Loan Market Still Seeing the Ghosts of LIBOR

At the end of 2021, publication of the Sterling LIBOR (GBP LIBOR) benchmark ended, with the technical exception of synthetic non-representative LIBOR settings available through the end of 2022. From the perspective of Wilmington Trust as an independent loan agent, transition from GBP LIBOR is mostly complete. However, dollar (USD) LIBOR remains a factor in the market. It will likely affect both origination and administration at least until the official cessation date for USD LIBOR of June 30, 2023.

With less than a year left before cessation, it is perhaps surprising that some loans still originate benchmarked to LIBOR rather than Secured Overnight Financing Rate (SOFR). The Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (FRB, FDIC, and OCC respectively) strongly encouraged “banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.”¹ Ostensibly, these new contracts include explicit fallback provisions for USD LIBOR.

However, that still leaves many existing loans pegged to LIBOR. Per the Loan Syndications and Trading Association (LSTA), a mere 12-13% of CLO loan collateral is on SOFR.² This figure largely conforms to our experience as a CLO trustee and administrator. Separately, the LSTA has estimated that over U.S. $4 trillion-plus in syndicated loans have not transitioned.³

The Three Factors of Delay

We attribute the current delayed progress of LIBOR remediation to three factors:

1. Nine months (i.e., before June 30, 2023) seems like a long time, especially under the complex market conditions we are currently seeing.
2. Lenders’ internal systems or third-party technology may still need to catch up to meet the requirements of complex compound SOFR or to handle Credit Spread Adjustments (CSAs) for the specific tranches and tenors of existing contracts.
3. Although the U.S. Congress passed the Adjustable Interest Rate (LIBOR) Act in March of 2022 to create protections for contract participants at LIBOR cessation, the FRB has not completed its implementation plans. Additionally, synthetic non-representative USD LIBOR complicates the picture of a full transition to SOFR by June 30, 2023.

Rational Procrastination

Recent history provides some helpful insight into why lenders may not yet be responding with urgency. When the Foreign Account Tax Compliance Act (FATCA) was passed, and the Common Reporting Standard (CRS) was agreed upon, they each placed a significant and costly compliance burden on financial institutions. Compliance initiatives had to meet complex and stringent requirements in both process and technology. As a natural result, many institutions held off until implementation became absolutely necessary.

We believe a similar phenomenon may influence some lenders today concerning LIBOR remediation. Many are focused on the more immediate challenges of responding to complexity and weakness in the credit markets alongside mixed macroeconomic signals. While the time is now for agents to begin issuing notifications and follow-up communications, we still expect much of the remediation work to occur within a few weeks before and after the end of USD LIBOR. This compression is similar to our experience with the end of GBP LIBOR. Agents and other service providers should make sure they are ready to deploy resources in the moment and do the groundwork on their own systems and processes in the meantime.

Technical and Operational Readiness

As we noted in an earlier article on LIBOR transition, the inherent difference between a forward-looking rate and risk-free daily compounded rates creates numerous challenges.⁴ While Term SOFR is a preferred option, there is still wide variegation in how to use it, whether to use CSAs on a flat basis across all tenors or curved with larger CSAs for longer tenors and how to factor debt tranches into the determination of CSAs.

These challenges have a direct impact on how agents and providers select and configure the technology they use to service loans. To date, such functionality is not available “out of the box” via platforms such as Finastra’s Fusion Loan IQ or the FIS Commercial Loan Servicing solution. It remains to be seen when and how platforms will adapt fully to post-LIBOR realities.

Acknowledging the broader implementation ambiguities, the Alternative Reference Rates Committee (ARRC) released a survey on August 9, 2022, asking borrowers and lenders how they have handled and how they plan to handle remediation. Per their press release, “the survey is being issued to assist the ARRC and market participants in assessing LIBOR transition readiness and the need to address any potential operational issues involved.”⁵

Open Questions

Moreover, there are some concerns about whether changing macroeconomic conditions and responses by central banks will create issues for SOFR as currently defined. The ARRC’s announcement of its formal recommendation for CME Group’s Term SOFR for corporate loans is just over a year old (dated July 29, 2021).⁶ Yet, despite its status as the preferred option, Term SOFR is still a derived rate, which may introduce new risks down the road. While it is likely that further consensus will emerge and strengthen over the next nine months, it has yet to do so as of September 2022.

U.S. federal legislation is an additional open question. It provides some comfort that it will protect decision-makers selecting a benchmark replacement from litigation, but critical elements remain undecided. The Federal Reserve Board of Governors (FRB) has not yet implemented the LIBOR Act. The Board opened a 30-day comment period from July 28, 2022,⁷ requesting input on the applicability of the Act to legacy contracts and its prescription of static spread adjustments based on the tenor of LIBOR referenced in those contracts. As a result, most stakeholders wish to avoid making early moves that may or may not be optimal within the FRB’s implementation approach.

Additionally, the publication of synthetic USD, Japanese Yen (JYP), and GBP LIBOR muddies the waters for the industry. Synthetic LIBOR is not based on contributions from panel banks. The resulting settings do not represent the underlying market or economic reality that LIBOR was intended to measure. Instead, it is considered a “reasonable approximation”⁸ to help mitigate disruption for contracts where transition is impossible.

The UK regulatory body, the Financial Conduct Authority (FCA), has compelled the publication of synthetic JPY and GBP LIBOR for 2022. Synthetic GBP LIBOR may be compelled for publication by the FCA for up to another 9 years. The FCA is still assessing if a synthetic USD LIBOR rate “might be appropriate for certain contracts that are not within scope of LIBOR-related federal legislation.”⁹ The publication of these rates could lead some credit parties to peg newly originated issuance to these non-representative benchmarks. Even though they are not intended for new contracts, their existence could seem like a convenient option because of their resemblance to representative but discontinued LIBOR.

Conclusion

Industry groups and loan market participants agree on two contradictory points. While there is general agreement that USD LIBOR transition is moving slower than hoped, they also understand that now is not an ideal time to begin.

Yet, for comparison, in Wilmington Trust’s experience with the earlier and successful wave of transition from GBP LIBOR, real momentum to the Sterling Overnight Index Average (SONIA) only built up in the final quarter before its cessation. It is also important to note what is happening behind the scenes, including the distribution of notifications and follow-ups and changes to loan servicer processes and technologies. As we move into the final quarter of 2022, we would advise lenders and borrowers to take note of the approaching deadline and follow up with service providers to understand their plans for readiness and eventual transition.

Please visit our Global Capital Markets LIBOR Transition resource page for more information.