LIBOR Transition Provides Potential Decoupling Exposure

Floating rate debt instruments for commercial property loans and many other forms of financing have relied on an interest rate index called the London Interbank Offered Rate for decades. If LIBOR went up or down, so would the interest a borrower paid. And LIBOR rates were quoted each business day for a range of loan periods, from one day to a year. In real estate, the most common loan period is traditionally 30 days, so LIBOR real estate loans are repriced every 30 days.

About ten years ago, it became clear that LIBOR was partly a reflection of creative writing by money traders at major banks. It did not provide a reliable or accurate reflection of actual market conditions for borrowing and lending. So the regulators and industry associations decided LIBOR was broken and the market should move to something better.

Thus began a multi-year and surprisingly complex exercise. So far, the main conclusion has been a suggestion to replace LIBOR, at least in the United States, with something called the Secured Overnight Financing Rate. SOFR fluctuates daily and is determined afterwards (in retrospect) rather than at the beginning of each loan period, which is always just one day. In contrast, LIBOR prices are set at the beginning of each loan period. And it offers a range of possible loan terms up to a year. SOFR also assumes an absolutely risk-free borrowing rate at all times and thus will not respond to changes in the pricing of money caused by changes in the overall credit risk in the financial markets as a whole. Based on these differences alone, the suitability of SOFR as a replacement for LIBOR seems hardly obvious.

International banking regulators have been beating their drums louder in recent months to announce LIBOR’s imminent demise, but the SOFR replacement has only gained limited traction. Promisingly, private players have come up with possible replacements for LIBOR: the Ameribor rate announced by the American Financial Exchange; Bloomberg’s Short Term Bank Yield Index (BSBY); and IBA’s Bank Yield Index.

Unlike the SOFR index, these three new potential replacements for LIBOR contain a credit risk element, are pre-quoted and offer a range of borrowing periods. They are much more like LIBOR. Regulators are generally open to these substitution rates, subject to some lingering concerns about how they might behave over time and especially during times of stress.

Market players have to be smart enough to figure it all out, with or without the help of regulators. Over time, the market should become familiar with one or more of these substitutes for LIBOR or any other privately created substitution index.

That creates a new problem. Some long-term financial structures with LIBOR-based interest rates involve two different sets of documents and relationships. Each set has its own language to deal with the possibility, once purely hypothetical, that LIBOR could disappear. For example, floating rate home mortgages have a mechanism to replace LIBOR if it falls. Many of those home loans generate mortgage payments that in turn fund payments to bondholders. But those bonds often have a different mechanism to replace LIBOR if it falls.

These differences create some discrepancy between the flow of incoming cash and the outgoing payments that the same cash flow is supposed to fund. One LIBOR replacement rate may be different from another. The result: a risk or perhaps a pleasant surprise for the institutions that make the outgoing payments to the bondholders. This disconnect can also create an opportunity for who gets to decide on any replacement for LIBOR. The result could be a process, unexpected gains or losses, and perhaps a new product for the derivatives industry.

Identifying the problems with LIBOR may have been relatively easy. Finding the ideal replacement for LIBOR turns out not to be so easy.

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