THE GREAT MIGRATION
AWAY FROM LIBOR
WHAT’S INSIDE
LIBOR: Getting to Transition
U.S. LIBOR Transition: Demystifying SOFR
Brave New World: Operationalizing SOFR!
Flashforward: LSTA Releases Draft SOFR “Concept Credit Agreement”
What’s Your Fallback?
Aligning Loans and CLOs
On Accounting, LIBOR Transition Has Been Relatively Smooth
1
THE GREAT MIGRATION AWAY FROM LIBOR
LIBOR: GETTING TO TRANSITION
BY MEREDITH COFFEY, EXECUTIVE VICE PRESIDENT, RESEARCH AND PUBLIC POLICY
L
IBOR, “the world’s most important number”, is likely to
cease after 2021. This presents significant—but hopefully
surmountable—challenges. Below, we discuss the LIBOR
problem, timeline and potential shorter- and longer-term
solutions. We know whereof we speak; the LSTA is a member
of the overall Alternative References Rates Committee
(“ARRC”), the body tasked with replacing U.S. dollar LIBOR.
We also co-chair the ARRC’s Business Loans Working Group
(which is tasked with solving LIBOR transition problems
for syndicated and bilateral loans) and the Business Loans
Operations Subgroup (which is working to operationalize loan
solutions), and are a member of the ARRC’s Securitization
Working Group (where we represent the interests of CLOs.)
WHAT IS THE “PROBLEM” WITH LIBOR?
During the financial crisis, allegations of LIBOR manipulation
led to banks paying billions of dollars of fines and people
going to jail. Since then, banks have reduced their interbank
funding (LIBOR) borrowings. As a result, there is only about
$500 million of daily three-month interbank (e.g., LIBOR)
trading. These trades are the informational foundation of
the LIBOR quotes submitted by banks. These quotes, in turn,
are used to create the LIBOR curve—and this LIBOR curve is
used to price $200 trillion of contracts (including $4 trillion of
U.S. syndicated loans and nearly $700 billion of CLO notes).
If something were to happen to LIBOR—like it suddenly
ceased or was deemed to be unreliable—there potentially
could be significant issues for those $200 trillion of contracts.
IS LIBOR “GOING AWAY”
AFTER THE END OF 2021?
It’s extremely likely. Due to potential legal liability and
the small number of actual interbank trades, banks don’t
particularly like providing LIBOR submissions. For now,
the panel banks have agreed to continue their LIBOR
submissions through 2021, but the UK Financial Conduct
Authority (FCA) have said they would not compel banks
to submit LIBOR thereafter.
2
THE GREAT MIGRATION AWAY FROM LIBOR
LIBOR: GETTING TO TRANSITION, MEREDITH COFFEY
At that point, banks may or may not submit LIBOR and LIBOR
may or may not continue. That said, Andrew Bailey, CEO
of the FCA recently stated that “We do expect bank panel
departures from the LIBOR panels at end-2021. That is why
we keep stressing that the base case assumption for firms’
planning should be no LIBOR publication after end-2021.”
WHAT MIGHT REPLACE LIBOR?
In the U.S., the Alternative Reference Rates Committee
(“ARRC”) has identified the Secured Overnight Financing
Rate (“SOFR”) as the LIBOR replacement for derivatives.
SOFR is the combination of three overnight treasury repo
rates. It is very liquid and very deep, with roughly $1 trillion
of trading on a daily basis. This means that it will likely
be robust, durable and hard to manipulate—all alleged
shortcomings of LIBOR. It is highly likely that SOFR also
will become the replacement rate for cash products like
institutional term loans, FRNs and CLOs.
HOW ARE SOFR AND LIBOR DIFFERENT?
SOFR is an overnight, secured risk-free rate, while LIBOR
is an unsecured rate with a term curve. Because SOFR is
secured and risk-free, it theoretically should be lower than
LIBOR. Moreover, SOFR, being an overnight rate, does
not naturally have a “term curve”, in other words forward
quotations of a 1-month and 3-month rate.
WILL A SOFR “TERM CURVE” BE DEVELOPED?
An “indicative” forward looking term SOFR has been
developed from futures trading. In addition, the ARRC
hopes to develop an IOSCO compliant “SOFR term reference
rate” before the end of 2021. However, a forward looking
term reference rate can only be developed if there are large
and consistent SOFR futures trading volumes—and this
is by no means guaranteed. Still, if a SOFR term reference
rate cannot be developed, cash products could use a
“compounded” overnight SOFR, which already exists. In
fact, a safer bet might be to rely on compounded SOFR
rather than waiting years for forward looking term SOFR.
WILL SOFR BE ADJUSTED
TO LOOK MORE LIKE LIBOR?
Because SOFR is a secured, risk-free rate, it theoretically
should be lower than LIBOR. In turn, market participants are
working to develop a spread adjustment, which would make
LIBOR and SOFR more comparable. This would be a one-time
adjustment; it is meant to apply primarily to legacy LIBORbased loans that would need to transition to SOFR-based
loans around LIBOR discontinuance. In December 2018, ISDA
released the results of a derivatives fallback consultation, and
expects to use a “historical mean/median” spread adjustment
for derivatives. They plan to begin publishing the spread
adjustment around year-end 2019. In addition, the ARRC has
said that it would consider publishing a spread adjustment
for cash products. However, it is likely that an ISDA spread
adjustment would work equally well for cash products.
HOW SHOULD LOAN DOCUMENTS EVOLVE TO
ADDRESS A POTENTIAL CESSATION OF LIBOR?
Loans tend to be relatively short-lived, are easily
refinanced or amended, and always have had a “fallback”
to Prime if LIBOR weren’t published. For this reason,
syndicated loans already were in better shape than
many other asset classes (many of which have longer
tenors, limited fallbacks and are hard to amend). However,
loans and CLOs still have their work cut out for them.
In April 2019, the ARRC released recommended loan fallback
language. There are two major components to LIBOR
fallback language: First is the trigger event that initiates
the transition from LIBOR to a replacement rate. (A simple
example is LIBOR cessation.) Second is the fallback rate
and spread adjustment. Below is a brief recap of fallback
language; please see nearby article for a detailed analysis.
The ARRC recommended fallback language includes two
fallback options. The first approach—the “amendment”
approach—is similar to, but more robust than, what occurs
in the loan market today. First, a specifically defined trigger
event must occur. Second, the borrower and agent identify
a replacement rate and spread. Third, the “Required
Lenders”, typically a majority, have a five-day window
in which they can reject the proposed rate.
The second approach—the “hardwired” approach—is
similar to what is occurring in all other cash asset classes.
When a trigger occurs, the loan immediately looks to a
waterfall of replacement rates and spreads. The first stage
of the rate waterfall is forward looking term SOFR plus
a spread adjustment (either from ARRC or ISDA). If that
does not exist, the second stage of the rate waterfall is
compounded overnight SOFR plus a spread adjustment
(either from ARRC or ISDA). If that doesn’t exist, the
hardwired approach falls back to an amendment approach.
Since the ARRC released its fallback recommendations, a
number of loan agreements have utilized the “amendment”
approach. Market participants agree that a hardwired
approach likely will make more sense longer term, but
are waiting until they have more clarity into SOFR behavior
before locking in that rate. (See related SOFR FAQ for
more details on its behavior.)
WHAT ELSE DOES THE LOAN MARKET
NEED TO DO TO PREPARE FOR A POTENTIAL
CESSATION OF LIBOR?
The loan market does not exist in isolation. Many loans
have embedded hedges and are held in CLOs. In an ideal
world, any transition from LIBOR to a new reference rate
would occur simultaneously for the loan, hedge and CLO. In
reality, the transition will likely be messier; however, market
participants should consider the impact on other nearby
markets and seek to minimize disruption.
3
THE GREAT MIGRATION AWAY FROM LIBOR
LIBOR: GETTING TO TRANSITION, MEREDITH COFFEY
Making the language of credit agreements (and CLOs)
work in a potential LIBOR cessation environment is critical.
However, market participants also have to consider other
issues, like tax and accounting issues and operational
challenges. Bank loan systems already are being recoded
to manage a number of different types of interest rates.
The way the loan market calculates delayed compensation
may also change as the reference rate changes. In addition,
issues like multicurrency facilities could be challenging.
IS THIS ONLY HAPPENING IN THE U.S.?
No. A number of jurisdictions are transitioning away from
their relevant currency IBOR to an overnight risk free rate.
In the UK, Reformed SONIA (Sterling Overnight Interbank
Average Rate) has been identified as the appropriate
replacement for GBP LIBOR (and in June 2019, the first
SONIA bilateral loan was announced). In Switzerland,
SARON (Swiss Average Overnight Rate) already has
replaced the TOIS benchmark. In Japan, TONAR (Tokyo
Overnight Average Rate) has been selected as the
alternative to yen Libor. Some of these risk free rates,
such as SONIA, are unsecured, while others, such as
U.S.’s SOFR, are secured. In the context of multicurrency
facilities, market participants should recognize that
different currencies might transition to alternative
rates at different times and the different alternative
rates may require different spread adjustments.
To facilitate an orderly transition, a number of global financial
trade associations are collaborating to help ensure that there
is coordination across jurisdictions and asset classes.
SO WHAT IS THE LSTA DOING?
The LSTA is on the ARRC itself, it co-chairs Business Loans
Working Group (which developed the LIBOR fallback
language) and the Business Loans Operations Subgroup
(which is operationalizing SOFR and other potential
replacement rates), and is a member of the ARRC’s
Securitization Working Group (where we represent CLOs),
the Accounting Working Group and the Infrastructure
Working Group.
We are working actively within the ARRC framework, and we also are
coordinating globally with other trade associations such as the LMA, ISDA,
the ABA, SFIG, SIFMA, CREF-C and more. In addition, at the end of 2018,
we began to tackle operational challenges that a transition away from
LIBOR will bring. We firmly believe that if market participants recognize
the challenges and mobilize now, an orderly transition is doable. We
encourage you to join our efforts. For more information, please contact
us! LSTA LIBOR team leaders are Meredith Coffey (mcoffey@lsta.org)
for policy and market impact, Tess Virmani (tvirmani@lsta.org) for legal/
documentation, Ellen Hefferan (ehefferan@lsta.org) for operations and
Phillip Black (pblack@lsta.org) for accounting.
4
THE GREAT MIGRATION AWAY FROM LIBOR
U.S. LIBOR TRANSITION:
DEMYSTIFYING SOFR
BY MEREDITH COFFEY, EXECUTIVE VICE PRESIDENT, RESEARCH AND PUBLIC POLICY
FIGURE 1: 1M LIBOR VS 1M FORWARD
LOOKING TERM SOFR
1M LIBOR
1M Forward Looking Term SOFR
2.5
2.25
2
SEP 19
JUL 19
AUG 19
JUN 19
APR 19
MAY 19
MAR 19
JAN 19
FEB 19
DEC 18
NOV 18
SEP 18
1.75
OCT 18
• Forward
Looking Term SOFR. This rate would be most
analogous to LIBOR in that it would have a term curve and
likely be quoted as 1-month or 3-month SOFR. It would
be easy to operationalize in loan systems—after all, it
locks an interest in in advance, just like LIBOR—and would
require few changes to conventions. The negative is that
SOFR is actually a daily rate and a Forward Looking Term
SOFR would have to be extrapolated from SOFR futures
trading. Though an indicative Forward Looking Term
SOFR exists today, there is no guarantee that an IOSCO
Compliant Forward Looking Term SOFR reference rate can
be created. In order for a forward rate to be robust and
stable enough to be an IOSCO compliant reference rate, it
will have to have significant history and be comprised of
a significant and consistent volume of futures trading.
Moreover, if lenders simply wait for Forward Looking
Term SOFR to exist, the necessary overnight SOFR futures
trading won’t occur and a forward looking reference rate
won’t develop. Classic chicken-and-egg problem.
• Simple Daily SOFR in Arrears. This is the simple—not
compounded—rate that accrues during the interest period.
Continuing the hypothetical example, for a 30-day loan
contract beginning on April 1, the parties would take the daily
AUG 18
The derivatives market has determined it will use “SOFR
Compounded in Arrears” for its LIBOR fallbacks. However,
there are four potential SOFRs that cash products may use:
• SOFR Compounded in Arrears. This rate would be
compounded during the life of the loan contract. Continuing
the hypothetical example, for a 30-day loan contract
beginning on April 1, the parties would take the daily SOFR
rate (or, potentially, the outstanding balance) and compound
it each day through April 30. The positives are that it is the
exact real interest rate for the contract period and it’s perfectly
hedgeable with swaps. The first negative is that the final rate
would not be known at the start of the interest period; this
may not be a fatal flaw as the accrued rate would be known
at any point in the period and, per the charts below, it would
be easy to observe the expected rate in the futures market.
Second, loan conventions would need to change and this type
of rate would be more complex to operationalize. (We will
discuss the operationalization approaches in another section.)
JUL 18
We begin with a short explanation of the potential new
reference rate. SOFR is comprised of three overnight U.S.
Treasury Repo rates. This repo market is very liquid and
deep, with around $1 trillion trading every day. Because this
market is deep, observable and published by the Federal
Reserve, it is hard to manipulate. In light of historical LIBOR
experiences, this is a good thing. However, SOFR is also a risk
free rate, and it is an overnight rate (as opposed to having a
term curve like LIBOR). For these reasons, some adjustments
may be needed for SOFR to work well in the cash markets.
• SOFR
Compounded in Advance. This is the rate that
would be compounded over the previous 30/60/90 days.
As a simplified hypothetical example, for a 30-day loan
contract beginning on April 1, the parties would calculate
the compounded rate from March 1-30 and lock it in on
April 1. The positives are that, like Forward Looking Term
SOFR, the rate would be known in advance and could be
operationalized easily. The potential negative is that it could
be perceived as being stale and could raise asset-liability
management challenges.
JUN 18
ost U.S. lenders and borrowers realize that LIBOR is
likely to end sometime after 2021. However, they may
be less familiar with SOFR, the Secured Overnight Financing
Rate, which will be the fallback for U.S. dollar derivatives and
likely will be the fallback for cash products. Thus, lenders
are keenly interested in seeing what SOFR actually looks
like. To tackle that issue, we first define the potential SOFRs
and then chart the different SOFRs to demonstrate their
characteristics. We hope that as market participants become
more familiar with the “look and feel” of the various SOFRs,
they also will become more comfortable with developing
hardwired LIBOR fallback language that references them.
Rate (%)
M
Source: NY Fed, St Louis Fed
5
THE GREAT MIGRATION AWAY FROM LIBOR
U.S. LIBOR TRANSITION: DEMYSTIFYING SOFR, MEREDITH COFFEY
2.25
2
1.75
JUL 19
AUG 19
JUN 19
APR 19
MAY 19
FEB 19
MAR 19
JAN 19
DEC 18
NOV 18
SEP 18
OCT 18
JUL 18
AUG 18
JUN 18
1.5
Source: NY Fed
Next we compare the look and feel of Forward Looking
1-month SOFR against 1-month SOFR Compounded in
Arrears. As Figure 3 illustrates, these rates are very similar. In
fact, this should not be a surprise. After all, Forward Looking
Term SOFR is the expectation of where interest rates should
be, while SOFR Compounded in Arrears is simply where
interest rates are. Unless there is an unexpected rate change
or a period of unexpected volatility, the rates should be
fairly similar. One of the reasons some lenders have been
uncomfortable with SOFR Compounded in Arrears is that
they would not know the exact rate they would receive and
the borrower would pay. While it may not be possible to
have a Forward Looking Term SOFR reference rate, it should
be possible to see the indicative forward looking term rate.
Though there would still be operational challenges around
SOFR Compounded in Arrears, the lack of visibility into the
ultimate rate probably should not be a stumbling block.
FIGURE 3: 1M SOFR FORWARD LOOKING TERM
SOFR VS. 1M SOFR COMPOUNDED IN ARREARS
1M SOFR Compounded in Arrears
1M Forward Looking Term SOFR
2.5
2.25
2
OCT 19
AUG 19
JUN 19
APR 19
FEB 19
DEC 18
1.75
OCT 18
In Figure 2, we compare 1-month SOFR Compounded in
Advance to 1-month SOFR Compounded in Arrears. As one
can quickly discern, these are exactly the same rates; the
only difference is that the Compounded in Arrears rate
(which is compounded during the life of the loan contract)
predates the Compounded in Advance rate by one month.
There has been some concern that SOFR Compounded in
Advance might be stale in periods of rapidly changing rates
or for particularly long interest contracts. This potential delay
should be weighed against the fact that SOFR Compounded
in Advance can be operationalized more easily.
2.5
AUG 18
While many lenders want a forward looking term SOFR, it
is certainly possible that there simply will not be enough
SOFR futures trading to create a robust IOSCO compliant
forward looking term reference rate. For this reason,
the market needs to plan for the possibility of using
compounded rates. So what do they look like?
1M Compounded in Advance
JUN 18
Figure 1 compares 1-month Forward Looking Term SOFR
to 1-month LIBOR. As can be seen, SOFR and LIBOR differ.
This difference is being addressed. The Alternative Reference
Rates Committee (the “ARRC”), the body that is responsible
for LIBOR transition in the U.S., has developed recommended
loan LIBOR fallback language, e.g., language that addresses
the question “If LIBOR ceases, to what rate does my loan
fall back?” For loans that fall back from LIBOR to SOFR,
the recommendations include a “spread adjustment” to
make SOFR more comparable to LIBOR. In its hardwired
version, the ARRC first recommends an ARRC-endorsed
spread adjustment for cash products. If that doesn’t exist,
the fallback language next recommends the ISDA spread
adjustment for derivatives. While it’s not completely final,
ISDA’s consultation results strongly suggest they would take
a historical mean or median of the difference between LIBOR
and SOFR to create the spread adjustment.
1M Compounded in Arrears
Rate (%)
But enough about what these rates are—how do they look
and feel? The Federal Reserve has begun to publish an
Indicative Forward Looking Term SOFR and Compounded
SOFR on its website. To be clear, the indicative rates are
only that; they are not to be used in contracts. So how
do they look?
FIGURE 2: 1M SOFR COMPOUNDED IN ADVANCE
VS. COMPOUNDED IN ARREARS
Rate (%)
SOFR rate each day through April 30, but not compound it.
The positives are that it is the exact real interest rate for the
contract period, it’s close to hedgeable with swaps and can
be operationalized fairly easily. The negative is that the rate,
like Compounded SOFR in Arrears, would not be known
at the start of the interest period. Again, this would mean
that loan market conventions may change substantially to
effectuate this type of rate.
Source: NY Fed
The LSTA is a member of the Alternative Reference Rates Committee (ARRC), co-chairs the ARRC’s Business Loans Working Group (BLWG) and initiated a BLWG
Operations Group. For more information, please contact Meredith Coffey (mcoffey@lsta.org) for policy and market analysis, Ellen Hefferan (ehefferan@lsta.org)
for operations or Tess Virmani (tvirmani@lsta.org) for legal and fallbacks.
6
THE GREAT MIGRATION AWAY FROM LIBOR
BRAVE NEW WORLD:
OPERATIONALIZING SOFR!
BY MEREDITH COFFEY, EXECUTIVE VICE PRESIDENT, RESEARCH AND PUBLIC POLICY
A
t this point, most lenders know that LIBOR is likely to
cease shortly after the end of 2021 and the Secured
Overnight Financing Rate (“SOFR”) is very likely to be the
replacement rate for syndicated loans and CLOs. While
we know that, a major question remains: How do we
make SOFR—a rate that is very different than LIBOR—
work for the loan market? We explain some of the key
issues for operationalization below.
First, as noted in Demystifying SOFR, there actually are
four SOFR rates that need to be operationalized. Two of
the SOFR rates—Forward Looking Term SOFR and SOFR
Compounded in Advance—are very similar to LIBOR
and should be relatively simple to operationalize. The
other two—SOFR Compounded in Arrears and Simple
Daily SOFR in Arrears—are very different and will be
much more complicated to operationalize. But there is a
decent chance that the syndicated loan market will adopt
SOFR Compounded in Arrears, and so it is necessary to
operationalize it—and quickly!
THE “KNOWN IN ADVANCE” SOFRS
Like LIBOR today, borrowers and lenders would know
their SOFR in advance of the interest period in a Forward
Looking Term SOFR and SOFR Compounded in Advance
world. If Forward Looking Term SOFR existed, there would
be a forward looking 1-month or 3-month rate published
every day. Meanwhile, SOFR Compounded in Advance
would be compounded before the interest period begins
and therefore the rate would be locked and known at the
beginning of the interest period. (Thus, we define these
as “Known in Advance” SOFRs.) This is the how LIBOR
works today: one rate is plugged into loan systems at the
beginning of the interest period and counterparties know
the exact amount they will pay or receive, and lenders
can easily calculate daily accruals. Thus, for the “Known
in Advance” SOFRs, accruals, notices and payment periods
can all behave the same way as they do for LIBOR today.
The major systems’ change is that for loans that transition
from LIBOR to SOFR, a spread adjustment must be added
to SOFR to make it more comparable to LIBOR.
So, this is very easy. Why isn’t it the sole solution? The
first issue is that there is no guarantee that a Forward
Looking Term SOFR reference rate will actually exist. It is
contingent upon there being enough SOFR futures trading
that a robust, stable and permanent forward looking
term rate develops. That is by no means definite—and
certainly not definite enough for all eggs to be put in this
basket. Meanwhile, SOFR Compounded in Advance has
the potential to be stale, particularly for longer tenors. For
instance, in a rising rate environment, borrowers might
be very interested in locking in long-tenored contracts
to lock in a low rate for a long time. Meanwhile in falling
rate environments, borrowers may trend toward shorter
contracts to be able to replace the rate with a lower rate in
the near term. This can make asset-liability management
challenging. For these reasons, we cannot just assume that
one of the “Known in Advance” rates will be the winner.
And so, we also have to operationalize the SOFRs that
are not “Known in Advance”. And we have to do it quickly.
THE “NOT KNOWN IN ADVANCE” RATES
The “Not Known in Advance” Rates represent a significant
change for the market. For these rates, the interest
rate is accrued daily over the life of the loan contract.
For instance, here is a hypothetical—and simplified—
“Compounded Balance” approach to compounding daily
SOFR.1 In 30-day loan contract beginning April 1st, a
lender/system would pull the April 1st interest rate on April
2nd and multiply it by the April 1st outstanding balance to
determine the April 2nd interest. On April 3rd, the lender/
system would pull the April 2nd SOFR and multiply it by the
April 2nd principal plus accrued interest as of April 1st to
determine the April 2nd interest accrual. And so on every
day for 30 days. (For Simple Daily SOFR in Arrears, the
process for pulling SOFR daily is similar, but the process is
much simpler because the rate is not compounded.) This
is clearly a very different from a world where the rate is
known in advance. So what are some of the conventions
and systems requirements that have to change to
operationalize these “Not Known in Advance” rates?
• C
ompounding: A critical convention is the recommended
compounding methodology, which the ARRC Business
Loans Working Group is developing. As of mid-October,
there is ongoing debate on whether to compound the
SOFR rate itself or compound the outstanding balance
of the loan. However, most market participants agree
that while SOFR should be compounded, any “spread
adjustment” (which will be used to make SOFR more
comparable to LIBOR) and the margin on the loan
should not be compounded.
Compounding only the SOFR rate works if there is no intraperiod prepayment of loans. However, it may be necessary to compound interest on the
outstanding balance of a loan if the outstandings fluctuate over the interest period.
1
7
THE GREAT MIGRATION AWAY FROM LIBOR
BRAVE NEW WORLD: OPERATIONALIZING SOFR!, MEREDITH COFFEY
for borrowers to be billed and pay interest the same
day. The solution for loans may be a “look back”, which
creates a multiple-day gap between when the final
interest rate is known, when the borrower is billed, and
when the interest is paid. In effect, instead of beginning
to compound interest based on the rate published on
April 1st, loans would “look back” five business days to
March 25th to begin the interest compounding period.
Thus, April 1st would use the March 25th SOFR, April 2nd
would use the March 26th SOFR…and so on until April
25th. On April 25th, the agent would know the full 30-day
interest amount and would be able to bill the borrower.
The borrower would then have five days to pay the
interest. (A particularly weedy issue—into which we will
not delve here!—is whether to use an “observation”
shift, which basically would align the business days in a
lookback with the weighting of that business day. Again,
this is how ISDA’s methodology works, and would be the
methodology in any SOFR Index that is developed.)
• Tools: If the discussion above seems complicated,
that’s because it is. But tools are being developed to
help market participants consume LIBOR without doing
complicated calculations themselves. First, the Fed is
planning to publish official “Compound Averages of
SOFR”. The benefit here is that lenders could pull these
rates from screens and put them directly into systems
and not do any calculations. While these Compound
Averages may be most useful for SOFR Compounded
in Advance, the New York Fed also is looking to
publish a “SOFR Index”, which would internalize all the
compounding and holiday conventions and simply spit
out a compounded rate when a practitioner selected a
start date and an end date. This could both simplify the
operationalization of SOFR in loan systems and provide
a simple public “golden source” to check the accuracy of
interest rates.
• Business Day Conventions: Compounding only SOFR
aligns loans with derivatives and hedges, which market
participants have said is important. But there are other
compounding conventions that are necessary to align
with derivatives. For instance, derivatives only compound
interest on business days; an uncompounded rate is
used on weekends or holidays. The loan market is likely
to follow this convention.
• Billing and Lookbacks: A “Not Known in Advance” rate
introduces complexities in billing and paying interest.
For instance, if a borrower has a 30-day loan that starts
April 1st and accrues every day until April 30th, the
final rate will only be known on May 1st. It is not fair
• Next Steps: The ARRC’s Business Loans Working Group
(BLWG) is developing a full list of recommended SOFR
loan conventions. This list includes items mentioned
above like compounding methodologies, spread
adjustments, look backs and holiday schedules, as well
as many other issues like rounding, break funding, SOFR
floors and day count conventions. The BLWG is working
with its counterparts in the UK, EU and Switzerland to
align the recommended conventions as much as possible
globally. These recommended conventions are being
developed with business people, operations specialists
and loan market vendors; this iterative process provides
information for vendors to build systems that can
internalize all variants of SOFR. And soon, the vendors
should provide timelines on when systems should
be SOFR-ready. For more information, please contact
mcoffey@lsta.org or ehefferan@lsta.org.
8
THE GREAT MIGRATION AWAY FROM LIBOR
FLASHFORWARD: LSTA RELEASES DRAFT
SOFR “CONCEPT CREDIT AGREEMENT”
BY TESS VIRMANI, ASSOCIATE GENERAL COUNSEL
& SENIOR VICE PRESIDENT, PUBLIC POLICY
R
ecently, the LSTA took the next step in its efforts
to educate market participants on replacement
benchmarks by distributing a draft “concept credit
agreement”1 referencing a compounded average of
daily SOFRs calculated in arrears (“Compounded SOFR
in Arrears”). The key points to highlight in the draft are
discussed below, but readers should bear in mind that
the draft is subject to evolution.2
WHY REFERENCE “COMPOUNDED
SOFR IN ARREARS”?
As we know, LIBOR is a forward-looking rate so it is known
at the beginning of the interest period or “in advance.”
By contrast, Compounded SOFR in Arrears is a rate that
is not known until toward the end of the interest period.
While this is a dramatic shift from the way loans, systems
and credit agreements work today, Compounded SOFR in
Arrears is the rate referenced by many SOFR floating rate
notes, the first cash products to reference SOFR, as well
as the designated fallback rate for USD LIBOR derivatives
that will be incorporated into ISDA standard definitions
next year. Moreover, it is the rate that both gives lenders
the time value of money for their loans as well as being the
most accurate average SOFR rate because the observation
period for the rate more closely matches the interest period
for which the rate is being determined. Remember, as the
official sector has warned, a forward-looking term SOFR
reference rate may not be available by 2021.3 For these
reasons, the LSTA has developed this concept document.
METHODOLOGY AND CONVENTIONS
Any version of “Compounded SOFR” is determined by the
calculation, methodology and conventions specified in
the contract definition. The definition of “Compounded
SOFR” found in the LSTA’s concept document follows the
general formula used by the Federal Reserve Bank of NY
in publishing its indicative compounded SOFR data and
provides for a lookback with observation shift (the length of
which is to be determined by the parties). A lookback with
observation shift would shift the SOFR observation period
(e.g., with a two-day business day shift, the observation
period would start and end two business days prior to the
interest period start and end dates) and each rate applies
to the repo transaction period it represents. The use of an
observation shift has a number of advantages: it applies
the correct weighting to the daily SOFR rates, it would allow
for the use of a published compounded SOFR index, and
it is easier to align with hedges that have established the
same observation period. While the use of a lookback with
observation shift would allow for the use of a published
SOFR index, the current definition of “Compounded SOFR”
does not provide for the use of such an index because one
is not currently available (please refer to footnote 9 in the
draft concept document for more information).
Another important point of discussion is with respect
to “SOFR floors.” Largely for operational reasons, this
concept document provides for a floor in the definition
of “SOFR” (i.e., the daily rate that is used in calculating
the compounded average of SOFRs) rather than in the
definition of “Compounded SOFR” itself. This proposal
is informed by conversations in the ARRC Operations
WG, but it is acknowledged that it would be a change in
practice to how floors are applied to LIBOR today and
could possibly present challenges if Compounded SOFR
is calculated using a SOFR index.
COST-PLUS FUNDING
In conversations with market participants, we have heard
a general assumption that new SOFR term loans would
be structured as simply referencing a SOFR variant plus
the applicable margin, and would not include a spread
adjustment intended to make the SOFR rate comparable
with LIBOR going forward. Readers should note that this
is in contrast to LIBOR-based loans that are falling back to
SOFR, where the spread adjustment is designed to make the
all-in rate of the loan comparable after the transition. The
concept document was developed on this assumption and
no spread adjustment is included. Also, given that SOFR, a
broad treasury repo rate, may not be reflective of lenders’
cost of funds, “cost plus funding” (or “match funding”)
provisions may no longer be applicable. Those provisions
customarily in LIBOR-based loans, such as market disruption
and breakfunding, have not been included in the concept
document. With respect to breakfunding, it is important to
remember not only that match funding is likely not applicable
The draft was distributed to the LSTA’s Primary Market Committee and the LSTA’s SOFR Working Group for review and feedback
and is available to any LSTA member on the LSTA website.
1
For reference purposes, a blackline against the LSTA’s draft LIBOR-based investment grade term loan which shows the cumulative
changes made to convert a LIBOR-referencing term loan credit agreement into one referencing Compounded SOFR in Arrears.
2
For more information on SOFR, please refer to “U.S. LIBOR Transition: Demystifying SOFR” on the LSTA website.
3
9
THE GREAT MIGRATION AWAY FROM LIBOR
FLASHFORWARD: LSTA RELEASES DRAFT SOFR “CONCEPT CREDIT AGREEMENT”, TESS VIRMANI
for SOFR-based loans, but also that Compounded SOFR in
Arrears is just compounded daily SOFRs so it is difficult to
translate today’s LIBOR breakfunding provisions into similar
provisions for Compounded SOFR in Arrears.
SOFR FALLBACK LANGUAGE
If this exercise has taught us anything, it is that nothing is
certain. Therefore, the concept document includes robust
fallback language if “Compounded SOFR” would no longer
be available as a reference benchmark. In drafting this
fallback language, we have included a modified version of
the ARRC’s recommended “amendment approach” fallback
language4 to apply its streamlined amendment process to
a future transition away from SOFR.
NEXT STEPS
When reviewing the concept document readers are
encouraged to keep in mind that the concept document
does not purport to represent or set any standard
market practice. It has been developed simply as a tool to
further familiarize market participants with replacement
benchmark alternatives, in this case Compounded SOFR in
Arrears, which will hopefully further assist each institution
with its own transition planning.
The concept document will be discussed in detail at
the LSTA’s Annual Conference in the “Post-LIBOR Credit
Agreements: What Changes and What Stays the Same?”
afternoon breakout session. Following the conference,
the draft will continue to be open for written feedback
from members. After considering all feedback received,
the final “concept credit agreement” will be published. As
the transition process unfolds, further iterations of the
concept document may be developed.
For further information on the concept document, please
contact Bridget Marsh or Tess Virmani.
Please refer to the ARRC website for the ARRC’s recommendation for syndicated loans and additional important information on the transition away from LIBOR.
4
10
THE GREAT MIGRATION AWAY FROM LIBOR
WHAT’S YOUR FALLBACK?
BY TESS VIRMANI, ASSOCIATE GENERAL COUNSEL
& SENIOR VICE PRESIDENT, PUBLIC POLICY
W
e know that LIBOR—the world’s ubiquitous
benchmark—may well disappear after 2021. Now
that we have entered the second half of 2019—with less
than 800 days left to go to potential LIBOR cessation—
market conversations have clearly evolved from
questioning to accepting this fact. U.S. dollar LIBOR is the
reference rate for nearly $200 trillion contracts, including
$4 trillion of syndicated loans and nearly $700 billion of
CLOs. Given its omnipresence in the financial world, the
task of transitioning to a replacement mark is a daunting
but necessary one. But where to start? Clearly, originating
new loans that do not reference LIBOR is a top order
of business, but that will take time. Triage dictates that
we ensure that new LIBOR loans have robust, workable
fallback language, i.e. the credit agreement clearly provides
for an alternative and appropriate benchmark (or process
for determining such benchmark) when LIBOR ceases.
The Federal Reserve-sponsored Alternative Reference
Rates Committee (ARRC) spent nearly a year developing
fallback language for U.S. dollar-denominated syndicated
loans (in addition to several other cash products) and in
April the ARRC released recommended fallback language
for syndicated loans (https://nyfed.org/2KeXvHn). The
article below unpacks the ARRC recommendation, looks
at early adoption of the language, and highlights key
considerations for market participants as we continue
the transition process.
HOW WAS THE ARRC RECOMMENDED
LANGUAGE DEVELOPED?
The process began in the loan market itself. Historically,
most syndicated loans provided for a fallback waterfall
that would, upon LIBOR not being available, first revert
to either the average of quotes in the London interbank
market obtained by polling banks or the unsecured
borrowing rate in the London interbank market for the
administrative agent and then would ultimately fall back to
the alternate base rate if such quotes cannot be obtained.
This would mean that borrowers would be forced to pay
significantly higher borrowing costs for the remaining
life of their loans if LIBOR disappeared. Recognizing that
this would not be a desirable outcome, credit agreement
drafters responded to Andrew Bailey’s now famous speech
foretelling the end of LIBOR by providing for a streamlined
amendment process that would allow parties to a loan
to select a replacement for LIBOR when that time came.
Adoption of this new LIBOR replacement language has
been widespread, but varies across agreements and is
typically simply limited to the permanent end of LIBOR.
The ARRC sought to build on what the market had
developed to create fallback language that reduced
systemic risk and minimized value transfer. The ARRC’s
Business Loans Working Group (BLWG), co-chaired by the
LSTA and ABA, is a group of many financial institutions who
collaborated to develop the recommended language. The
result was the release of two sets of fallback language—
an amendment approach which built on the market’s
LIBOR replacement language and a hardwired approach
which would allow for LIBOR to be automatically replaced
because all of the necessary terms are predetermined
at the time the loan was originated. This latter approach
is also closely aligned with the ARRC fallback language
recommended for other cash products, such as floating
rate notes (FRNs) and securitizations. Both approaches
provide for trigger events that initiate the transition from
LIBOR to a successor rate as well as the successor rate,
and in doing so, try to ensure that LIBOR and the successor
rate are made as comparable as possible upon transition.
WHAT ARE THE ARRC’S RECOMMENDED
TRIGGERS FOR LOANS?
To avoid market disruption, the recommended fallback
language for cash products like loans, FRNs and CLOs
generally attempt to use the same triggers so that a
transition would happen simultaneously for all products.
Syndicated loans have three triggers that begin the
transition process. The first two are “cessation” triggers
which will also be incorporated in the ISDA fallback
language for derivatives. The triggers state that either
i) the benchmark administrator (like ICE Benchmark
Administration) or ii) the administrator’s regulator
(currently the UK’s Financial Conduct Authority) has
announced the administrator has or will cease to
provide the benchmark permanently. The third trigger,
a “precessation” trigger, is a public statement from the
LIBOR administrator’s regulator saying that LIBOR is no
longer representative. One of the key features of the ARRC
fallback language is the use of clear and objective triggers
which are aligned with other cash products.
In addition to the three triggers described above, the
recommended fallback language for syndicated loans
also has an “early opt-in” trigger to allow parties to
begin moving away from LIBOR once an alternate
benchmark has been accepted in the loan market. For
the hardwired approach, once the administrative agent
or borrower can identify that a certain number of loans
have used Term SOFR, i.e. forward-looking term SOFR
11
THE GREAT MIGRATION AWAY FROM LIBOR
WHAT’S YOUR FALLBACK?, TESS VIRMANI
plus a spread adjustment, then the administrative agent,
“Required Lenders” (typically a majority) and borrower
can elect to switch to Term SOFR by affirmative vote. In
the amendment approach, the administrative agent or
“Required Lenders” can determine that loans are being
executed or amended to incorporate or adopt an alternate
benchmark and can elect to start the transition process.
This rate is then selected by the borrower and agent and
accepted by an affirmative vote of the “Required Lenders.”
The triggers described above are common to both
approaches, but how loans would transition away from
LIBOR varies across the two recommended approaches.
HOW DOES THE ARRC AMENDMENT
APPROACH COMPARE TO CUSTOMARY
LIBOR REPLACEMENT LANGUAGE?
Given that the ARRC recommendations for other cash
products do not include an amendment approach, inclusion
of this approach for loans was not a foregone conclusion.
There are, however, reasons that loans are treated
differently in this regard. Unlike most cash products which
are difficult to amend after they have been originated, loans
do offer some flexibility and are routinely amended or
refinanced during their life. It is understandable, therefore,
12
that market participants have decided to use loan flexibility
to postpone selection of a successor rate until more is
known about alternate rates and corresponding spread
adjustments. The ARRC amendment approach draws
heavily from the LIBOR replacement language that has
been embraced by the market, but it also includes several
enhancements to further minimize value transfer and
increase operational feasibility.
In the amendment approach, once a trigger occurs, the
borrower and administrative agent may select a successor
rate and spread adjustment, in both cases giving due
consideration to a recommendation by the “Relevant
Governmental Body” (such as the ARRC, the Federal
Reserve Board or FRBNY) or relevant market convention.
Once a successor rate is proposed to the lender group,
lenders have five business days in which they can object.
If lenders constituting “Required Lenders” object, then
the loan will bear interest at Prime until agreement on
a successor rate. If they do not object or the number of
lenders objecting falls short of a majority, LIBOR is then
replaced with the successor rate plus spread adjustment.
This architecture, which balances expediency and fairness,
is present in many credit agreements as we have seen
THE GREAT MIGRATION AWAY FROM LIBOR
WHAT’S YOUR FALLBACK?, TESS VIRMANI
even before the ARRC published its recommendation. In
a recent study of 155 publicly available credit agreements
dated between May 2018 and April 2019, Practical Law
Finance found that 97% of credit agreements included
similar LIBOR fallback language. Of that cohort, 97% of
credit agreements provided “Required Lenders” with a
negative consent right.1 The picture changes somewhat,
however, when we focus on the institutional loan market.
Covenant Review recently analyzed 107 credit agreements
from August and September 2019 and found that 82%
included a negative consent right, while 17% did not
include a lender objection right and 1% included an
affirmative lender consent right. While the vast majority
of institutional loans do include a negative consent right
for lenders, it is not true of all deals. It should be noted
that including a negative consent for lenders, however,
allows for a streamlined, efficient amendment process
while reducing the discretion of administrative agents
and providing opportunity to all stakeholders.
The inclusion of a spread adjustment in the ARRC
recommended fallback language is seen as important
because it helps to minimize value transfer. For instance,
because SOFR is secured and expected to be lower than
LIBOR, a spread adjustment is necessary to make it more
comparable to LIBOR (see related article–LIBOR: Getting
to Transition). While the spread adjustment is a critical
component to robust fallback language, it is also unknown
today. Because the amendment approach language does
not specify a successor rate—rather it outlines the path to
selecting a successor rate—the spread adjustment is also not
specified. The language provides that the borrower and the
administrative agent will select the spread adjustment giving
due consideration to a recommendation by the Relevant
Governmental Body or relevant market convention. Given
that some institutional loans do not include lender consent
at the time of transition, an explicit placeholder for a spread
adjustment is a benefit of the ARRC language.
Aside from inclusion of the spread adjustment, the other
notable features of the ARRC amendment approach are
aimed at bolstering the feasibility of transitioning loans
through an amendment process. The flipside to preserving
flexibility in the amendment approach is that transition will
require each LIBOR-referencing facility to be amended. If
LIBOR should cease unexpectedly, it would be extremely
cumbersome and costly to transition entire loan portfolios
in a short time span. To address this fact, the ARRC
language includes an “early opt-in trigger” described above
and provides that, in the case of a preannounced cessation
of LIBOR, the amendment process can begin up to 90 days
before LIBOR ceases. Finally, the ARRC recommended
language permits the administrative agent the unilateral
1
ability to make certain technical, administrative or
operational changes that may be required to implement
and administer the successor rate. It is foreseeable that
certain changes to accommodate the successor rate
will be required and this ability will allow for smooth
administration of the loan.
In the six months since the publication of the ARRC
recommendations in April there has been some adoption
of the ARRC language. Covenant Review's recent analysis
also showed that 19% of reviewed credit agreements
included the ARRC amendment approach language,
while 81% included some form of LIBOR replacement
language that had become customary in the loan market
prior to the ARRC’s publication. We will see if the ARRC
amendment approach takes a stronger hold in the
market, but the ARRC recommendation does represent
safer, more robust fallback language. The bigger shift
will be adopting hardwired fallback language. At the time
of writing, we are not aware of any credit agreements
which include hardwired fallback language, but that
will not always be the case. What it lacks in flexibility,
the ARRC hardwired approach more than makes up for
in certainty and operational feasibility. It obviates the
possibility for gamesmanship because decisions are not
made in an unknown economic environment. Moreover,
if thousands of credit agreements need to be transitioned
simultaneously, the amendment approach might simply
not be workable. For these reasons, it is expected that
the loan market will eventually adopt hardwired fallback
language when the time is right—and that may not be as
far off as it initially appears.
HOW DOES THE HARDWIRED
APPROACH WORK?
The hardwired approach includes predetermined terms
that provide a waterfall to select the successor rate and
spread adjustment. It is also closely aligned with the ARRC
recommended fallback language for other cash products,
such as FRNs and securitizations and its successor rate
waterfall uses two variants of SOFR—the chosen replacement
rate for fallback language in U.S. dollar derivatives. Once
one of the above-described triggers occurs, the hardwired
approach first looks to replace LIBOR with forward-looking
term SOFR plus a spread adjustment. If that does not
exist, the hardwired approach next looks to replace LIBOR
with a compounded average of daily SOFRs plus a spread
adjustment. If that too does not exist, then the hardwired
approach essentially falls back to the amendment approach
as an escape hatch. In looking at the successor rate waterfall,
there are several important considerations. First, the
availability of a forward looking term SOFR reference rate—
at the end of 2021 or beyond—is uncertain. Moreover, we
Practical Law Finance, “Current Trends in LIBOR Successor Rate Provisions” (June 2019).
13
THE GREAT MIGRATION AWAY FROM LIBOR
WHAT’S YOUR FALLBACK?, TESS VIRMANI
know that fallback language for derivatives will replace
U.S. dollar LIBOR with SOFR compounded in arrears (plus
spread adjustment). For market participants that wish to
align as closely with derivatives as possible, excluding the
Term SOFR step of the waterfall is an option. (It is important
to note that Term SOFR is the first step of the replacement
rate waterfall in the ARRC recommendations for FRNs and
securitizations as well, however the ARRC user’s guides to the
FRNs, securitizations and syndicated loans recommendations
state that removal of this step would still be consistent with
the ARRC’s principles and recommendations.) Second, the
next step of the replacement rate waterfall is a compounded
average of daily SOFRs, but the language in the hardwired
approach would allow for the rate to be calculated in
advance (locking it in at the beginning of the interest period)
or in arrears (accruing it during the actual interest period).
For market participants who wish to keep alignment with
derivatives, SOFR compounded in arrears would be the
appropriate choice. While this SOFR variant would represent
a significant departure from current practice and will require
a systems overhaul, it is the rate that is likely to be used on a
going forward basis by FRNs, securitizations and derivatives.
As described above, SOFR is secured and thus expected to be
lower than LIBOR so the hardwired fallback language must
also include a waterfall of corresponding spread adjustments.
The hardwired approach first suggests a spread adjustment
selected or recommended by a Relevant Governmental Body.
If that does not exist, the spread adjustment used by ISDA in
their fallback language will be applied.
such as institutional term loans, which may be sooner able
to adopt a hardwired approach to fallback language. From a
CLO perspective, in particular, achieving alignment in fallback
language across CLO notes and the underlying loan collateral
significantly reduces basis risk.
For many market participants, understanding what the
spread adjustment will be and seeing it published is a gating
item for adopting hardwired fallback language in loans.
However, ISDA has stated that their spread adjustment
(designed for SOFR compounded in arrears) will be available
around the end of this year. Once this important unknown
is known, the hardwired approach may prove attractive
to some loan market participants. For example, FRNs
have begun adopting ARRC hardwired fallback language.
Moreover, the recommendation ARRC recently published
for securitizations, such as CLOs, only includes hardwired
fallback language, and hardwired fallback language is being
used in the CLO market. It is true that different segments
of the loan market may not be accepting of the ARRC
recommended hardwired language. For credit facilities,
like revolvers, which may need incorporation of a credit
component going forward, the ARRC recommendation
which focuses on SOFR variants may not be as desirable. It
is also true that the ARRC recommendations are specifically
designed for U.S. dollar-denominated facilities. Multicurrency
facilities pose unique challenges and it may take longer to
develop a workable hardwired approach for those types of
loans. Hopefully, these pockets of loans do not prevent the
movement to a hardwired approach for market segments,
Faced with the reality that LIBOR may not exist long after
2021, it is imperative that robust fallback language be
included in all financial contracts. Fortunately, for the
syndicated loan market, iterative versions of fallback
language have been routinely included in new and
amended credit agreements in 2018 and 2019. However,
both sets of the ARRC recommended fallback language for
syndicated loans represent safer, more balanced versions
of fallback language. Market participants should educate
themselves on the ARRC recommendations and choose to
adopt the ARRC language where appropriate. Furthermore,
the certainty, clarity and overall feasibility of hardwired
fallback language should present many advantages for
the market. Now that the FRBNY has published indicative
forward term SOFR data and compounded SOFR data, the
market has gained insight into how these rates look and
feel. (For more information, please refer to U.S. LIBOR
Transition: Demystifying SOFR.) Moreover, publication
of an indicative spread adjustment to be used in ISDA's
derivatives fallback language around the end of 2019,
together with a known timeline for the operationalization
of compounded SOFR, may tilt the balance in favor of
hardwired fallback language sooner than we think.
CONCLUSION
14
THE GREAT MIGRATION AWAY FROM LIBOR
LIBOR: ALIGNING LOANS AND CLOs
BY MEREDITH COFFEY, EXECUTIVE VICE PRESIDENT, RESEARCH AND PUBLIC POLICY
T
he floating rate markets are busy preparing for the
impending end of LIBOR. The first step many markets
have taken is to develop workable “fallback” language,
which answers the question “If LIBOR ceased, to what
rate would my contract fall back?” Critically, both loans
and CLOs need to have workable fallback language. And,
it would be very helpful if both products fell back at the
same time and to the same rate. Below, we discuss how
fallback mechanics in both markets work, where they are
aligned and where they diverge.
There are $1.2 trillion of institutional loans outstanding, and
nearly $700 billion are housed in CLOs. When the reference
rates of loans and CLOs are not aligned, basis risk emerges.
A particularly notable example of this occurred in 2018
when the 1-month/3-month LIBOR curve steepened and
corporate borrowers switched to one-month LIBOR while
CLO liabilities continued to reference three-month LIBOR.
As we move from LIBOR to SOFR for institutional loans and
CLOs, the potential of basis risk emerges in several ways.
First, it will be important for both products to fall back to
the same rate. Second, it would be preferable for them to
fall back at the same time. And, third, if we fall back to a
certain type of SOFR—specifically SOFR Compounded in
Arrears—the 1-month/3-month basis noted above may
nearly disappear.
So, how would all this work? To begin, there are two major
components of ARRC-recommended fallback language: 1)
the trigger event that initiates the transition from LIBOR to
a replacement rate and 2) the selection of a replacement
rate (plus spread adjustment in most cases).
The loan hardwired fallbacks (https://nyfed.org/2KeXvHn) and
securitization fallbacks (https://nyfed.org/2KtLga7) (including
CLOs) have both these components and the ARRC attempted
to align them as much as possible. That said, there are some
inevitable differences. (Note that because replacement rates
are not predetermined in the “amendment approach” to loan
fallbacks, it is not possible to determine whether they would
be aligned with CLO liabilities.)
TRIGGERS
Loans and CLOs have the same “basic” triggers, but each add
an additional trigger that permit earlier fallbacks. Both loans
and CLOs have triggers if the LIBOR administrator or the
relevant regulator announces that LIBOR has or will cease,
or if the relevant regulator states that LIBOR is no longer
representative. If any of these triggers occur, then loans and
CLOs convert to a replacement rate at the same time.
However, both loans and CLOs want the opportunity to
shift to a replacement rate well before the end of LIBOR.
For this reason, loans also have an “Early Opt-In” trigger,
whereby if a certain number of loans are being issued or
amended to shift to term SOFR, then the loan can be more
easily amended to transition to SOFR. This permits lenders
and borrowers to reduce their LIBOR inventory.
Meanwhile, securitizations do not want to have liabilities
tied to LIBOR if many of their assets are tied to SOFR. Thus,
securitization fallback language also includes a trigger if
more than 50% of a securitization’s assets have shifted
to a replacement rate.
WATERFALLS
Both hardwired loan and securitization fallback language
have a waterfall of replacement rates and spread
adjustments. The first two levels of the waterfall are the
same. After those two levels, the loan replacement rate
is chosen via the amendment approach, while CLOs
continue to work down their waterfall.
The first waterfall level for both loans and CLOs is
Forward Looking Term SOFR plus a spread adjustment.
If Forward Looking Term SOFR does not exist, the second
level is Compounded SOFR plus a spread adjustment.
The preferred spread adjustment would be the one
recommended by Relevant Governmental Body (ARRC or
Fed); if that doesn’t exist, it would be the spread adjustment
recommended by ISDA. If even that doesn’t exist, the
securitization language also has a spread adjustment
selected by the “Designated Transaction Representative”
(e.g., someone designated to do this dirty work).
As discussed above, if neither term SOFR nor compounded
SOFR are available, then loans flip to the amendment
approach, while CLOs continue down the replacement
rate waterfall. The third level of the securitization
waterfall is the rate of interest selected by the Relevant
Governmental Body plus a spread adjustment. If that
doesn’t exist, the fourth level is the ISDA Fallback Rate plus
a spread adjustment. If that doesn’t exist, the final stage is
that the Designated Transaction Representative selects the
rate plus spread adjustment.
15
THE GREAT MIGRATION AWAY FROM LIBOR
LIBOR: ALIGNING LOANS AND CLOS, MEREDITH COFFEY
In fact, most hardwired adherents believe we will not
go past the first two stages of the waterfall; after all,
Compounded SOFR already exists and ISDA plans to
publish the spread adjustment around year-end 2019.
However, if for some reason this combination does not
still exist at LIBOR cessation, CLOs and loans may diverge.
MITIGATING BASIS RISK
If loans begin to switch to SOFR first, this will introduce
some basis risk into CLOs. However, if the market gets
the spread adjustment right, the basis risk should be
minimized. Forward Looking Term SOFR also could
continue to have some basis risk if borrowers select onemonth SOFR and CLO liabilities are on three-month SOFR.
Interestingly, if both markets move to SOFR Compounded
in Arrears, the basis risk problem should be nearly
eliminated because three-month Compounded SOFR is
just a longer version of one-month Compounded SOFR.
Ultimately, the best way to minimize basis risk around
LIBOR transition likely is for both loans and CLOs to adopt
a hardwired approach—and potentially skip directly to
SOFR Compounded in Arrears. In such a world, the main
triggers and fallback rate would be perfectly aligned.
The LSTA is on the ARRC itself, it co-chairs Business Loans Working Group
(which developed the LIBOR fallback language) and the Business Loans
Operations Subgroup (which is operationalizing SOFR and other potential
replacement rates), and is a member of the ARRC’s Securitization Working
Group (where we represent CLOs), the Accounting Working Group and
the Infrastructure Working Group. We are working actively within the
ARRC framework, and we also are coordinating globally with other trade
associations such as the LMA, ISDA, the ABA, SFIG, SIFMA, CREF-C and
more. In addition, at the end of 2018, we began to tackle operational
challenges that a transition away from LIBOR will bring. We firmly believe
that if market participants recognize the challenges and mobilize now,
an orderly transition is doable. We encourage you to join our efforts.
For more information, please contact us! LSTA LIBOR team leaders
are Meredith Coffey (mcoffey@lsta.org) for policy and market impact,
Tess Virmani (tvirmani@lsta.org) for legal/documentation, Ellen Hefferan
(ehefferan@lsta.org) for operations and Phillip Black (pblack@lsta.org)
for accounting.
16
THE GREAT MIGRATION AWAY FROM LIBOR
ON ACCOUNTING, LIBOR TRANSITION
HAS BEEN RELATIVELY SMOOTH
BY PHILLIP W. BLACK, ASSOCIATE, RESEARCH & PUBLIC POLICY
W
hile we’ve experienced plenty of challenges with the
LIBOR transition, one area that has been relatively
smooth is that of necessary accounting relief. Indeed, to
the loan market’s great relief, we’ve helped the relevant
accounting and tax bodies knock down the accounting
hurdles this year like tenpins.
The prime mover in the campaign to ease the transition’s
accounting burdens has been the Financial Accounting
Standards Board—the FASB—which in June promised to
issue relief addressing the critical question of whether it
would allow loans to be classified as “modified” following
transition without undergoing the tedious and, in cases
where many loans are held in portfolio, laborious 10% test.
After announcing in July that it would also address the
hedge accounting issues raised by transition, the FASB
released a comprehensive set of relief in September,
addressing both of these major issues at once. And the
relief does pretty much what we hoped and expected it to
do: it exempts loan market participants from conducting
the 10% test on loans and allows hedging relationships to
continue unchanged.
So much for financial accounting issues. What about taxes?
Copyright © LSTA 2019. All rights reserved. | 10-2019
Here, the relevant body isn’t the FASB but the Treasury, and
its Internal Revenue Service. They have done their fair share
of guidance issuing, too. In October, they issued proposed
regulations clarifying that adjustments to debt contracts
reflecting transition would not constitute modifications
for tax purposes and thus would not result in income tax
gains or losses—a big win for loan market participants who
worried transition would trigger an unexpected tax event.
Of course, these regulatory actions were in no sense
preordained. They were the product of engagement,
education, and encouragement on the part of private-sector
groups that have been monitoring the situation most closely.
Primary among these groups is the ARRC and its
accounting and tax working group, of which the LSTA is
a member. Indeed, the ARRC has been busy submitting
letters, memos and analyses to the regulatory bodies
identifying the problems and offering solutions.
So while progress on the LIBOR front might appear in some
places to be slow and full of unexpected hurdles, we should
keep in mind that our efforts can lead and indeed already
have led to outcomes that will ultimately make the LIBOR
transition at the end of 2021 a smooth one.
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