The transition away from the historic LIBOR lending rate for financial transactions toward an alternative such as the Secured Overnight Financing Rate (SOFR) began earlier this year. What caused the shift, and how are lenders and other financial professionals responding? In this, the first of a three-part series of articles, which also includes Term SOFR Adds Appeal to LIBOR Alternative and Context for SOFR as Rates Shift, the SRS Acquiom loan agency team offers rich insight into the rise of SOFR as a replacement rate for LIBOR, its advantages and challenges, and how SOFR and other substitute rates will take effect.
LIBOR to SOFR: Rescuing a Lending Market Marred by Scandal
The primary rate for financial contracts that banks charged customers to borrow cash, known as LIBOR, suffered nearly a decade of negative headlines and misconduct. After the 2008 financial crisis, some LIBOR rate-setting banks were accused of manipulating the benchmark to benefit their bottom lines. In 2014 the Federal Reserve commissioned the Alternative Reference Rate Committee (ARRC) to select a replacement benchmark rate for LIBOR, which reigned as the primary rate since the 1980s. The Secured Overnight Financing Rate (SOFR) emerged as the preferred solution in 2017.
What is SOFR?
SOFR is a dollar-denominated, stable interest-rate benchmark that is not subject to the vulnerabilities of LIBOR. While LIBOR was unsecured and based upon quotations provided by a group of banks, SOFR uses U.S. Treasury bonds for collateral and is data-derived. It is based upon the overnight general collateral Treasury repo rate, reflecting the financing cost for Treasury securities. It is published each morning by the Federal Reserve Bank of New York and reflects the previous business day’s rate. SOFR is regulated by the Fed Board and Financial Stability Oversight Council (FSOC).
Although market participants have started transitioning away from LIBOR, any remaining contracts linked to LIBOR are poised to expire on June 30, 2023. The Federal Reserve and U.S. regulators urged the cessation of LIBOR as a benchmark rate as of Dec. 31, 2021, to facilitate the transition from LIBOR-based products to those using SOFR. Given that USD LIBOR legacy contracts greatly exceed other currencies, comprehensive planning is imperative. As such, global companies using multiple currencies have been swiftly transitioning from LIBOR as have smaller U.S. companies. The only currency option for SOFR is the U.S. dollar, unlike LIBOR that included sterling, euros, yen and Swiss francs.
Legacy LIBOR Debt Challenges
With trillions of dollars-worth of LIBOR-based contracts outstanding, repricing to SOFR will not be an easy task. One way to eliminate legacy LIBOR debt ahead of the midyear 2023 deadline is to refinance or upsize debt. Lenders may opt to proactively move away from LIBOR. Infrastructure to perform calculations will need to be in place and regulators have suggested “fallback clauses” in all new contracts that outline how LIBOR to SOFR will be calculated.
The worldwide transition will affect corporate and municipal borrowers who use floating-rate loans and bonds tied to LIBOR, end-users hedging risk with LIBOR-based derivatives, underwriting banks, investors managing portfolios of instruments tied to LIBOR, LIBOR-backed mortgage or student loan debtholders, and some credit cards that use LIBOR.
Pricing New Issue Loans
Back in the days of LIBOR, loan pricing included a LIBOR base rate, a credit-risk-based spread and an original issue discount. Under SOFR, loan pricing will also contain a credit spread adjustment (CSA) curve of 10bps for 1-month tenors, 15bps for 3-month tenors and 25 bps for 6-month tenors.
SOFR: Not The Only Rate in Town
SOFR is an essentially risk-free borrowing rate. This SOFR-unique feature makes it less volatile and therefore cheaper for borrowers during times of stress and limits banks’ profit margins. Conversely, credit-sensitive rates, like LIBOR, rise and fall to reflect risk and compensate lenders during restrictive or accommodative credit conditions. For this reason, some midsize lenders are opting to use Ameribor, which was developed by the American Financial Exchange, while some regional banks are leaning towards the Bloomberg Short Term Bank Yield (BSBY).
The BSBY rate may be better suited for larger banks that derive a portion of their funding from long-dated bonds rather than short-term repos. These alternatives to SOFR are not without risks. Whereas SOFR is determined by over $1 trillion of daily repo transactions, Ameribor and BSBY are derived by transactions worth just $2.5 billion and $15 billion, respectively. In a liquidity crunch environment, these markets are more susceptible to becoming illiquid.
There are also liquidity concerns with regard to trading costs. Smaller businesses using SOFR can buy swap contracts in a larger trading pool to protect themselves from rising interest rates; however smaller businesses using Ameribor link debt and derivatives to a narrower pool that reacts more slowly and is likely to be more expensive.
In March, Congress approved a law allowing banks and their clients to renegotiate existing LIBOR loans with any rate deemed appropriate. These alternative rates include non-SOFR options. If contracts fail to renegotiate by the mid-year 2023 deadline, SOFR automatically takes effect.
Stay tuned for the next article in this SOFR series where we will delve deeper into the transition to SOFR from LIBOR, fallout clauses and the effects of SOFR in a rising interest rate environment. In the meantime, if you have questions concerning any of these topics, please reach out to our loan agency team for additional insights.