UNILATERAL SELECTION PROVISION?
Unlikely replacements:
• 1 year Treasury Index/Monthly Treasury Average
• Certificate of Deposit Index
• Constant Maturity Treasury
40
VIII. POTENTIAL NEW BENCH MARK
• Alternative Reference Rates Committee
• Fannie Mae and Freddie Mac
41
IX. WHAT TO DO?
42
