“You need lucky breaks to be successful.”
I don’t know if the Intercontinental Exchange Benchmark Administration’s (IBA) announcement on November 30, 2020 counts as a lucky break, but on that day a collective sigh of relief could be heard across the financial industry.
If by chance you are still buried under the demands of these challenging times, you may be unfamiliar with recent events. To summarize, the announcement indicated that the publication of some USD LIBOR, the London Inter-Bank Offered Rates, that were originally intended to cease by year-end 2021 may be extended through June 2023. However, the less commonly referenced, one week and two-month, USD LIBOR publications are still scheduled for cessation as of December 2021.
So, now that we have one less looming deadline, let’s take a few minutes and consider the facts and implications from a Global, National, State, and Community perspective.
A GLOBAL HISTORY:
Globally, LIBOR is one of the most referenced short-term rates, with approximately $200 trillion of debt securities, loans, and derivatives based on the USD benchmark, alone.
LIBOR is believed to have originated in 1969 and was formalized two decades later when the British Banker’s Association (BBA) began overseeing the data collection and rate publications. The rate was based on a panel of large financial institutions, who reported their funding rates to the BBA. They, in turn, processed the data and published the rates daily.
However, the credibility of LIBOR came into question during 2007, when the rate behaved in a manner inconsistent with the financial crisis and other comparable rates at that time. As a result, an independent review was commissioned in 2012. As their investigation uncovered evidence of widespread manipulation, the independent commission recommended that the administrative responsibilities for LIBOR publications be transitioned from the BBA to the Intercontinental Exchange Benchmark Administration (IBA). That transition took place in 2014.
Although oversight was improved, the process for data collection and rate calculations remained unchanged. Over the years, though, the sample size of data has sharply declined. Fewer panel banks are reporting, and the number of actual transactions used as a basis for the rates have declined. As such, published rates have become exceedingly reliant on expert judgement. As a result, the IBA announced in 2017 that they would cease the publication of LIBOR rates by year-end 2021.
OUR NATION’S RESPONSE:
While the transition of administrative responsibilities to the IBA provided hope for a more reliable rate, the Federal Reserve took a different approach in 2014. Specifically, they formed the Alternative Reference Rates Committee (ARRC) and tasked the group with the responsibility of recommending a benchmark rate to replace LIBOR.
In June 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the recommended replacement rate for the USD LIBOR and began the arduous task of developing a transition plan. This has proven to be a challenging task due to the inherent differences between the two rates. One such difference is the credit risk factor. LIBOR includes a credit risk adjustment, whereas SOFR does not. Additionally, LIBOR is published for multiple terms, based on averages. SOFR is a daily quote. The following table highlights the key differences between the two rates:
Bank submittions ans expert judgement
Market represented by:
Bank unsecured wholesale financing
Overnight, 1 week, 1 month, 2 months, 3 months, 6 monyhs, 1 year
Unsecured deposits, Primary Issuance CP & CD`s
U.S. Treasury Securities
Bank-to-Bank lending rate
Risk free rate
Forward looking/Backward looking:
Interest known in advance
Interest Known in arrears
Estimated rated transactions:
Of primary importance for debt securities, derivatives, and loans, is the determination of a spread adjustment that neutralizes the financial impact due to the transition from LIBOR to SOFR —a highly complex task based on their considerable differences.
The AARC provided further insight regarding spread adjustments in their September 2020 request for proposals when they included the following statement:
“The ARRC conducted two market-wide consultations this year (issued in January and May) regarding the appropriate methodology for its recommended spread adjustments. Following feedback to the initial consultation, the ARRC recommended a spread adjustment methodology based on the historical median difference between LIBOR and SOFR over a five-year lookback period…”
Despite challenges, the slow adoption of SOFR in the financial markets, and a global pandemic, the ARRC is steadfastly working toward the nation-wide transition from LIBOR to SOFR.
THE STATE’S LEGAL CHALLENGES:
To further complicate matters, not all existing contracts include language for a replacement rate. As such, there is no legal provision that allows for the use of an alternative rate when LIBOR publications are no longer available. With contract law governed at the state level, this issue ultimately falls to the states to resolve.
On January 19, 2021, New York became the first state to propose legislation to address the issue of LIBOR based contracts that lack the appropriate fallback provisions. The legislation addressed two primary issues:
- It provided for a replacement rate for silent contracts.
- It provided for safe harbor from litigation resulting from the use of a recommended replacement rate.
If passed, the legislation may serve as the roadmap for other states as they work to minimize the legal and economic impact associated with the cessation of LIBOR.
THE IMPACT ON COMMUNITY FINANCIAL INSTITUTIONS:
Although the AARC is diligently working toward replacing LIBOR with SOFR, Community Financial Institutions are not required to use SOFR as their replacement rate. The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation included the following declaration in a recent joint statement:
“A bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs.”
While Community Financial Institutions may enjoy the freedom to choose from various replacement rates, they are strongly encouraged to transition away from USD LIBOR as soon as practical. In the following joint statement issued on November 30, 2020, Statement on LIBOR Transition - November 30, 2020 (federalreserve.gov), the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation noted the following key points:
- “New contracts entered into before December 31, 2021 should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation.”
- “Given consumer protection, litigation, and reputation risks, the agencies believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly.”
Although challenging, the transition from LIBOR to SOFR would offer the financial industry a short-term reference rate that is free from reliance on expert opinions. By extending the publication of the most widely used USD LIBOR rates until June 30, 2023, Community Financial Institutions would gain additional preparation time to evaluate and select replacement rates, communicate with impacted customers, update systems, and modify accounting processes. Furthermore, the additional time would allow for some legacy USD LIBOR contracts to mature before LIBOR ceases publications.
A CALL TO ACTION FOR INVESTMENT PORTFOLIO MANAGERS:
How will the cessation of LIBOR impact the investment portfolio of your Community Financial Institution? This question is just one more issue to address as you manage through margin compression, unprecedented liquidity, and a dearth of investment opportunities. As the industries low-cost advisor of fixed income portfolios, let SB Value Partners, LP show you how to generate additional ROA and ROE from your investment portfolio.
ABOUT THE AUTHOR
Leslie Heath | Vice President, MBS Specialist
My true passion is sailing. Having spent my childhood living abroad in France, Germany, Libya, and Italy, we finally returned to the states when I was in my early teens. You would think that once we settled back home that I would never again leave solid ground, but I took to the water at 14 years old and have been there ever since. Many weekends are spent enjoying the calm waters, a seasonal breeze, and the setting sun.
With 35 years of extensive experience as a fixed income trader, I’d like to say that I started at age 14, as well, but alas, that is not the case. During those years, I developed a diverse investment background and currently specialize in mortgage related securities: MBS’s, CMO’s, ABS,’s, CMBS’s, ACMBS’s.
Being in the industry for so many years, I’ve had a front row seat for every ebb and flow of the market, and I find that there are many similarities between sailing and market cycles. Sometimes the wind is to your back, the waters are smooth, and it feels like it will never slow down. Other times its choppy, erratic, and unpredictable. As both a fixed income trader and an avid sailor, I find it’s best to be prepared for the unexpected, maintain a standard of excellence, and keep an eye on the horizon.