With all the distractions and distracting challenges faced this year by the nation’s community bankers, it’s easy to understand how some may have lost track of an approaching deadline that could have significant consequences for their institutions and their customers. Unless something changes and the authorities have been pretty clear that that’s unlikely to happen, the world’s most widely used benchmark for short-term interest rates will probably not be around after the end of 2021. After that, the London Interbank Offered Rate (LIBOR), long criticized for lacking transparency and market responsiveness, will be replaced by the Secured Overnight Funding Rate (SOFR) as the primary reference rate for all dollar-denominated loans, derivatives, and debt instruments.
What’s the Big Deal?
To many, the transition to SOFR from LIBOR might seem like a simple task; just switch rates. But if that switch affects more than $200 trillion in mortgages, consumer loans, corporate debt, and derivatives, as this one does, there’s nothing simple about it. Even though the volume of financial assets subject to the change is massive, that may not represent the greatest hurdle. If LIBOR is an apple, then SOFR is an orange, and while both are fruits, they are not exactly interchangeable parts.
LIBOR’s roots go back to the late 60s, when a panel of bankers would each day report their funding costs to what has now become the Intercontinental Exchange Benchmark Administration. Those numbers would be averaged, adjusted, and then reported to the world around noon, London time. The outdated process and its vulnerability to fraud and manipulation, coupled with a dwindling sample size that poorly reflected market conditions, had to go, and pretty soon, it will be gone.
Thankfully, the Alternative Reference Rate Committee (ARRC), a brainchild of the Federal Reserve, has come up with a better idea based on actual transactions in the vast, Treasury-collateralized repo market. SOFR is easy to track, impossible to fudge, and moves with the market. What’s not to love?
Well, for one thing, SOFR is an overnight rate, whereas LIBOR comes with terms as short as a day and as long as a year. To come up with term rates, some type of prior-period compounding will likely be used, but the specific methodology is still uncertain. Another incongruity between the two rates is that SOFR reflects financing transactions that are free of credit risk, whereas LIBOR has always been a product of unsecured lending. Some type of spread adjustment to account for that difference will have to be added, but how and how much are still open-ended questions.
Uncertain Life Span
Some are questioning the assumption that LIBOR will even make it to the end of next year. That’s not a given. If the ever-dwindling number of reporting banks, currently somewhere between 11 and 16, falls below four, that could trigger an early end to LIBOR. Or, in these tumultuous times, a regulatory determination to prematurely end the use of LIBOR because it fails to reflect market conditions could also lead to an early demise. Fannie Mae and Freddie Mac will no longer be buying ARMs tied to LIBOR after the end of this year, but they will begin accepting SOFR-based ARMs before this year is out.
According to John Williams, president of the New York Fed, the use of LIBOR in loan agreements should have stopped by now, and lenders are encouraged to develop the fallback language for LIBOR referenced loans that will specify the replacement rate (SOFR) upon LIBOR’s cessation. For community bankers, communication with customers is key, and the earlier that process is started, the more smoothly the rate transition is likely to go, especially if LIBOR goes away sooner than expected. For more information about the transition, a link to the ARRC’s website is provided below. (https://www.gobaker.com/wp-content/uploads/articles/TBG-B0081-ARRC-Best-Practices.pdf)
Lester Murray joined The Baker Group in 1986 and is an associate partner within the firm’s Financial Strategies Group. He helps community financial institutions develop and implement investment and interest rate risk management strategies. Before joining The Baker Group, he worked at two broker/dealer banks in Oklahoma City and was also an assistant national bank examiner. A graduate of Oklahoma State University, he holds Bachelor of Science degrees in finance and economics. Contact: 800-937-2257, lester@GoBaker.com.