What’s Next After the Use of LIBOR Comes to a Screeching Halt?
The LIBOR, or the London Interbank Offered Rate, is the world’s most widely-used benchmark for global borrowing. Mounting concern is tormenting investors, consumer and corporate lenders and borrowers throughout the world, with the question of what happens next following the demise of the scandal-plagued benchmark that underpins an estimated $370 trillion of financial products globally — including certain types of mortgages, consumer loans and bonds by 2021.
Although alternative contenders have appeared, the process of relocating trillions of dollars to new rates will be very complicated, to say the least. One problem is that there is not yet a market for term loans such as one and three months, as in LIBOR. Another crucial issue is that LIBOR, as the rate at which banks lend to each other, entails credit risk, whereas overnight rates do not.
In the UK, the Financial Conduct Authority and Bank of England are encouraging a shift to the Sterling Overnight Index Average (SONIA), while the Japanese have selected TONAR as an alternative to yen LIBOR, both unsecured rates. Meanwhile, the European Central Bank is developing a daily euro unsecured overnight index rate.
Here in the US, the Secured Overnight Funding Rate (SOFR) has been published on a daily basis since April 3, 2018, as the replacement for LIBOR, with the expectation that LIBOR and SOFR will exist in parallel with one another before the sunset of LIBOR. Contrary to the LIBOR, which is an unsecured rate, the SOFR is linked to the extremely liquid, high-volume repo market and is a secured rate, because the Treasury serves as collateral.
It will be a while before liquidity in derivatives based on the rate is generated. Investors will also need to adapt to the day to day capriciousness of the repurchase market, where rates often spike ahead of monthly and quarterly closings.
Meanwhile, a myriad of factors including Fed rate hikes, U.S. tax cuts, and technical factors related to heavy Treasury bill issuance have pushed the three-month Libor to its highest level in a decade. Three-month LIBOR hit 2.30% — double that of a year ago, at the end of the first quarter.
While a notable amount of commercial real estate floating-rate loans are set to mature before 2021, there are plenty of these loans that will not mature until after LIBOR has been phased out.
But, what does this mean for current debtors, lenders and other instrument holders of commercial real estate? It is tough to tell this early, but early projections and backward-looking analysis have shown that SOFR rates will likely cause slightly less fluctuation than LIBOR rates, which could force a slight hike in floating rate debt instruments in the real estate market. Moreover, the market-based determination will be intrinsically less vulnerable to manipulation and corruption, which will hopefully soothe worries for early users to the benchmark.
Overall, it is doubtful that the transition from LIBOR-based rates to SOFR-based rates will produce any major deviation in debt underwriting, profiting profoundly from the more than three-year ephemeral phase and flexibility encouraged by ARRC through its replacement. The main anxieties for debt holders will emanate from instruments whose term lasts past LIBOR’s expiry that do not have contractual language vis-à-vis a successor rate.