Ultimate Resource On Libor As It Transitions To Another Benchmark Index (#GotBitcoin)
Wall Street Banks Manipulated LIBOR In Rigging Us Treasury Auctions. Ultimate Resource On Libor As It Transitions To Another Benchmark Index (#GotBitcoin)
Annie Bell Adams 65-Year-Old Pensioner Leads LIBOR Class-Action Suit In New York Against 12 Major Banks.
As a result of the scandal, the Serious Fraud Office of Britain may pursue criminal prosecutions, and the United States Department of Justice’s criminal division is building cases against multiple financial institutions. It is the standard for $300 trillion of securities and loans. The Financial Times estimates as many as 100,000 plaintiffs will join in on the lawsuit.
Pension plans and municipalities have launched similar lawsuits attempting to recoup LIBOR-related costs, but it’s believed this lawsuit is the first time a person on the level of the individual homeowner has taken legal action in the unfolding story.
According to the Office of the Comptroller of the Currency, there were at least 900,000 outstanding home loans indexed to Libor originating from 2005 to 2009. The unpaid principal balance was $275 billion.
Annie Bell Adams, on behalf of herself and all others similarly situated, Dennis Paul Fobes, on behalf of himself and all others similarly situated, Leigh E. Fobes, on behalf of herself and all others similarly situated, Margaret Lambert, on behalf of herself and all others similarly situated & Betty L. Gunter, on behalf of herself and all others similarly situated, Plaintiffs, represented by John Walter Sharbrough , John W. Sharbrough, III, PC & Stephen George Stim , Stimconsul Ltd. 110636484
Annie Bell Adams may have recently lost her house to foreclosure but she’s fighting back.
The 65-year-old pensioner is currently leading a class-action suit in New York against a dozen of the world’s largest banks for their alleged participation in the manipulation of the London Interbank Offered Rate (Libor) rate.
Adams’ lawsuit contends the Libor rate was raised artificially on the first day of the month, when her adjustable-rate mortgage rate was recalculated, thereby making her subprime loan payments substantially higher between 2000 and 2009.
Traders Manipulated Rates
Barclays has agreed to pay more than $500 miillion US in fines after internal emails revealed traders were claiming borrowing rates that were higher or lower than what they were actually having to pay in reality.
The Libor is the average interest rate at which international banks borrow from each other. It is calculated using major banks in London and is controlled by the British Bankers’ Association (BBA).
The Beginning of the Libor Scandal
The Libor scandal broke in June 2012 when British bank Barclays agreed to a $450 million settlement. This was in response to accusations by both British and American authorities that it manipulated the Libor rates. Questions are now being raised to why regulators did not put an immediate stop to the practice since evidence showed the Bank of England and the Federal Reserve of New York were both allegedly aware of the practice.
Since American financial institutions typically reference the Libor to set financial derivatives, mortgages and student loans, any manipulation of those rates can greatly impact a borrower’s payment. It is the standard for $300 trillion of securities and loans.
Adams, along with her four co-lead plaintiffs, has filed a class-action lawsuit against 12 banks, including: Citigroup Inc., HSBC Holdings Plc, Rabobank International Holdings BV, Credit Suisse Group AG, Deutsche Bank AG, Lloyds Banking Group Plc and Royal Bank of Canada.
The alleged artificial increase in Libor allowed banks to raise the interest rates on adjustable-rate loans. Since most adjustable-rate mortgages use the first of the month to reset rates, a manipulation of rates on that day would result in higher mortgage payments for countless people.
Altered Libor Rates And Their Effects
The lawsuit claims statistical analysis showed the Libor numbers consistently moved by 7.5 basis points on reset days between 2007 and 2009.
According to the lawsuit, the banks unjustly “enriched themselves” by manipulating the rate and thereby raising payments for homeowners with adjustable-rate loans and increase profits.
The complaint referenced traders’ emails published during the Barclays settlement. In one, the trader openly asked for a higher Libor rate because “We’re getting killed on our [three-month] resets.”
The plaintiffs, according to attorney John Sharbrough (Recently Dis-Barred Alabama-based lawyer), have each lost thousands of dollars because of this manipulation of rates. Libor manipulation claim lawsuits have been grouped together under one judge in the Southern District of New York. The banks have requested a hearing to dismiss the claims.
Insider dealing, the rigging or manipulation of benchmarks such as Libor, was deemed illegal as of last week. Backed by an influential European Parliament committee, traders who violate this new regulation could be sent to jail for a minimum five years. Less serious offenses would be eligible for a minimum two year sentence.
Traders outside of Europe suspected of similar crimes could face extradition, as long as regulators are willing to cooperate.
Wall Street Banks Manipulated LIBOR In Rigging Us Treasury Auctions (#GotBitcoin)
Declaring an end to Libor is one thing, making it happen another altogether. The deadline to drop the discredited London interbank offered rate is approaching at the end of 2021, leaving the financial world scrambling to adjust contracts on hundreds of trillions of dollars’ worth of products, from mortgages and credit cards to derivatives.
The risk of a chaotic transition has been likened to Y2K and the fear of computer systems misfiring at the end of the last millennium, only with the added challenge of a global pandemic thrown in. Whether the outcome will be as benign as Y2K turned out for the financial industry is about to unfold.
1. What’s The Worry?
As much as half of the outstanding Libor-priced contracts expire after the deadline. That means the clock is ticking to switch those agreements — often termed “legacy contracts” — to non-Libor rates. The process has been delayed somewhat by the pandemic, while the sheer breadth and scale of Libor’s use means that multiple industries and regulators are having to adjust.
In practice, some are doing so with more urgency than others.
2. What Is Libor And Why Is It Disappearing?
For about 50 years, Libor has helped determine the cost of borrowing around the world. It is a daily average of what banks say they would have to pay to borrow from one another and forms the basis for floating-rate or variable loans and bonds, as well as derivatives.
The London-based British Bankers’ Association formalized the gauge in 1986 when it needed a way to price interest-rate swaps and syndicated loans. But as markets evolved, the trading that helped inform banks’ estimates dried up. And ever since evidence emerged in 2008 that European and U.S. lenders had manipulated rates to benefit their own portfolios, the benchmark has been seen as tainted. By the end of 2016, a dozen banks had paid penalties approaching $10 billion.
3. Who Cares?
Lots of people do. They include pension and fund managers, insurance companies, lenders big and small and Wall Street banks that package loans into securities. Equipment leases, commercial paper, sovereign bonds, student and auto loans, bank deposits and mortgages are among the $370 trillion of financial products that the International Swaps and Derivatives Association says are tied to Libor and related interbank rates. The biggest use is for derivatives like interest-rate swaps, which companies, banks and investors use to hedge risk or to speculate.
4. What’s Taking Libor’s Place?
Central banks have been working to develop replacement benchmarks based on what are called risk-free rates. The goal is to find rates that are a truer reflection of the cost of capital, and are based on actual transactions.
The upshot is an array of acronyms with varying degrees of catchiness, including the U.S.’s Secured Overnight Financing Rate (SOFR), the U.K.’s Sterling Overnight Index Average (Sonia) and the Euro Short-Term Rate (ESTR).
5. How Do The Replacements Stack Up?
In one important aspect they fall short. Libor offers forward-looking rates — that is, rates that incorporate market expectations for the cost of borrowing over a particular time scale, from overnight to a year. By contrast, the new benchmarks mostly reflect overnight lending rates. SOFR, for instance, is based on the U.S. repo market, where cash is briefly exchanged for high-quality securities such as U.S. Treasuries.
In A Post-Libor World, Here Are The Benchmarks That Will Matter
6. Why The Trepidation Over Loans?
Rewriting legacy contracts so they track an overnight benchmark instead of, say, a three-month rate, would be hugely complicated and probably requires renegotiation. Lawyers say many such contracts may end up in court since getting unanimous agreement on a replacement or “fallback” rate would be difficult.
“The big elephant in the room is legacy transactions which have no fallback provisions,” said Y. Daphne Coelho-Adam, counsel at Seward & Kissel LLP in New York. “There is a risk of litigation.” Moody’s Investors Service has warned of increased credit risks due to slow progress on switching from Libor.
7. What About The Derivatives Market?
There’s less concern there. A protocol taking effect in late January will enable firms to incorporate so-called fallback language into contracts, so they can transition smoothly into replacement benchmarks. That will help firms avoid complicated renegotiations and a cliff-edge Libor scenario.
An estimated $200 trillion of financial contracts reference dollar Libor alone, with 95% of this exposure in derivatives, according to the Federal Reserve Bank of New York. Widespread adoption of the protocol is necessary to mitigate broader risks, according to the Financial Stability Board, an international body that monitors the global financial system.
A milestone was reached in October when interest-rate swaps on more than $80 trillion in notional debt switched to the new U.S. benchmark SOFR as the discounting rate.
8. What Are Governments Doing?
The U.K. is handing regulators extra powers to help with legacy contracts that can’t be easily renegotiated. In the U.S., planned New York state legislation would incorporate recommended fallback language for particular products in an effort to enable automatic transition to other rates.
However, lawmakers have been so preoccupied with Covid-19 that the draft law has been held up, fueling anxiety on Wall Street.
9. How Else Has Covid-19 Changed The Landscape?
It disrupted the campaign to ditch Libor and even intensified its use. Both the U.S. and U.K. governments allowed Libor to be referenced as part of emergency loan programs to help keep businesses afloat. The Bank of England delayed plans to encourage banks to ditch the rate and the U.K. pushed back a deadline for lenders to cease issuing Libor-linked contracts.
10. How Will This Affect Regular Consumers?
There’ll be scrutiny over whether they will be forced to pay higher rates. Banks and asset managers face a greatly increased risk of fines, litigation and reputational damage if they poorly manage the transition for existing contracts and products, with regulators likely to watching closely whether they are treating customers fairly.
11. Will Libor Be History From 2022?
Regulators insist the transition won’t be delayed, but be prepared for a possible “synthetic” Libor. The U.K. regulator has hinted at the continued publication of the benchmark using a “more robust” methodology not based on bank submissions. This would only be applicable for legacy contracts that can’t switch to another rate. Details remain sketchy.
The probe, which exposed weaknesses in the way the US Treasury prices the interest on the country’s debt obligations, has been an embarrassing one for Washington since it was first exposed in June 2015.
Investigators are hitting dry wells in their evidence hunt through thousands of pages of Bloomberg chats, plus dozens of interviews, to bring a clear case, one law enforcement official familiar with the probe told The Post.
“There just wasn’t enough there,” the person said.
The probe, which exposed potential weaknesses in the way the US Treasury prices the interest on the country’s debt obligations, has been an embarrassing one for Washington since it wasfirst exposed by The Post in June 2015.
Jacob Lew, then head of the Treasury under President Barack Obama, wanted a quick resolution to the probe soon after it was revealed, The Post reported in 2017
Since then, Lew was replaced by Goldman alumnus Steve Mnuchin, who is now Treasury secretary under President Trump. Another ex-Goldman partner who joined the White House, Gary Cohn, had overseen the division that submitted the bids to Treasury at the time.
No one has accused Lew, Mnuchin or Cohn of any wrongdoing in the matter.
While charges are unlikely to be filed, it’s not clear that banks won’t suffer some negative consequences.
A class-action lawsuit filed in 2015 showed that, after The Post first broke the story, banks changed their behavior in how they bid for Treasury bonds.
The suit, which was brought on behalf of pension funds and investors, also relied on a confidential informant who helped describe how the banks allegedly rigged the Treasury markets.
As recently as 2017, Department of Justice investigators were focused on a period from 2007 to 2011 when Goldman was particularly successful in bidding for Treasury bonds, sources told The Post in 2017.
Since then, however, a string of departures at the department also slowed the investigation, a third source told The Post.
The talks between Goldman and the feds have been “inactive,” another person familiar with the talks told The Post.
The investigation was one of many that looked into banks for potential conspiracies to rig markets in the wake of blockbuster interest-rate and currency-rigging probes that led to billions of dollars in fines and the resignation of top execs, including Barclays chief executive Robert Diamond.
Other banks, including Deutsche Bank, Royal Bank of Scotland, BNP Paribas, Morgan Stanley, and UBS, had trading and chat records subpoenaed by the Department of Justice.
In addition, the Securities and Exchange Commission and the New York Department of Financial Services were investigating the alleged rigging.
Spokespeople for the Department of Justice and the SEC didn’t return requests for comment, and a DFS spokesman declined to comment.
Wall St. Traders Secretly Used Chat Rooms To Rig Treasury Bond Prices:
Wall Street banks secretly shared client information in online chat rooms in order to rig auctions for the $14 trillion US Treasurys market, according to an explosive lawsuit filed in Manhattan federal court on Wednesday.
The move wrongly fattened the banks’ profits and picked profits from clients, the suit claims.
The new accusations, leveled by several pension funds and wealthy individual investors, are contained in an expanded class-action suit originally filed in July 2015 — and include an unusual twist: Some of the evidence came from confidential informants and one of the banks sued in the earlier action.
That bank is now cooperating with the plaintiffs in the massive civil action, and is providing an in-depth look into how Wall Street allegedly conspired to rig Treasury bond trades.
The revised lawsuit expands on details on how the banks conspired to set Treasury bond prices — like moves to manipulate the price of the bonds higher on days when there was a lot of demand, and vice versa, court papers claim.
The funds, representing retirees and public workers, also claim the banks conspired to rig the secondary Treasury markets beginning in the 1990s through tightly controlled electronic platforms that inhibited more competitive trading — a new allegation that wasn’t in the original suit but mirrors similar complaints filed against banks in other markets, like stock loans.
The amended suit tightens its focus on a select number of banks, naming Goldman Sachs, Morgan Stanley, the Royal Bank of Scotland, BNP Paribas, and UBS, among others, as the firms behind the rigging, which they allege occurred from Jan. 1, 2007, to mid-2015.
Last year, the judge presiding over the class-action suit had questioned whether the claims were strong enough to proceed.
The funds continue to allege the banks mined their own customers’ bids for Treasury bonds to get a bigger share of the auction, and sell the bonds for more profit.
Probes on the auction practices are being conducted by the Justice Department, the Securities and Exchange Commission and other federal, state and overseas regulators, sources said. No regulator has accused any bank of wrongdoing.
The banks named in the suit are primary dealers, which means they buy the debt directly from the Treasury and resell it to their clients at a pre-determined price.
Typically, the Treasury holds an auction, then banks submit their bids for US debt based on how much they think those bonds are worth. The Treasury then doles out the bonds proportionately to the bidders at the same price. The bank that asked for the best price gets the most bonds.
Traders at the Wall Street banks shared the prices that their clients had sought to buy the bonds, giving each of the banks in the alleged cartel a clearer picture of what they thought the market was, and a better chance at getting a bigger share of the bonds to sell, according to the complaint.
Details about bid prices are supposed to be a closely held secret.
Washington’s probe into the alleged rigging of the $13 trillion US Treasurys market by Wall Street banks has narrowed its focus to a handful of firms — including Goldman Sachs.
In addition, European authorities have opened their own investigation into possible Treasurys bid-rigging, sources said.
Investigators in the fraud division of the Justice Department have obtained chats and emails from Goldman that appear to implicate the company in manipulating the price of Treasury bonds, according to two sources familiar with the investigation.
Those chats and emails are being analyzed to determine if traders at other banks could be involved with any possible bid-rigging of US government debt, those two people said.
The identities of any traders in investigators’ cross hairs couldn’t be learned.
Goldman is said to be cooperating with the probe, one person said.
In June, The Post reported exclusively that Justice was in the early stages of investigating banks for rigging the price of Treasurys, the largest and most easily tradeable asset in the world.
Goldman is one of about 22 financial institutions that have been probed for any evidence that they may have manipulated Treasury auctions — a secretive process where banks and other financial services companies bid on the price of government debt, sources said.
Justice is also looking into whether there was price-rigging in the secondary market for Treasurys, where debt is sold at a premium, sources added. It’s unclear if investigators have yet found any improprieties or criminality.
Goldman, run by Chief Executive Lloyd Blankfein, is a major player in US government bond trading, and regularly submits bids for auctions.
In November, Goldman disclosed in a regulatory document that it was being probed for possible manipulation of government bond prices. Michael DuVally, a Goldman spokesman, declined to comment further.
Meanwhile, the European Commission, the law enforcement arm of the European Union, has opened its own investigation, joining Justice, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the New York Department of Financial Services, according to two sources.
The rigging investigation is the biggest scandal to hit the quiet but crucial Treasurys market since 1990 when Paul Mozer, a former Salomon Brothers partner, illegally cornered the government debt market. Mozer’s actions are known to readers of Michael Lewis’ “Liar’s Poker.”
Traders are thought to have rigged the market in two possible ways: by agreeing beforehand to keep bond prices higher than normal in order to boost profits in other positions that depend on higher rates, similar to how banks rigged the London-based Libor rate.
Banks also could have colluded to keep prices lower than normal to sell them at a higher price — and score a bigger spread — to their clients, who agreed to pay a fixed amount beforehand.
69% Of Reissued Treasury Auctions Were Suspicious, Suit Says
Same Type Of Analysis Caught Cheating In Currencies And Libor
The same analytical technique that uncovered cheating in currency markets and the Libor rates benchmark — resulting in about $20 billion of fines — suggests the dealers who control the U.S. Treasury market rigged bond auctions for years, according to a lawsuit.
The analysis was part of a 115-page lawsuit filed in Manhattan federal court on Aug. 26 by Quinn Emmanuel Urquhart & Sullivan LLP and other law firms. The plaintiffs built their case against the 22 primary dealers who serve as the backbone of Treasury trading — including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley — using data from Rosa Abrantes-Metz, an adjunct associate professor at New York University who has provided expert testimony in rigging cases.
Her conclusion: More than two-thirds of a certain type of Treasury auction appear to have been rigged. She found issues with other auctions, too.
“The only plausible explanation is that Defendants coordinated artificially to influence the results of the auctions in the primary market,” according to the complaint filed by the Cleveland Bakers and Teamsters Pension Fund and other investors.
The lawsuit, which seeks unspecified damages, comes as the U.S. Justice Department probes whether information in the Treasury auction market is being shared improperly by financial institutions, three people with knowledge of the investigation said in June. Treasury traders at some banks learn of customer demand hours before auctions, and were communicating with their counterparts at other firms via chat rooms as recently as last year, Bloomberg News reported earlier this year.
Abrantes-Metz’s analysis is similar to one used in lawsuits claiming bank and broker manipulation of the London interbank offer rate, or Libor. Those cases resulted in about $9 billion in settlements from the financial firms. Banks and brokers have paid about $9.9 billion in fines to global regulators related to manipulation of currency markets as of May.
Representatives of Goldman Sachs, JPMorgan and Morgan Stanley declined to comment on the Treasury lawsuit’s allegations.
The U.S. Treasury initially sells securities to the primary dealers who in turn sell them to clients, creating a secondary market for trading. Sometimes, after auctioning off debt, the government later issues an identical batch of securities — known as reissued Treasuries.
When the second set of Treasuries is issued, their prices and yields can be compared with the identical securities already trading in the secondary market. If there are pricing differences, that could be evidence of a problem. According to the plaintiffs, 69 percent of the auctions of reissued Treasuries from 2009 to 2015 appear to have been rigged, artificially boosting yields by 0.91 basis points.
The plaintiffs said there’s evidence of cheating from at least 2007 through earlier this year, when press reports revealed the Justice Department investigation into the auction process.
“These analyses reveal a consistent pattern: Treasury auction yields were artificially high (and prices correspondingly low),” according to the complaint. “Defendants then turned around and sold the Treasuries at higher prices (and correspondingly lower yields) in the secondary markets, reaping substantial profits.”
The data analysis showed similar discrepancies when prices at Treasury auctions were compared to those in the secondary market as well as the when-issued market. Treasury futures experienced similar downward pressure on prices leading up to auctions, the lawsuit claims.
Among the lawyers representing the investors is Daniel Brockett, a Quinn Emmanuel attorney who recently won a $1.87 billion settlement against Wall Street’s largest banks in a case alleging they conspired to limit competition in the market for credit-default swaps.
Brockett said in an interview that the new lawsuit alleges the artificially low auction prices grew in direct proportion to how many primary dealers were involved in an auction.
“No matter which way you measure it, they end up benefiting in ways that wouldn’t otherwise be possible in a liquid market of this size,” he said. The $12.8 trillion Treasury market helps sets interest rates on everything from home mortgages to credit cards and is often described as the largest, most-liquid market in the world.
Another group of investors, including Boston’s public employee retirement system, has filed a similar suit against Wall Street primary dealers. Experts interviewed by Labaton Sucharow LLP, the law firm that filed that suit, analyzed auctions and the market for when-issued securities, which are essentially agreements to buy or sell Treasury bonds, notes or bills once they’re issued.
They claim that banks colluded to push prices artificially low at auctions, and to drive prices for when-issued securities to artificially high levels, until December 2012, when news broke of investigations into how Libor was set.
“These scenarios all turn on a very simple conflict of interest,” attorney Michael Stocker said in a telephone interview. “You had banks who were auction participants who also had the power to move the prices that those markets depended on.”
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A Justice Department spokesman didn’t return an email seeking comment, while EC spokesman Ricardo Cardoso declined to comment.
Each bank declined to comment on the lawsuit after it was first filed.
Regulators Ask Banks About Preparations for Libor’s Demise
Banks must show how they are managing risks stemming from the planned end of the benchmark rate next year.
Financial regulators are asking banks to show they have plans in place to manage the risks stemming from the planned demise of a key benchmark interest rate.
Regulators, which for months have urged banks and other financial services firms to prepare for the likely end of the London interbank offered rate in 2021, have recently begun asking for evidence of their preparations.
The New York State Department of Financial Services is requiring banks and insurers to submit plans for managing the risks associated with the end of Libor, the agency said in a letter last week. The Office of the Comptroller of the Currency, which oversees national banks, said in December that it plans to increase oversight of the issue and that examiners will evaluate whether banks have made an inventory of all contracts that could be affected.
The Federal Reserve’s supervisors have also begun asking banks about their plans, Vice Chairman for Supervision Randal Quarles said in June. The Federal Deposit Insurance Corp. declined to comment.
“They are all making similar noises: ‘We need you to pay attention. It is important. It isn’t going to go away,’ ” said Paul Forrester, a partner at law firm Mayer Brown LLP who focuses on corporate finance and securities.
Global banks face a particularly thorny challenge in moving away from Libor because they need to take into consideration the range of alternative rates that could be used in currencies across the world, Mr. Forrester said.
Major banks have made progress in preparing for the transition, according to Dan Stipano, former deputy chief counsel at the OCC. However, the coming transition to an alternative rate is rife with legal and operational risks for the industry, lawyers said.
“They need to give themselves a lot of lead time,” said Mr. Stipano, who is now a partner at Buckley LLP.
Libor Troubles Deepen As Deadline For Benchmark’s Demise Approaches
Regulators and investors say transition remains on track despite setbacks including the Covid-19 pandemic.
No one said replacing the London interbank offered rate would be easy, but many regulators and investors contend the cumbersome process remains on track despite setbacks including the coronavirus pandemic.
Deeply rooted in markets after decades and linked to trillions of dollars of financial products, Libor is slated for replacement by the end of 2021. Policy makers and regulators moved to scrap the benchmark after concluding it was balky and prone to manipulation, as exposed by a 2012 scandal that led to convictions for some traders and penalties for numerous banks.
If the transition doesn’t go as planned, it could leave everyone worse off. Consumers could end up on the hook for increased payments on credit-card loans and other borrowings, while small businesses could face higher fixed rates for loans. About $190 trillion of interest-rate derivatives and $3.4 trillion of business loans are tied to the rate.
Bankers and others in the market for short-term lending say a number of developments this year give them confidence that they can manage Libor’s demise and the transition to alternative lending benchmarks.
A Federal Reserve committee of regulators, banks and asset managers chose the Secured Overnight Financing Rate, or SOFR, as the official replacement.
The Alternative Reference Rates Committee, consisting of major banks, insurers and asset managers alongside the New York Fed, have been rallying derivatives investors and users of Libor to be ready for the end. Fannie Mae and Freddie Mac have said they would stop accepting adjustable-rate mortgages tied to Libor by the end of 2020. Banks are spending millions of dollars and mobilizing everyone from lawyers to trading-floor staff.
But efforts were put on ice for more than a month as financial institutions grappled with tumbling stocks, margin calls and clients racing for cash as the coronavirus sent markets into a tailspin prompting unprecedented action by the Fed.
The temporary breakdown of U.S. Treasury markets in March led some to question the stability of SOFR, which is based on the cost of transactions in the market for overnight repurchase agreements, or repos. That is where financial companies borrow cash overnight using U.S. government debt as collateral.
SOFR dropped to 0.26% on March 16 before doubling the next day, only to fall again. Moves that week reminded investors of volatility last September, when SOFR surged above 5% because of idiosyncratic strains in the repo market.
“There is a growing consensus that SOFR as a replacement for Libor doesn’t really work,” said Scott Shay, co-founder of New York-based Signature Bank.
Smaller and midsize banks are favoring another benchmark: Ameribor. Established by Richard Sandor, a key player in the creation of futures markets in the 1970s, Ameribor is based on rates set on the American Financial Exchange, which he founded.
Smaller banks say Ameribor reflects the cost of funds in trading in financial markets for banks that aren’t among the Fed’s exclusive counterparties—also known as primary dealers.
Some wonder whether the deadline for the transition away from Libor will be pushed back. Investment-bank analysts and salespeople estimate that only a quarter of clients are ready for the benchmark to disappear.
“I think Libor will go away, but will everybody be ready for it in 18 months?” said Paul Noring, managing director at BRG, a consulting firm in Washington, D.C.
Tom Wipf, a vice chairman at Morgan Stanley who is chairman of the Alternative Reference Rates Committee, said that the move to SOFR was on track and that the committee was able to double the number of virtual meetings—with travel schedules restrained by lockdowns related to the pandemic—to get the job done.
He said policy makers weren’t pleased with Libor’s volatility during the March stress period, underscoring the need to make the transition in a timely manner.
“All the concerns that got us here in the first place were revealed again during that period of market stress,” said Mr. Wipf.
The U.K. regulator in charge of overseeing Libor made it clear a deadline extension was out of the question. Edwin Schooling Latter, a senior regulator at the Financial Conduct Authority, said in July that Libor’s death notice wouldn’t be pushed back by the impact of the coronavirus.
“The four to six months ahead of us are arguably the most critical period in the transition away from Libor,” Mr. Latter said in a speech.
Josh Younger, head of interest-rate derivative research at JPMorgan Chase & Co., said investors and asset managers saw significant risks of a delay until U.K. officials came up with a solution in June to overcome one of the biggest hurdles blocking a smooth transition away from Libor: so-called tough legacy contracts.
These include floating-rate notes that require bondholders to agree on a new reference rate, which is a nearly impossible task, according to lawyers at companies advising banks and clients.
To avoid litigation, the U.K. government said in June it would amend the rulebook, handing the FCA, the benchmark’s overseer, the power to craft what some call a “zombie-type” Libor that could exist for certain legacy contracts.
“Dealing with tough legacy contracts potentially accelerates the time frame over which this transition can happen,” Mr. Younger said.
Banks Brace For ‘Big Bang’ Switch On $80 Out $200 Trillion Worth of Swaps
The big bang is one of the most important steps in the Libor transition to SOFR.
It’s being called the “big bang,” and it has derivatives traders on high alert.
In a critical development in the global shift away from old benchmarks that was triggered by Libor’s shortcomings, interest-rate swaps on more than $80 trillion in notional debt will transition this weekend to a new rate for determining their value.
While the switch to the secured overnight financing rate, or SOFR, is expected to boost longer-term liquidity in the new benchmark, it also is fueling concerns about unruly price action because it is expected to trigger the sale of swaps on tens of billions of dollars of debt.
“The big bang is one of the most important steps in the Libor transition,” said Marcus Burnett, director of SOFR Academy, an education technology firm whose clients include banks and asset managers. “We expect rates desks from the largest banks in New York to be participating.”
The reset, which will see SOFR replace the effective federal funds rate in calculations that value swaps, is part of a push to make SOFR a standard U.S. reference rate in debt and derivatives markets. SOFR is intended to replace dollar Libor, which still underpins hundreds of trillions of dollars of assets such as mortgages in the U.S. and syndicated loans in Asia.
The big bang follows a smaller-scale pivot in Europe this July, a less-complicated switch that occurred without much impact on the market.
Interest rate swaps allow two parties to trade one stream of payments for another, over a set period of time. The most common variety, known as a vanilla swap, involves exchanging payments from a fixed rate for payments from an adjustable rate that is based on Libor or some other reference rate. Another kind, known as a basis swap, involves two adjustable rates.
While SOFR has struggled to gain traction since its introduction in 2018, analysts say the upcoming big bang has already triggered a shift toward more trading in SOFR-linked swaps.
This could help pave the way for a curve that reflects expectations for where the rate will be in the future, addressing one of the new benchmark’s key weaknesses.
The big bang “will have a very, very good impact on liquidity,” said Jason Granet, chief Libor transition officer at Goldman Sachs Group Inc.
Still, in the immediate future there will be turbulence in pricing. Clearing houses are planning to effectively neutralize the changes in swap values caused by the big bang, and traders will see their positions automatically adjusted. LCH Ltd. and CME Group Inc. are preparing to distribute compensation from clients whose position values go up to those who see them decline.
LCH will facilitate payment of hundreds of millions of dollars in cash to cover lost value, and at least tens of billions of dollars in basis swaps to compensate for risk, said David Horner, head of risk at SwapClear, which is part of LCH.
However, some firms do not use basis swaps to hedge their discount-rate risk or are otherwise incapable of keeping them on their books, so they are expected to sell them. This Friday LCH will hold auctions in which 18 banks can close out $25 billion in unwanted basis swaps.
Buyers, ideally, would snap them up either as hedges against risk or for their own value. But the approach is largely untested since basis swaps were not distributed in the European version of the big bang.
“For about six months our members and clients have been able to look on their screens and see a forecast for the compensating cash payments and compensating swaps they will receive, so they are familiar with what’s about to happen,” said Horner. “It’s important for the market that it runs smoothly.”
CME will hold a similar auction on Monday. Clients have agreed to a maximum loss, said Sunil Cutinho, president of CME Clearing, and “if their positions cannot be auctioned off then they are fully protected and they can use their own private means to dispose of their positions.”
However, there are concerns about price swings in the market amid a surge in supply as some banks ditch basis swaps they received as compensation.
The big question is how well the auctions go. Clearing houses are not guaranteeing the minimum prices for the basis swaps, which could fall below the maximum that firms are prepared to tolerate, said Joshua Younger, a strategist at JPMorgan Chase & Co.
“Many would then likely unwind them in the open market and the price action could get very disorderly,” he said.
Firms need to understand they are facing more risk from this change first before they eventually get less risk, said Pieter Van Vredenburch, a principal at Market Alpha Advisors and previously a member of the Alternative Reference Rates Committee, which is guiding the U.S. Libor transition, when he worked for HSBC Holdings Plc in 2016.
“The big banks are very prepared for the big bang,” said Van Vredenburch. “But do I think the smaller banks are ready for this? Not even close.” When it comes to the overall switch to SOFR, he said, “there are so many nuances to the transition and the devil is in the details. There is nothing simple in all this.
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Libor’s Survival Beyond 2021 Death Date Becomes Hot New Wager
Don’t count Libor out just yet.
From traders scurrying to exit bets on a replacement for the benchmark, to analysts at Wells Fargo giving good odds it’ll keep going, there’s newfound uncertainty in markets over whether the beleaguered index will disappear at the end of next year like it was supposed to.
Eurodollar futures — among the world’s largest interest-rate derivative markets — sprang to life Wednesday after Libor’s administrator and U.K. financial regulators opened the door for the dollar version of the index to survive its previous Dec. 31, 2021, expiration date. The futures contracts reference three-month dollar Libor, set daily by ICE Benchmark Administration but which had been slated for extinction by global regulators.
The market priced in a longer timeline for the interest rate, and the move may have further to run. For dollar Libor, “the chance has increased significantly that it will survive past 2021,” Wells Fargo strategists Zachary Griffiths and Mike Schumacher said in a note. “We doubt that market prices fully reflect this likelihood,” and expect forward one- and three-month rates “to continue rising for early 2022 vs late 2021 dates.”
A series of bets set up to exploit the replacement of Libor got wiped out Wednesday. Traders rushed to buy March 2022 Libor contracts, driving down their spread over December 2021 equivalents, which had been steadily widening on expectations that rates would be higher after the benchmark switchover. The March contract was the most actively traded of the day on volumes almost four times higher than Tuesday, and a drop in its open interest suggested positions were being unwound.
A combined daily volume of 1.2 million futures across December 2021 as well as March and June 2022 contracts was only topped one other day this year on March 2. The surge in volume represented both outright buying and selling of the contracts and spread among the three tenors.
ICE Benchmark Administration Limited said it intends to cease publication of most major Libor benchmarks at the end of 2021, with the exception of the dollar variety where discussions are still continuing with key stakeholders. That was enough to raise the possibility among market participants that the replacement of dollar Libor may be on a different timeline.
The move toward Libor alternatives, such as the Secured Overnight Financing Rate, is a response to concerns about the benchmark, including revelations about manipulation in the wake of the financial crisis. For more than three years, global policy makers have been developing new benchmarks.
The Federal Reserve Bank of New York, meanwhile, on Thursday tweeted a reiteration of its support for a “smooth transition for consumers, businesses and market participants” away from Libor in dollar-related markets, noting that the clock is ticking for the beleaguered benchmark.
Traders had been using spread trades to bet on expected rates moves around the transition period — buying or selling one contract against another to capture relative changes between the two, rather than directional moves.
While it’s possible that market watchers have read too much into Wednesday’s statement, the ambiguity over a timeline suggests Libor fixings for early 2022 may take place under the current methodology, instead of the incoming method of SOFR plus a spread.
This is also reflected in the narrowing of the difference in premiums between the December 2021 and March 2022 contracts against the overnight rate or FRA/OIS.
March 2022 FRA/OIS, which is determined by expectations of where ISDA’s fallback rate will be, narrowed as much as 1.7 basis points Wednesday. That came as traders bet the continuation of the Libor benchmark will push the premium toward December 2021 FRA/OIS, which is based on Libor expectations and is around six basis points lower.
Libor’s Likely Reprieve Is a Welcome Acknowledgment of Reality
Libor is flawed. But better to let it wither on the vine than try to force its early abolition.
The overseers of three-month dollar Libor are considering a stay of execution for the benchmark interest rate for trillions of dollars’ worth of securities that was scheduled to expire at the end of next year. It’s a welcome acknowledgment of the reality that the financial industry has failed to embrace any potential replacements for the suite of interest rates once dubbed the world’s most important numbers.
The London interbank offered rates dictate the pricing of everything from mortgages to corporate loans to derivatives contracts, across a range of maturities and currencies. But they’re flawed: The wholesale interbank lending market on which they were based dried up in the wake of the global financial crisis, while many of the banks responsible for setting their values have paid billions of dollars in fines for rigging the benchmarks in their own favor.
So market regulators have proposed alternatives, including the Secured Overnight Financing Rate in dollars and the Sterling Overnight Interbank Average Rate in U.K. markets. But adoption has been slow, particularly in the U.S. market. For example, in the week ended Nov. 20 almost $2.5 trillion of dollar interest-rate swaps tied to Libor were traded, compared with just $70.5 billion contracts that referenced SOFR, according to figures compiled by the International Swaps and Derivatives Association. So far this year, $96 trillion of Libor swaps outstrip the $1.8 trillion of SOFR trades.
What’s more worrying is the patchy preparations for Libor to be turned off. A Duff & Phelps survey published in September of more than 100 companies, including hedge funds, private equity firms and banks, showed that while two-thirds hadn’t completed planning for the change, one in five hadn’t even started the process of making the transition away from Libor. The pandemic may be more of an excuse than a reason for the lack of activity, but that doesn’t make the issue any less real.
The proposal by the ICE Benchmark Administration Ltd. would see three-month dollar Libor continuing until the middle of June 2023, along with its six- and 12-month flavors. That 18-month extension would mean the vast majority of existing contracts tied to Libor would have expired by the time the benchmark ceased to exist. There’d be no need to rewrite an untold number of agreements signed when Libor looked set to last.
That’s a sensible way to deal with the issue, given that market participants continue to question the usefulness of the replacements. For one thing, the new benchmarks are based on overnight borrowing costs, making it tricky (though not impossible) to calculate the matrix of longer-term tenors that the market relies on. Perhaps more importantly, the credit risk currently reflected in Libor is absent from the new values, leading to a complicated system of adjustments needed to compensate for discrepancies between the different benchmarks.
I argued in May that Libor should be reprieved. The overseers of Libor in other jurisdictions, notably the U.K., should reconsider their end-2021 deadline in light of the U.S. decision to think again (although ISDA’s figures suggest that the City of London has been more responsive to the Financial Conduct Authority’s urgings, with SONIA swaps this year worth more than $15.6 trillion outpacing the $12 trillion of sterling Libor interest-rate derivatives).
Market regulators may feel slightly embarrassed at having to backtrack. But allowing a longer period for the universe of legacy contracts to shrink while continuing to urge financial firms to stop writing new business tied to Libor is a smart strategy. It sure beats the potential disruption of forcing the market to switch before it’s ready.
Libor Overhaul Gets Boost In Cuomo Bid To Avert Transition Chaos
New York Governor Andrew Cuomo has proposed legislation that would help prevent hundreds of billions of dollars of financial contracts from descending into chaos when the London interbank offered rate expires.
Provisions to help troublesome Libor-linked contracts switch to replacement rates are contained in Cuomo’s state budget plan, which was published on Tuesday. Bankers, investors and regulators see such proposals as crucial to ensuring that a large swath of the global financial system isn’t disrupted.
Various tenors of dollar Libor may be given a reprieve until mid-2023, in part to allow legacy contracts that lack a clear replacement rate to die off naturally. While that would help reduce the threat to financial stability, the most challenging floating-rate debt and securitizations — as well as Libor-based mortgages and student loans — will run on past the new deadline, making legislation critical. As home to the world’s biggest financial center, much of the debt falls under New York law.
“This legislative proposal is essential in order to provide legal certainty and minimize the adverse economic impacts for legacy Libor contracts,” said Tom Wipf, vice chairman of institutional securities at Morgan Stanley and chairman of the Alternative Reference Rates Committee, the Federal Reserve-backed body guiding the transition. The governor’s decision to include it in his budget plan “marks notable progress,” he said.
The U.K. hasn’t faced the same complications around sterling Libor, partly because of its different exit strategy. Proposals to keep publishing a “synthetic” Libor number that doesn’t require trading data from panel banks would help legacy contracts that can’t transition to avoid a cliff-edge scenario at the end of 2021, when the U.K. benchmark will likely retire.
In New York, the bill would allow contracts to instead use the replacement rate recommended by the Fed Board, New York Fed, or the ARRC. The proposal includes language providing some safety measures, allowing the use of the replacement rate only in situations where it is reasonable and comparable to Libor.
The replacement benchmark should not “prejudice, impair, or affect any person’s rights or obligations under or in respect of any contract, security or instrument,” according to the bill language.
Policy is often negotiated alongside fiscal plans in the New York state budget process, which is kicked off by the governor. The final budget deal is due by March 31, the end of the state’s fiscal year. The Libor discontinuation legislation would take effect immediately after the passage of the budget, according to the bill language.
“It’s an important first step,” said Priya Misra, head of global rates strategy at TD Securities in New York, and also a member of the ARRC. “Hopefully it passes in the New York legislature and then can become a template for other states, too.”
Do You Consider Bitcoin As A Hedge Against A Rigged And Failing Financial System?
Finance Executives Look To Advance Libor Transition In 2021
The interest-rate benchmark is being phased out, forcing companies to update contracts and adjust funding projections.
Efforts to skip the London interbank offered rate for new transactions by end of next year are forcing finance executives to take stock of their contracts, communicate with banks and investors and adjust their interest-rate cost calculations.
Global policy makers decided to do away with Libor, an interest-rate benchmark underpinning trillions of dollars worth of financial instruments, after concluding it was prone to manipulation. Banks face a Dec. 31, 2021, deadline to replace Libor with alternative rates for new contracts following a yearslong transition effort.
A majority of financial and nonfinancial companies recently said their Libor transition plans are ahead of schedule, according to a survey by consulting firm Accenture PLC released earlier this month. In some cases though, the pandemic has caused delays.
Corporations including Walt Disney Co. , network-equipment maker Juniper Networks Inc. and cancer treatment firm Varian Medical Systems Inc. have started alerting investors to the pending changes and the potential challenges as they shift to a new rate regime.
Businesses face potential adjustments to interest costs, arising from Libor being calculated differently than its likely successor in the U.S., the Secured Overnight Financing Rate, or SOFR.
For one, the immediate cost of borrowing may be cheaper. While Libor is derived from daily price quotes provided by a panel of banks, SOFR is based on the cost of transactions in the market for overnight repurchase agreements, or repos. Financial companies already use the repo rate to borrow cash, using U.S. government bonds as collateral. SOFR is considered a less risky rate, which means overall interest costs for companies could be lower than under Libor.
But SOFR currently doesn’t allow for predictive, forward-looking rate calculations, a notable deviation from Libor, which can be calculated three, six or 12 months out. This limits the insight treasurers can glean into future interest-rate costs.
Timken Co. ’s Chief Financial Officer Philip Fracassa is working to ensure that the North Canton, Ohio-based maker of engineered bearings and power-transmission products shifts its contracts to SOFR. “The discontinuation of Libor requires a lot of restructuring of debt agreements,” Mr. Fracassa said.
He doesn’t expect big changes to Timken’s interest costs as part of the transition, but foresees additional paperwork, including updating contracts and policies. “There’s a lot that you’ve got to do,” he said.
Finance executives also need to deal with existing contracts that cite Libor. That can be tricky—especially in cases where some of these debt instruments are held by hundreds of investors who all need to agree to the changes. Transaction lawyers suggest that finance chiefs create an inventory of agreements that reference Libor, and take a look at when they run out and who the other party is. The cut-off date for existing contracts to stop referencing Libor is June 30, 2023.
“The issue for treasurers and CFOs is managing the transition across the whole company,” said Michele Navazio, a partner at law firm Seward & Kissel LLP. “It is not going to happen simultaneously, which could add to the complications.”
Serena Wolfe, CFO at Annaly Capital Management Inc., a New York-based mortgage real-estate investment trust, hopes legislators will make it easier for companies to deal with some of these legacy contracts. A potential fix for certain residential credit securitizations currently is being debated by New York state lawmakers.
Annaly Capital has a Libor working group, which found that recent upgrades to the company’s technology systems will make it easier to manage the data required to transition away from Libor, Ms. Wolfe said. Other companies, especially those still relying on manual data entry and Microsoft Excel, could find that harder, she said.
Dealing with two benchmark rates—SOFR for new contracts after Dec. 31, 2021, and Libor for legacy contracts until June 30, 2023—won’t be a problem for Annaly Capital, Ms. Wolfe said, adding that the company already holds swaps which cite different rates.
For some businesses though, the dual rates will present a challenge, said Venetia Woo, lead Libor adviser at Accenture. “Corporates now have two expiration dates for Libor contracts and they need to determine if the economics to convert [by year-end] outweigh the burden of running two operations,” she said.
Libor Proving Hard To Kill In $200 Trillion Derivatives Market
It’s one of the most confounding questions facing regulators in the fight to phase out the London interbank offered rate.
How do you wean everyone from asset managers and traders to corporate treasurers off derivatives that are so ubiquitous, they’ve become part of the fabric of the financial system?
For the better part of three years, U.S. officials have been preaching patience. Libor-based interest-rate swaps, futures and options, among the most liquid markets in the world, would gradually give way to new securities tied to new benchmarks, they said, including the Secured Overnight Financing Rate, dollar Libor’s anointed successor.
Yet activity in those markets isn’t disappearing. What’s more, acceptance of alternative products has been slow. While some headway has been made, average open interest in three-month SOFR futures barely topped 5% that of eurodollar contracts last month. And recent high-profile milestones in the Libor transition that were expected to jump-start trading in the new instruments have delivered relatively modest boosts so far.
As the Federal Reserve’s year-end deadline to halt new Libor contracts creeps closer, some are beginning to express concern that the slow pace of progress could undermine efforts to ensure a smooth transition, posing a risk to financial stability.
While few expect a delay similar to the one announced in November for legacy contracts that can’t be shifted to SOFR, it’s another example of the difficulties regulators have had in getting critical corners of the financial world on board.
“We’re in this classic chicken-and-egg scenario, where participants don’t want to trade because liquidity is low, but there’s not going to be enough liquidity unless people trade it,” Thomas Pluta, global head of linear rates at JPMorgan Securities, said of SOFR derivatives. “It’s increasing, but quite frankly there’s an awful lot more that needs to be done for this transition to happen.”
More than $200 trillion of financial instruments globally are tied to dollar Libor, with the vast bulk of that exposure in the form of derivative contracts, according to the Bank for International Settlements. The products are used by money managers to bet on the direction of monetary policy and corporations to hedge their interest-rate exposure.
Some market watchers predict the shift to SOFR derivatives will ramp up in the coming months after the Fed made clear late last year that it still expects banks and other regulated firms to stop entering into new Libor-based transactions by the end of 2021.
“That will force the issue quite a bit,” said Tyler Wellensiek, a managing director in rates sales at Barclays Plc. Nonetheless, she acknowledged that “there’s definitely a lot more work to do in SOFR liquidity.”
Officials at the Alternative Reference Rates Committee — the Fed-backed group tasked with overseeing the Libor transition in the U.S. — point to the gradual increase in SOFR activity across the swaps curve since the middle of last year as evidence that the benchmark is gaining traction among derivatives traders.
“The depth of liquidity has improved a lot,” said Tom Wipf, ARRC chair and a vice chairman of institutional securities at Morgan Stanley.
Add to that another potential boost in activity in the coming months with the setting of the International Swaps and Derivatives Association’s spread adjustment — used to determine fallback rates for Libor contracts maturing after the benchmark is phased out — and SOFR’s proponents see reasons to be encouraged.
Still, there’s no guarantee the fixing of the spread adjustment will spark a surge in trading.
Other recent milestones in the Libor transition, including the so-called big bang shift by derivatives exchanges to SOFR for calculating the value swaps, and ISDA’s publication of a highly anticipated legal protocol to help convert Libor-linked contracts to SOFR, have produced relatively fleeting boosts so far.
Just 5.6% of all U.S. dollar risk in cleared over-the-counter and exchanged-traded interest-rate derivative transactions was tied to SOFR in November, according to data from ISDA and Clarus Financial Technology. While that’s almost double the 3% of trading activity that referenced the rate in June, it’s well off the record 9.7% reached in October, when global clearing houses made the shift to SOFR.
JPMorgan’s Pluta said he had expected the big bang to be “a catalyst for lots of different market participants to start trading SOFR actively,” but “many participants just did what they needed to do, and then reverted for the most part to Libor.”
Should the shift to SOFR derivatives struggle to gain pace in 2021, it could delay the ARRC’s ability to develop a forward-looking term reference rate, according to Marcus Burnett, the director of SOFR Academy, an education technology firm whose clients include banks and asset managers.
That may in turn discourage underwriters and issuers in the loan market from pricing new deals based off of the alternative benchmark.
“Without that, it’s less likely that we’re going to have a robust liquid and institutional-sized lending market based on SOFR,” Burnett said. “Without the lending market, we can’t have a broad-based transition.”
Some are already concerned that it could threaten the orderly functioning of markets.
“On some level it has to have implications for financial stability because of the uncertainty it generates,” Anne Beaumont, a partner at law firm Friedman Kaplan Seiler & Adelman in New York, said of SOFR’s modest progress so far. “You’re already going to have this fragmented world of new instruments linked to SOFR and legacy ones that rely on fallbacks.”
While recent jumps in SOFR trading that coincided with transition milestones have proven that banks can scale up their execution, the data suggest many likely aren’t seeing significant demand from clients for SOFR transactions and risk management, according to Chris Barnes, a senior vice president at Clarus.
SOFR still needs to gain significant traction to ensure a smooth transition, he said, especially with the possibility looming that the Fed will limit trading of Libor-linked derivatives in less than a year.
“Twelve months is an incredibly short period of time to try and change the precise product that people are trading,” Barnes said. But “if we as a market, as an industry can’t get behind a change in four years, that’s not a great sign.”
Libor Is Going Away For Real
Libor Is Canceled
I Guess They Were Serious About That, Huh:
* Regulators kicked off the final countdown for the London interbank offered rate Friday, ordering banks to be ready for the end of a much maligned benchmark that’s been at the heart of the international financial system for decades.
* The U.K. Financial Conduct Authority confirmed that the final fixings for most rates will take place at end of this year, with just a few key dollar tenors set to linger for a further 18 months.
Here is the FCA’s announcement, and here is one from Intercontinental Exchange Inc., which actually administers Libor.
And here are two announcements—“LIBOR Cessation and the Impact on Fallbacks” and “ISDA Statement on UK FCA LIBOR Announcement”—from the International Swaps and Derivatives Association, which administers the market for interest rate derivatives.
One thing that is happening here is that ICE will stop calling up banks every day and asking them “at what rate can you borrow unsecured from other banks” and then using their answers to calculate Libor. That’s what ICE does now, and what the British Bankers’ Association did before ICE. It has become an increasingly untenable way to calculate an interest-rate benchmark, insofar as:
(1) the banks were lying about their borrowing costs for a while and
(2) the interbank unsecured funding market is a lot less robust than it was back before the financial crisis, so it’s hard to answer that question truthfully even if you’re trying to. So, at the end of the year, it will mostly stop, though it will keep going for the main tenors of U.S. dollar Libor until June 2023.
Another thing that is happening here is that ICE will stop publishing Libor, sort of. Actually it will keep publishing some Libor rates for a while after it stops collecting them, though with an asterisk. (The asterisk says that the new Libors will not be “representative.”)
They will be “synthetic” Libor: Instead of being based on a poll of banks’ borrowing costs, the new rates will be computed based on “a forward-looking term rate version of the relevant risk-free rate plus a fixed spread aligned with the spreads in ISDA’s IBOR fallbacks.”
In the U.S., for instance, Libor is supposed to be replaced by SOFR, the Secured Overnight Financing Rate, a risk-free rate based on the cost of borrowing secured by U.S. Treasuries. When Libor is replaced by “synthetic Libor,” the synthetic Libor will be:
(2) compounded in arrears to get a term rate,
(3) plus a spread.
The spreads are based on the historical differences between Libor and the relevant risk-free rate; here they are. 1 So for instance when ICE stops polling banks for 3-month U.S. dollar Libor, 3-month dollar “synthetic Libor” will just be SOFR, compounded for three months, plus 0.26161%.
I have written before that Libor is a “function call”: You write in a contract that the interest rate will be Libor, and then you go and pull Libor in from ICE (or from a Bloomberg page that gets it from ICE), and you don’t really care about the guts of how ICE calculates Libor. Right now ICE calculates Libor through this rickety mechanism of calling up banks and asking them to make up numbers.
In the future it will calculate Libor by looking at published risk-free rates—which benchmark administrators calculate by looking at real transactions in secured funding markets—and adding a number to them.
In theory Libor could just keep going forever, in this vestigial way: The “real” benchmark would be SOFR or whatever, and then Libor would just be a minor arithmetic manipulation of SOFR, SOFR plus 0.26%. You could still write loans or derivatives that reference Libor, and everyone would know that “Libor” is a weird archaism for “SOFR plus 0.26%.”
But The Regulators Don’t Want That Either:
* The BOE will hold executives to account for progress in the transition under the U.K.’s regulatory regime for senior managers, according to people familiar with the matter. If firms fail to take appropriate steps, there is the potential for measures such as capital sanctions, though these would come further down the line.
* Progress toward replacement benchmarks, such as the Secured Overnight Financing Rate in the U.S. and the Tokyo Overnight Average Rate in Japan, has been sluggish, and there are hopes Friday’s announcement could accelerate the process — particularly in the vast global derivatives market. …
* The Fed, for its part, is intensifying its scrutiny of banks’ efforts to shed their reliance on Libor, and has begun compiling more detailed evidence on their progress.
* “In the months ahead, supervisors will focus on ensuring that firms are managing the remaining transition risks,” said Randal Quarles, vice chair for supervision at the Federal Reserve Board and chair of the Financial Stability Board.
We’ve had several years now of regulators saying “you have to stop using Libor,” and Libor is still pretty popular, but maybe this will do it. I wonder if old-school bankers will cling to Libor in a sort of hipsterish way.
Maybe the senior banker will say “ah yeah their term loan is at Libor plus 50” and the analyst will be confused and go back to her desk and ask the associate “hey what does Libor plus 50 mean” and the associate will be like “it means SOFR plus 76, that’s just how people talk sometimes.”
Why Won’t Libor Die? It’s Complicated
The broken interest rate benchmark still dominates derivatives trading. Regulators may need to be more forceful in persuading banks to drop it.
The funeral dates for Libor are finally set, with some sensible concessions that keep part of the suite of interest rates alive for longer than initially planned. Those exemptions must be strictly controlled so as not to impede a much broader acceptance of the replacement benchmarks. For now, that’s proving harder than even those most resistant to change might have expected. So market regulators need to step up efforts to force bankers and financiers to embrace Libor’s successors.
The London interbank offered rates fell into disrepute for being easily rigged by the traders charged with submitting borrowing costs. Plus, the underlying wholesale funding market they’re based on melted away during the global financial crisis. In mid-2017, the U.K.’s Financial Conduct Authority said they’d be phased out by the end of 2021.
Since then, different alternatives have been created for different markets. In dollars, the replacement rate is the Secured Overnight Financing Rate, known as SOFR. In the U.K. markets, it’s the Sterling Overnight Index Average, dubbed Sonia. But the switch has been very, very slow, increasing the risk that a last-minute scramble to adapt to the changeover could lead to unwanted and potentially costly market distortions.
Just 10% of the total risk in the global market for interest-rate derivatives was tied to the replacement rates in both December and January, according to figures compiled by the International Swaps and Derivatives Association. Although the 2020 monthly average of 7.8% was an improvement on 2019’s 4.7%, the percentage peaked at 11.6% in October.
Those figures mask important regional differences. In the year ended Feb. 26, the notional value of trades in dollar-denominated interest-rate derivatives tied to Libor was more than $20.8 trillion, dwarfing the $472 billion that referenced SOFR, according to ISDA data. U.S. swap traders still haven’t kicked their Libor addiction. But figures for January suggest the U.K. regulator’s efforts to encourage sterling traders to switch to the new interest-rate flavor are showing signs of success.
Even in sterling, though, the most active market remains beholden to Libor. Just 20% of the risk traders took in three-month interest-rate futures was connected to Sonia rather than Libor in January, according to Intercontinental Exchange Inc.
Beyond the excuse of inertia, the market’s caution in adopting the new benchmarks is understandable. The replacement rates are based on overnight lending, which has made it tricky to calculate the matrix of different maturities to match Libor.
Moreover, speculation that some of the more important rates might get a stay of execution proved correct. While the bulk of the Libor spectrum will be phased out at the end of this year, the key one-, three-, six- and 12-month dollar rates will survive until mid-2023, allowing the bulk of existing financial contracts to mature without needing to be changed. That’s a smart concession to market reality.
The FCA estimates the value of outstanding financial contracts that still reference Libor is about $260 trillion, with cleared interest-rate swaps and exchange-traded derivatives accounting for about 80% of that total. The figure, though, excludes the bond, loan and mortgage markets.
And those are where life gets trickier. The FCA is considering allowing synthetic Libors — based on the new rates but adjusted for maturity and with an added credit spread — to take the contractual place of the current rate in contracts that can’t easily be switched to the replacement benchmarks. It’s a legal sleight of hand that slides the new borrowing costs into existing contracts, covering hard-to-adjust legacy documentation that might not even surface until after Libor’s demise.
But regulators should take a hard line on restricting what qualifies for that special treatment, otherwise firms will have an excuse not to make the change and Libor will linger on indefinitely. Banning new contracts from referencing Libor was a good start, but forcing banks and insurers to list their exposures to the old benchmark by category would do wonders.
It would focus attention on the need to revise the terms of those trillions of dollars of outstanding obligations. Goldman Sachs Group Inc. for example, said this week that it’s still deciding how to deal with about $29 billion of Libor-linked bonds and preferred shares that run past Libor’s expiry date.
With the FCA’s final timetable for Libor’s endgame, regulators will be hoping the pace of adoption of the new reference rates accelerates. If it doesn’t, more stick might be needed to shift market players out of the status quo. Enlightened self-interest would suggest it’s time to euthanize Libor.
Libor Wall Street Fix Gets A Boost As N.Y. Senator Backs Move
A key New York state lawmaker is supporting legislation intended to protect hundreds of billions of dollars of contracts from legal chaos when Libor is phased out as an interest-rate benchmark, marking a potentially crucial step toward securing its passage.
Democrat Senator Liz Krueger, the head of the finance committee, said in an interview that she is in favor of provisions contained in Governor Andrew Cuomo’s proposed budget that would allow existing contracts to use replacement indexes recommended by regulators. She said failing to enact that could give large companies power to impose their own changes instead, potentially to the peril of consumers.
Bankers, investors and regulators see such proposals — which will help troublesome Libor-linked contracts switch to replacement rates — as crucial to ensuring that a large swath of the global financial system isn’t disrupted.
Krueger’s support matters because she previously challenged similar reforms proposed by the Alternative Reference Rates Committee, the Federal Reserve-backed body guiding the transition, on the grounds that they could put retail consumers at a disadvantage.
Krueger said in the interview that she has thoroughly examined the plan in Cuomo’s budget and concluded it is “legitimate” and adequately protects consumers. The deadline for passing the budget is April 1.
“It still needs to be negotiated,” she said, adding that she’s hopeful it will make it into the final budget.
While most Libor indexes will be retired at year-end, various tenors of the dollar-denominated benchmark may be given a reprieve from the phase out until mid-2023, in part to allow older contracts that lack a clear replacement rate to expire naturally.
While that would help reduce the threat to financial stability, the most challenging floating-rate debt and securitizations — as well as Libor-based mortgages and student loans — will be in place after Libor is no longer used, making legislation critical.
Backing from the committee head makes the law more likely to pass, according to Priya Misra, global head of interest rate strategy at TD Securities and a member of the ARRC, the Fed-backed transition planning group.
“We are down to the wire with the New York state legislation and it is extremely important to address the problem of legacy cash products with inappropriate fallback language,” she said. Passing the law “would be a win-win since it helps bring clarity for issuers and investors.”
Tom Wipf, vice chairman of institutional securities at Morgan Stanley and chairman of the ARRC, said the body “welcomes all support for the legislation, which is essential to providing legal certainty and financial stability.”
Lawyers say even if the law passes, separate legislation is likely to be needed to protect sections of the market that fall beyond Wall Street. Federal Reserve Chair Jerome Powell said in February that national legislation would be the best solution.
“Once you have legislation in New York, you have a template that other states can piggy back off and hopefully even have a federal legislative solution,” said Y. Daphne Coelho-Adam, a counsel at Seward & Kissel LLP. “It gives everyone ability to look forward without hitting that wall or going off a cliff.”
Libor Enters ‘Final Chapter’ As Global Regulators Set End Dates
Regulators kicked off the final countdown for the London interbank offered rate Friday, ordering banks to be ready for the end of a much maligned benchmark that’s been at the heart of the international financial system for decades.
The U.K. Financial Conduct Authority confirmed that the final fixings for most rates will take place at end of this year, with just a few key dollar tenors set to linger for a further 18 months.
The move comes in the wake of major manipulation scandals and the drying up of trading used to inform the rates, which are linked to everything from credit cards to leveraged loans. Global regulators have made a concerted effort to wind down the benchmark in 2021, with the Federal Reserve and others pushing market participants toward a slew of alternatives.
“Outside the U.S. dollar markets, this marks the end game,” said Claude Brown, a partner at Reed Smith LLP in London.
“The rate that linked the world, and then shocked the world, will leave this world in 2021.”
Libor is deeply embedded in financial markets. Some $200 trillion of derivatives are tied to the U.S. dollar benchmark alone and most major global banks will spend more than $100 million this year preparing for the switch. Other players — from corporations to hedge funds — will also be affected, with many only beginning to shift from legacy contracts.
Bank of England Governor Andrew Bailey said this was now the “final chapter,” and there’s no excuse for delays.
The BOE will hold executives to account for progress in the transition under the U.K.’s regulatory regime for senior managers, according to people familiar with the matter. If firms fail to take appropriate steps, there is the potential for measures such as capital sanctions, though these would come further down the line.
Progress toward replacement benchmarks, such as the Secured Overnight Financing Rate in the U.S. and the Tokyo Overnight Average Rate in Japan, has been sluggish, and there are hopes Friday’s announcement could accelerate the process — particularly in the vast global derivatives market.
“This was the much anticipated final piece of clarity the market needed to really kick on,” said Kari Hallgrimsson, co-head of EMEA rates at JPMorgan Chase & Co. “We would expect liquidity for trading the new rates to keep increasing from here on out.”
Friday’s decision is a cessation event and locks in the benchmark’s fallback spread calculations, which for dollar Libor will be added to SOFR, the main U.S. replacement. Where firms have adhered to International Swaps and Derivatives Association’s Libor protocol, their contracts will automatically transition to replacement rates the moment Libor ends, avoiding a cliff-edge scenario.
The delay in the most-used dollar Libor tenors — notably the three-month benchmark — is a concession to market concerns, but regulators remain adamant that dollar Libor shouldn’t be used for new contracts after 2021. Firms should expect further engagement from their supervisors to ensure timelines are met, the FCA warned.
The Fed, for its part, is intensifying its scrutiny of banks’ efforts to shed their reliance on Libor, and has begun compiling more detailed evidence on their progress.
“In the months ahead, supervisors will focus on ensuring that firms are managing the remaining transition risks,” said Randal Quarles, vice chair for supervision at the Federal Reserve Board and chair of the Financial Stability Board.
While speculation about the announcement’s timing jolted the eurodollar market in December, the market reaction on Friday was subdued. The spread between June 2023 and September 2023 Eurodollars widened one basis point, as did the difference between December 2021 and March 2022 short sterling contracts.
The FCA also detailed proposals to deal with the most troublesome loans and securitizations that can’t be switched to replacement rates. The regulator will consult on synthetic Libor — which doesn’t rely on bank panel data — for the sterling and yen benchmarks, and will continue to consider the case for using these powers for some dollar Libor settings.
Worries are mounting that hundreds of billions of dollars of these legacy contracts will never be able to transition, even with the extension of certain dollar Libor tenors. This will present a key challenge to banks, regulators and lawmakers in the months ahead.
“Some cash products have not embraced Libor and the clock is ticking loudly,” said Priya Misra, global head of interest rate strategy at TD Securities. “A lot of them will mature by June 2023, but there will be a lot left over after that.”
HKMA Delays A Target For Phasing Out Libor Products To End-2021
The Hong Kong Monetary Authority has pushed back a target for banks to phase out certain products tied to the London interbank offered rate, according to a statement Thursday.
HKMA said that the so-called milestone for banks to cease issuing new Libor-linked products that will mature after 2021 will now be the end of this year. That’s a shift from the previous goal of the end of June.
HKMA said it and the Treasury Markets Association agreed that it’s no longer appropriate to stick to the end-June deadline partly in light of feedback from banks. The HKMA added that authorized institutions should press ahead with their transition preparations.
Global regulators are driving the shift to alternative risk-free rates to replace Libor, which was tainted by a rate-rigging scandal but still underpins hundreds of trillions of dollars worth of financial assets.
The latest change will more closely align Hong Kong’s schedule with a similar timetable in the U.S., where authorities have asked banks to stop entering new contracts based on U.S. dollar Libor after the end of 2021. Last year, the ICE Benchmark Administration Ltd., which is the administrator of the dollar benchmark, also said it was looking to push back the timeline for abandoning some of the discredited interest-rate settings to mid-2023.
N.Y. Governor Signs Libor Fix Into Law To Avert Transition Chaos
New York Governor Andrew Cuomo late Tuesday signed into law a measure that will help prevent hundreds of billions of dollars of financial contracts from descending into chaos when the London interbank offered rate starts phasing out at the end of the year.
The measure, passed by the state Senate and Assembly last month, would allow existing contracts to use replacement indexes recommended by regulators.
The New York law establishes that the recommended benchmark replacement is a “commercially reasonable substitute for and a commercially substantial equivalent to Libor” and that using the recommended benchmark replacement “provides a safe harbor from litigation.”
While most Libor indexes will be retired at year-end, various tenors of the dollar-denominated benchmark may be given a reprieve from the phase-out until mid-2023, in part to allow older contracts that lack a clear replacement rate to expire naturally. While that would help reduce the threat to financial stability, the most challenging floating-rate debt and securitizations — as well as Libor-based mortgages and student loans — will be in place after the benchmark is no longer used.
Almost $2 trillion of debt pegged to dollar Libor won’t mature until after the discredited rate expires in mid-2023, according to the Alternative Reference Rates Committee, the Federal Reserve-backed group guiding the transition.
Federal legislation may still be needed. Fed Chair Jerome Powell said last month that national legislation is necessary to ensure a smooth transition.
Libor-Replacement Competitor Gains Strength From New Offerings
Ameribor poses a challenge to the Secured Overnight Financing Rate, preferred by many Wall Street banks and regulators.
Financial industry pioneer Richard Sandor is ramping up his efforts to compete in the race to replace the London interbank offered rate, which helps set borrowing costs on everything from mortgages to business loans.
Mr. Sandor—who helped create interest-rate futures in the 1970s and launched his own replacement for the scandal-marred short-term interest-rate benchmark in 2019—is expanding offerings to include one-month and three-month borrowing rates.
Ameribor is set on the American Financial Exchange, which was founded by Mr. Sandor and is where banks lend to each other through mutual lines of credit. Some small and medium-size lenders favor Ameribor because it changes with their funding costs.
The benchmark poses a challenge to the Secured Overnight Financing Rate, the Libor alternative preferred by many Wall Street banks and regulators and which currently only offers an overnight rate. Major U.S. corporations and regional banks have been clamoring for longer-term rates before they choose a new benchmark.
Linked over decades to trillions of dollars of financial products such as mortgages and corporate loans, Libor is slated for replacement by the end of 2021. Finding a substitute poses a major challenge for the financial industry.
Banks and companies want a reference rate that reflects the risks from short-term lending, supported by a market that behaves in a predictable manner, to ensure that loans are affordable for borrowers and profitable for lenders.
The Alternative Reference Rates Committee, a group of large banks and investment firms convened by the Federal Reserve to find a substitute, selected SOFR in 2017. But corporations and banks have been slow to switch.
Push To Replace Libor Intensifies (March 26) Companies Still Working on Libor Changeover (March 12)
Loans tied to Libor have grown over the past year instead of dwindling, sparking warnings from regulators. Around $223 trillion worth of contracts now reference Libor, compared with $199 trillion at the end of 2016, according to a report from ARRC.
Chief financial officers and lenders said they need one- and three-month options, like those offered by Libor, to mirror existing contracts and avoid complex calculations. Mr. Sandor said his new Ameribor Term-30 rate fits within existing bank models, giving it an edge over SOFR.
The new Ameribor rate is based on short-term funding data collected by the Depository Trust and Clearing Corporation, which processes trades for Wall Street. That data includes commercial paper—a market that reflects the costs for companies to access money for periods ranging from 30 to 270 days.
“Ameribor Term-30 is designed to be a ‘plug-in and play’ replacement for one-month Libor, fostering an easy transition for operations and accounting departments,” said Mr. Sandor.
Meanwhile, the committee of banks and regulators behind SOFR said in March that it wouldn’t recommend longer-term SOFR rates for now because the derivatives market hasn’t grown enough to support a robust forward-looking benchmark.
SOFR is based on the cost of transactions in the market for overnight repurchase agreements, or repos, where large banks and hedge funds borrow or lend to one another using U.S. Treasurys as collateral.
Analysts and officials said SOFR proved resilient during the pandemic-fueled market swings last year, when swings in the bond market forced Fed intervention. But some worry that without a large secondary market for futures and swaps, the new benchmark could be prone to the same manipulation that upended Libor.
J. Christopher Giancarlo, former chairman of the Commodity Futures Trading Commission, said in a webinar hosted by Mr. Sandor that he was surprised regulators were pushing a single benchmark, especially one reflecting Wall Street’s borrowing costs instead of Main Street’s.
“The lack of choice is somewhat striking—I find it odd there is official sanction to move to one benchmark, especially for a market as diverse and complex as the U.S. banking industry,” said Mr. Giancarlo. “The problem with Libor is that we had one rate. Don’t we hazard the same risk?”
Pressure to make the switch is mounting. The Fed recently warned banks that they could face regulatory consequences if plans aren’t in place to move away from the benchmark before it expires for some shorter-dated dollar rates on Dec. 31.
Smaller banks said they favor Ameribor because it reflects the cost of funds trading in financial markets for banks that aren’t among the Fed’s exclusive trading partners—also known as primary dealers. These smaller banks typically don’t have access to repo markets.
“SOFR is defined for large institutions, but it’s not a great option for a commercial loan in my opinion,” said Reed Whitman, treasurer at Brookline Bancorp Inc., a bank serving the Boston metro-area. “We want to make sure when we offer customers loans there is no mismatch for us.”
Libor Contracts Caught In Limbo Spur Calls For Congressional Fix
President Joe Biden’s administration and the Federal Reserve are pushing for U.S. lawmakers to ease Wall Street’s transition away from the London interbank offered rate and help head off legal headaches for many contracts that risk being left in limbo under present plans.
In testimony set to be delivered at a House Financial Services subcommittee meeting Thursday, officials from both the Treasury Department and the Fed will voice support for federal legislation that would allow for an orderly way to shift existing financial products from the discredited set of reference rates, which currently underpins trillions of dollars in securities, derivatives and other contracts.
While banks and regulators have been busying themselves with arrangements for many major markets and products — and a newly passed law in New York state provides a further backstop for some agreements — a vast swath of contracts is still potentially vulnerable. That’s where Congress comes in.
“Federal legislation would establish a clear and uniform framework, on a nationwide basis, for replacing Libor in legacy contracts that do not provide for an appropriate fallback rate,” Mark Van Der Weide, general counsel for the Fed’s Board of Governors, said in written testimony released ahead of the hearing.
The phase-out of the widely used benchmark by mid-2023 has vast implications for financial markets, given that it is enshrined in contracts for everything from Wall Street derivatives to consumer credit cards.
Both Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen have previously called for U.S. legislation to prevent the contracts from being cast into legal uncertainty or subject to waves of potentially costly litigation once the index disappears.
“What the markets need is a clear instruction manual,” the Bank Policy Institute’s Tara Payne and Brett Waxman wrote in a blog post on Monday ahead of the hearing.
The U.S. dollar Libor indexes were tied to about $223 trillion of contracts at the end of 2020, according to documents released ahead of the hearing. Those indexes were initially set to be phased out at the end of this year, but the ICE Benchmark Administration plans to keep publishing most of them to give more time for banks to transition.
Yet that delay over the next two years won’t resolve the legal status for contracts that can’t easily be shifted to an alternative index and will still remain in force. While New York enacted a law that would allow such contracts to shift to new rates recommended by regulators, analysts said national legislation is still needed for products including credit cards, mortgages and small business loans covered by various state laws.
“New York legislation doesn’t provide a universal solution,” said John Libra, an attorney at securities litigation firm Korein Tillery. “There are still a large amount of deals outstanding that have different law provisions.”
The Treasury, meanwhile, says that federal legislation could ensure that it has sufficient authority to address the tax consequences of the Libor transition and also to amend a provision related to federal student loans, according to testimony from Brian Smith, deputy assistant secretary for federal finance at the department.
Some in the financial industry are seeking relief from the Trust Indenture Act, a New Deal-era investor protection law. The statute requires unanimous consent for any changes, which could cover the interest rate on securities agreements.
Should Congress fail to pass legislation it will only inject more uncertainty into an already complicated transition that some have likened to Y2K, the turn-of-the-century computer glitch that presented significant operational challenges to Wall Street even if it ultimately proved benign.
The absence of a new federal law may also increase the amount of litigation as market participants turn to the courts to determine fallback rates.
“Potential safe harbor provisions will likely reduce the amount of litigation going forward,” Libra said. “It would give trustees and stakeholders comfort.”
The Race For Libor’s Replacement Is Too Close To Call
The interest-rate benchmark’s heir apparent, SOFR, has weaknesses that others are trying to exploit.
By now, Wall Street is well aware that its days of using the London Interbank Offered Rate are numbered. What’s increasingly unclear, however, is what will rise from its ashes.
In the U.S., Libor’s heir apparent was supposed to be the Secured Overnight Financing Rate, or SOFR. It began picking up momentum years ago but hasn’t come anywhere close to Libor’s ubiquity as banks and other market players drag their feet on transitioning away from the rate they’ve used for almost half a century.
In 2019, the U.S. Treasury began exploring the idea of issuing SOFR-linked debt, which would be a huge step toward cementing its legitimacy as a future borrowing benchmark, yet it never moved forward; Wall Street now thinks such an offering won’t happen anytime soon. Still, strategists generally expect that it will morph into a liquid derivatives and cash-market benchmark by the time dollar Libor is supposed to be retired in mid-2023.
Yet that hasn’t stopped banks from generating buzz about upstart challengers that are looking to seize upon SOFR’s weaknesses in a post-Libor world. The chatter suggests a real possibility that the future of short-term benchmarks won’t be as simple as substituting in a single new reference rate. At the very least, three distinct rates look poised to give SOFR a run for its money.
For starters, there’s the Bloomberg Short Term Bank Yield Index, known as BSBY, which launched in January and is based on actual transactions and executable quotes. (It’s administered by Bloomberg Index Services Limited, a subsidiary of Bloomberg LP, the parent of Bloomberg News.) The press release said it’s meant “to meet market demand for a credit sensitive index to serve as a supplement to SOFR,” though it’s also available as a standalone rate.
Last month, Bank of America Corp. issued the first BSBY-linked floating-rate note, something the bank’s rates strategists suggested would help it gain further acceptance among borrowers given it already has “strong investor demand.” On Friday, Bank of America and JPMorgan Chase & Co. struck the first swaps trade tied to BSBY, with the other side linked to SOFR.
That breakthrough is old hat for another Libor challenger, known as Ameribor. The American Financial Exchange in December completed its first interest-rate swap linked to the alternative benchmark, which is calculated from actual borrowing costs between mostly small and midsize banks. Barclays Plc strategist Joseph Abate wrote in an April 28 report that “Ameribor and Libor are very similar,” which bolsters its pitch as an easy “plug and play” alternative. However, BSBY has similar attributes and “Ameribor seems to be somewhat noisier,” he wrote.
As if that weren’t enough, Libor’s administrator, the ICE Benchmark Administration, introduced its own Bank Yield Index as a potential replacement. Like BSBY and Ameribor, it incorporates banks’ credit risk while SOFR doesn’t. That’s obvious when looking at the prevailing rates: Overnight SOFR is just 0.01% and has been pinned there since March 11, while BSBY is 0.058% and Ameribor is 0.1%. Overnight dollar Libor is currently 0.07125%.
So to recap, there’s BSBY, which recently won compliance with the International Organization of Securities Commissions’ Principles for Financial Benchmarks. There’s Ameribor, which is also IOSCO-compliant and last week gained support from PNC Bank, which called it a “truly national benchmark.” And then there’s ICE’s own alternative to Libor.
Meanwhile, regulators prefer SOFR because it’s underpinned by some $1 trillion of daily trading, insulating it from the type of corruption that tarnished Libor. The Alternative Reference Rates Committee, a group of banks, asset managers and insurers brought together by the Federal Reserve in 2014 to oversee the Libor transition, has designated it the preferred alternative.
Yet SOFR has two glaring weaknesses. First, as previously mentioned, it doesn’t capture credit risk, leaving it something closer to a risk-free rate rather than truly capturing unsecured cost of funds for banks and moving higher during times of market stress. SOFR also lacks a forward-looking term rate, which some borrowers use to manage their liquidity. The ARRC said in March that it still can’t guarantee a forward-looking SOFR term rate by the end of the year.
Simply put, one of the most important shifts ever undertaken in the global financial markets remains about as much of a toss-up as ever. It says a lot that Scott O’Malia, chief executive officer of the International Swaps and Derivatives Association, claims to be “agnostic” about which dollar Libor alternative is ultimately adopted, given that more than $200 trillion of over-the-counter and exchange-traded derivatives are tied to the benchmark.
Even strategists who closely follow the twists and turns of the funding markets end up with just as many questions as answers.
“As supervisory pressure on banks intensifies, which rate will they adopt: BSBY, Ameribor or SOFR, or could they use all of them but for different purposes?” pondered Abate at Barclays.
“It is becoming likely that multiple rates will have a significant role in the post-Libor world,” Dan Krieter and Daniel Belton at BMO Capital Markets wrote last month, adding that there’s a “very real chance” that BSBY overtakes SOFR as the primary replacement for Libor. Bank of America sees investors likely choosing to “gravitate toward a forward-looking, credit sensitive” rate instead of SOFR, given its limitations.
Maybe this is all fine, with SOFR’s advantages giving it a leg up for use in floating-rate notes and derivatives, while business loans are priced using one of the credit-sensitive benchmarks. Just because Libor was all-encompassing doesn’t mean that’s the only way of doing things — the Bank for International Settlements acknowledged years ago that a one-size-fits-all alternative may be neither feasible nor desirable.
This sort of competition emerging after a years-long effort to phase out Libor could either be seen as a last-ditch effort to get a share of the new world or an indication that weening Wall Street off of its longtime benchmark will be as difficult as ever, with no successor emerging as a clear favorite. Either way, the clock is ticking and the race is too close to call.
Libor Replacement Race Heats Up
Some analysts say multiple rate benchmarks are likely to emerge instead of just one.
New contenders are emerging in the race to get rid of the London interbank offered rate by year-end.
Bank of America Corp. and JPMorgan Chase & Co. traded the first complex derivative using a Bloomberg index crafted to replace Libor, exchanging $250 million worth of an interest-rate swap earlier this month. The Bloomberg Short Term Bank Yield Index competes with the alternative preferred by regulators including the Federal Reserve Bank of New York.
The transaction between the two large Wall Street firms marks a shift in the yearslong plan to move away from the troubled rate underpinning trillions of dollars in financial contracts, with some analysts now saying multiple benchmarks are likely to replace Libor instead of just one. Libor underpins trillions of dollars worth of financial contracts and is scheduled for replacement at the end of 2021 in the wake of a manipulation scandal.
The Alternative Reference Rates Committee, consisting of major banks, insurers and asset managers working alongside the New York Fed, have been rallying investors and companies to move to the Secured Overnight Financing Rate, or SOFR.
While large banks and mortgage lenders like Fannie Mae have started actively using the benchmark, some large U.S. corporations and other borrowers held off, seeking a benchmark that could fix rates over longer time spans.
Bankers said clients are using the Bloomberg index because the ARCC has been slow to roll out those forward-looking reference rates. The committee initially planned to recommend such a rate by the beginning of 2021. After it held off, citing a lack of sufficient transactions and data, some treasurers and traders took matters into their own hands.
Thomas Pluta, global head of linear rates trading at JPMorgan, said the delay breathed life into competing rates, and his trading desk has seen high demand for the Bloomberg rate from clients.
“The Bloomberg Short Term Bank Yield Index is very similar to Libor, so people comprehend what it is,” said Mr. Pluta. “It has emerged as the most likely front-runner among the credit-sensitive rates being developed.”
Mr. Pluta said he expects SOFR will emerge as the primary rate used in financial markets, but that some borrowers will choose alternatives more suited to their needs. Some regional banks are already using Ameribor, a rate created by futures guru Richard Sandor, because it changes with their funding costs. Set on the American Financial Exchange, the rate reflects what banks pay to lend to each other through mutual lines of credit.
SOFR is an overnight rate dubbed nearly risk-free, which means it doesn’t reflect increased costs of funding during a crisis. Sonali Theisen, head of fixed-income e-trading and market structure at Bank of America, said that makes switching complex for borrowers who need a rate sensitive to market conditions, such as corporate treasurers, who like to fix payments in advance.
“Providing the market more than one option, particularly to support loan transition, seems prudent,” said Ms. Theisen. “We are looking to provide our clients choice.”
The ARRC is making an effort to speed up its support for forward-looking rates, also known as term rates, in the financial industry. It recently published a list of standards to back longer dated SOFR rates in a bid to increase its adoption. Tom Wipf, a Morgan Stanley banker who also leads ARRC, said the committee was taking its time to make sure the rates would be based on sufficient transactions.
“Recent developments underscore there is very strong demand for a term rate,” said Mr. Wipf. “It’s clear that this last piece of puzzle is important to the market.
Why Ditching Libor Is Vexing the Financial World
For half a century, the London interbank offered rate, or Libor, has helped determine the cost of borrowing around the world. Now seen as outdated and discredited, the benchmark is being killed off from the end of 2021.
That’s sent the financial world scrambling to adjust contracts on hundreds of trillions of dollars’ worth of products, from mortgages and credit cards to interest-rate swaps — and to figure out life after Libor.
1. What Is Libor And Why Is It Disappearing?
Libor is a essentially daily average of what banks say they would charge to lend to one another. The British Bankers’ Association formalized the gauge in 1986 when it needed a way to price interest-rate swaps and syndicated loans. But as markets evolved, the trading that helped inform banks’ estimates dried up.
Evidence emerged in 2008 that European and U.S. lenders had manipulated rates to benefit their own portfolios, tainting the benchmark and resulting in a dozen banks paying billions of dollars in penalties. In 2017, the Bank of England declared that Libor would be phased out by the end of 2021.
2. Who Uses Libor?
The list is long and includes pension and fund managers, insurance providers, big and small lenders and Wall Street banks that package loans into securities. Some $370 trillion of financial products are tied to the benchmark, including equipment leases, commercial paper, sovereign bonds, student and auto loans and bank deposits. The biggest component is derivatives such as interest-rate swaps, which companies, banks and investors use to hedge risk or to speculate.
3. What’s The Worry About Killing Off Libor?
As well as the need to find suitable replacements, the main concern has centered on the millions of Libor-priced contracts that run beyond 2021, known as legacy contracts. Updating legacy contracts to cover what happens next can prove a slow and complicated process, raising the risk of a chaotic transition that has been likened by some to Y2K and the fear of computer systems misfiring at the end of the last millennium.
Rather than planes potentially falling from the sky, the worry is that a mass of litigation will ensue as lenders and borrowers fail to agree on what rate to pay following Libor’s demise.
4. So We’re Heading For Trouble?
Several developments have eased those concerns. The derivatives market established a protocol to include so-called fallback language in contracts that will automatically transition them from Libor. New York state approved a law providing a further backstop for contracts hatched on Wall Street. The Biden administration and the Federal Reserve are pushing for legislation to mop up the rest.
Vitally, regulators extended until the end of June 2023 the deadline for dealing with legacy contracts priced in most U.S. dollar Libor rates. (Used for more than $200 trillion of products, dollar Libor is the most widespread of five Libor currency rates.) That means most dollar Libor contracts will expire naturally, without needing to shift to a new benchmark. Regulators reiterated that no new dollar Libor contracts can be issued after 2021.
5. How Are Libor’s Replacements Shaping Up?
Central banks have been working to develop benchmarks that are a truer reflection of the cost of capital and based on actual transactions (the five main replacements are listed below), but in one respect several fall short. Libor offers rates for different time frames, from overnight to one year. Some of the new benchmarks, such as the Secured Overnight Financing Rate in the U.S., or SOFR, mostly reflect overnight rates because they do not yet have the depth of transactions to establish a forward-looking curve.
6. Why’s That A Problem?
Borrowers over longer time frames will no longer know in advance how much interest they will pay, since overnight rates fluctuate. Unlike Libor, the new rates also fail to capture the credit risk that banks assume when they lend to each other. (Libor jumped during the 2008 financial crisis as central banks cut rates.)
These shortcomings have had an unintended consequence in the U.S.: Alternative rates are gaining popularity. The likes of Ameribor, published by the American Financial Exchange, have the potential to disrupt the transition to SOFR by attracting the very liquidity that’s needed to establish the official replacement for Libor over longer periods.
7. How Will The New Rates Affect Consumers And Banks?
There’ll be scrutiny over whether regular borrowers will be forced to pay higher interest rates after the switch from Libor. Analysts say banks and asset managers face a greatly increased risk of fines, litigation and reputational damage if they poorly manage the transition, with regulators likely to be watching closely whether they are treating customers fairly. Most major global banks will spend more than $100 million in 2021 preparing for the end of Libor.
U.S. Financial Regulators Push Banks To Transition Away From Libor
Yellen, Quarles make the case for new benchmark at meeting of top regulators.
Top U.S. financial officials on Friday pressed banks to stop using the London interbank offered rate on new transactions by the end of 2021, warning that firms aren’t moving swiftly enough to replace the benchmark for hundreds of trillions of dollars in financial contracts.
Treasury Secretary Janet Yellen and other top officials pressed the issue at a meeting of the Financial Stability Oversight Council, a group that monitors the stability of the financial system.
“We are at a key inflection point,” Randal Quarles, the Fed’s point person on financial regulation, said at the meeting. “The deniers and the laggards are engaging in magical thinking. Libor is over.”
The exhortations amount to the strongest and clearest guidance yet from top policy makers about the risks to banks for writing new contracts based on Libor. The benchmark is scheduled for replacement at the end of 2021 in the wake of a manipulation scandal.
Rather than dwindling as regulators have urged, loans tied to Libor grew to around $223 trillion early this year compared with $199 trillion at the end of 2016, according to a March report from the Alternative Reference Rates Committee, a financial industry group made up of major banks, insurers and asset managers alongside the Federal Reserve Bank of New York.
The increase is one sign lenders have yet to fully embrace the Fed’s preferred replacement: the Secured Overnight Financing Rate, or SOFR. While large banks and mortgage lenders like Fannie Mae have started actively using the benchmark, some large U.S. corporations and other borrowers held off, seeking a benchmark that could fix rates over longer time spans.
Ms. Yellen urged bankers and other market participants to avoid alternative rates that, she said, aren’t robust enough to become a benchmark for a multitude of other products and transactions.
“The most critical step in the transition is the move toward truly robust alternative rates like SOFR,” said Ms. Yellen, who chairs the risk panel. “A failure to adopt robust, alternative rates would leave us continuing to face the same risks and challenges we face today.”
Securities and Exchange Commission Chairman Gary Gensler criticized one such alternative, the Bloomberg Short-Term Bank Yield Index. The index’s value is based primarily on trading in commercial paper and certificates of deposit issued by 34 banks, he said.
The index has some of the same shortcomings as Libor, Mr. Gensler said. There isn’t enough trading behind it to support a reliable index rate to be used to price other assets, whose value would far exceed the trading underpinning the bank yield index, he said.
“When a benchmark is mismatched like that, there’s a heck of an economic incentive to manipulate it,” Mr. Gensler said. “It presents similar risks to financial stability and market resiliency” as Libor.
A representative for Bloomberg LP didn’t immediately respond to a request for comment.
Deeply rooted in markets, Libor was marred by a 2012 scandal that led to convictions for some traders and penalties for numerous banks.
If the transition doesn’t go as planned, consumers could end up on the hook for increased payments on credit-card loans and other borrowings, while small businesses could face higher fixed rates for loans.
Why Ditching Libor Is Vexing The Financial World
For half a century the series of interest rates known collectively as the London interbank offered rate, or Libor, has helped determine the cost of all sorts of borrowing around the world. Now seen as outdated and discredited, the benchmark is being killed off from the end of this year. That’s sent the financial world scrambling to adjust the terms in contracts on hundreds of trillions of dollars’ worth of products — from mortgages and credit cards to interest-rate swaps. Life after Libor could be messy, and major global banks will spend more than $100 million in 2021 in preparation for its demise.
1. What Is Libor?
Libor is a daily average of what banks say they would charge to lend to one another. It’s offered in five currencies and over various time periods, up to one year. Formalized by the British Bankers’ Association in 1986 to help set prices for derivatives and syndicated loans, Libor is used by pension and fund managers, insurance providers, big and small lenders and Wall Street banks that package loans into securities.Some $370 trillion worth of financial products are tied to the benchmark, including equipment leases, student and auto loans and bank deposits.The biggest component is derivatives such as interest-rate swaps — trades of a fixed interest rate for a floating one or vice versa — which are used by companies, banks and investors to hedge risk or speculate. Of the five Libor currency rates, the one tied to the U.S. dollar (“dollar Libor”) is most widespread, accounting for more $200 trillion worth of products.
2. Why Is It Disappearing?
As markets evolved, the trading that helped inform banks’ estimates dried up. Evidence emerged in 2008 that European and U.S. lenders had manipulated rates to benefit their own portfolios, tainting the benchmark and resulting in a dozen banks paying billions of dollars in fines. In 2017, the Bank of England decided that Libor would be phased out by the end of 2021.
3. Why Is Killing Libor Such A Challenge?
The finance industry needs to find suitable replacements. Beyond that, there’s the fate of millions of Libor-priced contracts that run past 2021, known as legacy contracts. Updating legacy contracts can prove a complicated process, raising the risk of a chaotic transition that has been likened by some to Y2K and the fear of computer systems misfiring at the end of the last millennium. Rather than planes potentially falling from the sky, the worry is that a mass of litigation will ensue as lenders and borrowers fail to agree on what rate to pay following Libor’s exit.
4. Does That Mean Trouble Is Coming?
Several developments have eased the concern. Regulators in the derivatives market established a protocol to include so-called fallback language in contracts that will automatically transition them from Libor. In the U.S., New York state approved a law that provides a further backstop for contracts hatched on Wall Street. President Joe Biden’s administration and the U.S. Federal Reserve are pushing for legislation to mop up anything else. Vitally, regulators extended the deadline until the end of June 2023 for dealing with legacy contracts priced in most dollar Libor rates.Most of those contracts will have expired by then. Regulators reiterated that no new dollar Libor contracts can be issued after 2021.
5. How Are Libor’s Replacements Shaping Up?
Central banks have been working to develop benchmarks that are a truer reflection of the cost of capital and based on actual transactions. One common problem is that some of the new benchmarks, such as the Secured Overnight Financing Rate in the U.S., mostly reflect overnight borrowing rates, since there isn’t yet a sufficient volume of transactions to establish a so-called forward-looking curve. Borrowers dislike that because they’re less able to predict payments, and loans won’t reflect expectations of rate changes — key attractions of Libor. Also unlike Libor, the new rates fail to capture the credit risk that banks assume when they lend to each other.During the 2008 financial crisis, Libor jumped even as central banks cut interest rates because of the heightened risk that lenders would go bust.
6. What Do These Shortcomings Mean?
In the U.S., alternative benchmarks that offer longer-term rates and incorporate credit risk are gaining popularity with borrowers and banks. The likes of Ameribor, published by the American Financial Exchange, have the potential to disrupt the transition to SOFR by splintering the trading that’s needed to establish the official replacement for Libor.
7. Will Regular Consumers Be Affected?
There’ll be scrutiny over whether regular borrowers will be forced to pay higher interest rates after the switch from Libor.
Analysts say banks and asset managers face a greatly increased risk of fines, litigation and reputational damage if they poorly manage the transition, with regulators likely to be watching closely whether they are treating customers fairly.
‘Nonchalant’ CLO Market Faces Hedging Risks In Libor Transition
The booming collateralized loan obligation market faces a chaotic end to 2021, when the benchmark London interbank offered rate is retired for new loan contracts.
At issue is how to hedge the risk to investors in CLOs, which are based on Libor, when their collateral pools are made up of leveraged loans based on a completely different benchmark. New loans may switch to an alternative such as the recommended Secured Overnight Financing Rate, which measures the cost of borrowing using Treasury securities as collateral.
Some investors are worried that this mismatch will add a new layer of so-called basis risk — the possibility of losses or gains due to imperfect hedging — to an already complex product. Prices in the $820 billion U.S. CLO market could become more volatile, and there’s a chance of reduced returns to CLO equity holders, who hold the riskiest slice of the deal and are the last to be paid, but can earn the highest potential payments.
“The CLO market has so far been incredibly nonchalant about the upcoming benchmark transition,” Laila Kollmorgen, a CLO portfolio manager at PineBridge Investments, said in an interview. “We’re not seeing any attention being paid to it at all, even by the investors who may be most impacted – the equity investors. Either they’re so sophisticated that they’re already aware, or perhaps they know and they dismissed it — or perhaps some investors don’t know and don’t know to ask.”
CLOs already suffer from some basis risk with leveraged loans — most leveraged loans are pegged to one-month Libor, while CLOs are priced off three-month Libor — and the transition away from Libor exacerbates it.
Libor is being eliminated out of concern it can be manipulated, and as underlying trading informing the rate has dried up.
Regulators told U.S. banks to end Libor origination “as soon as practicable” and no later than December 31 of this year. The rate will be retired for good from all transactions by June 2023 at the latest.
While some CLOs have so-called fallback language in their documentation governing the cessation of Libor, some still don’t.
Investors say they expect a period of confusion over basis risk in early 2022 that could last several months.
“We have been internally trying to identify transactions in which we have risk,” PineBridge’s Kollmorgen said. “While we don’t expect this to cause a huge disruption in the CLO market, it’s really more about being informed, which is important.”
The expected turbulence will cap what is projected to be a record-setting year of sales of CLOs, with Bank of America Corp. forecasting $360 billion of U.S. CLO issuance. That includes $140 billion for new issuance and $220 billion for refinancings and resets of older deals.
JPMorgan Chase & Co. published a research paper on Thursday that said the global CLO market has now reached $1 trillion as “investors are looking for supply and spread in highly-rated instruments.”
The phase-out of Libor on new leveraged loans will pressure spreads on CLO AAA tranches in the fourth quarter, said Maggie Wang, a CLO analyst at Citigroup. Moreover, the basis risk can lead to 30 basis points of fluctuation in quarterly CLO equity cash flows, which may resolve over time but still pose interim risk.
“The ultimate impact on CLO spreads will largely depend on how quickly the loan market transitions and how CLO investors and transactions position themselves,” Wang said.
In a bit of good news for investors, this year’s record CLO refinancing wave has allowed managers to amend documents on many existing deals to include the latest fallback language by the Alternative Reference Rates Committee, a group put together by the Federal Reserve and the New York Fed to help with the transition.
Still, if a CLO’s documents are unclear on the matter, managers may have to get consent from debtholders, who hold the controlling class of the transaction. Switching the benchmark can become more complicated in this instance, since controlling classholders will do what benefits them most, and may be different from what the CLO manager wants, according to Deutsche Bank analysts.
The general governing rule in documentation is that if 50% or more of a CLO’s collateral is based off a particular benchmark, then a CLO manager can move the CLO bonds to that new benchmark as well.
“New CLOs coming to market at the end of 2021 and in 2022 will be some mixture between Libor and SOFR,” PineBridge’s Kollmorgen said. “We’ll just have to see exactly how mixed they are. It all depends on how volatile that basis risk is going to be.”
Banks Weigh Alternatives To Libor Replacement As Companies Seek Longer-Term Rates
Lenders are looking beyond SOFR to meet corporate borrowers’ needs.
Some big banks are evaluating if the reference rate that is backed by regulators as the best replacement for the scandal-plagued London interbank offered rate is the only option for companies, or if they should offer other rates.
Many large U.S. financial institutions are providing the Secured Overnight Financing Rate, or SOFR, to corporate borrowers as part of the transition away from Libor.
But SOFR may not cover all companies’ needs, banks and corporate advisers say, because the benchmark lacks rates that are weeks or months in the future, making it hard for companies to plan around future interest-rate risk.
Lenders are considering making index rates such as the American Interbank Offered Rate (Ameribor) or the Bloomberg Short Term Bank Yield Index (BSBY) available as alternatives. Still more research needs to be done to determine how these alternative rates would fare in an economic downturn and if there is enough transaction volume to generate a reliable reference metric, banks say. While regulators are urging banks to offer SOFR for capital markets and derivative transactions, the Federal Reserve says it is open to other rate options for loans and other financial instruments.
These alternate rates to SOFR are credit-sensitive, meaning they provide a more accurate reflection of lenders’ funding costs. For instance, clothing company Duluth Holdings Inc. in May received a corporate syndicated loan tied to BSBY, citing lower borrowing costs, said CFO David Loretta on a June earnings call. Duluth has a relatively healthy financial risk profile, said CreditRiskMonitor, a provider of commercial credit reports. The company didn’t respond to a request for comment. Other corporate borrowers are pursuing rival rates as the year-end Libor expiration date draws closer.
This search for a benchmark rate for corporate borrowings began after authorities decided to phase out Libor by the end of 2021. A widespread manipulation scandal led to penalties for banks and convictions for some traders. Until then, Libor helped set borrowing costs on everything from business loans to mortgages globally, and is the reference rate for trillions of dollars in financial contracts.
Banks can’t issue new financial contracts using Libor after Dec. 31, but may continue to reference it for many existing debts through June 2023.
SOFR, which rose to become the benchmark rate favored by regulators and the Fed, is a backward-looking metric that is based on the cost of transactions in the market for overnight repurchase agreements. Many banks and regulators prefer this as a Libor alternative, saying it is robust enough to support a large volume of transactions and financial products.
Last month, a group of major banks, insurers and asset managers endorsed “Term SOFR,” a series of forward-looking SOFR benchmarks issued by derivatives-exchange operator CME Group Inc. to promote broader market adoption. SOFR is based on a roughly trillion-dollar market; Ameribor and BSBY for example underpin tens of billions of dollars.
Still, some smaller regional banks use Ameribor, a rate created by Richard Sandor, chairman and chief executive of the electronic marketplace American Financial Exchange LLC. They say the rate can change with their funding costs, reflecting what banks spend to lend to each other through mutual lines of credit. BSBY, owned by financial-data and media company Bloomberg LP, has also gained interest after Bank of America Corp. and JPMorgan Chase & Co. in May traded the first complex derivative using the index.
Truist Financial Corp. , a Charlotte, N.C.-based bank holding company, and PNC Financial Services Group Inc. offer SOFR and BSBY but not Ameribor. Truist’s Chief Financial Officer Daryl Bible said the bank offers BSBY in part because its similarity to Libor makes it a more familiar option for customers, but is watching to see how many companies adopt it.
The rates for a three-month loan were 0.049%, 0.104% and 0.097% for Term SOFR, Ameribor and BSBY, respectively, as of Thursday. The rates reflect different underlying market conditions, given Ameribor and BSBY have a credit component while SOFR doesn’t.
It is hard to determine whether one rate is more beneficial than the other as the appropriate credit spreads for each corporate borrower would also be a factor, said Amanda Breslin, managing director of treasury advisory at financial-risk adviser Chatham Financial Corp.
Large banks haven’t written off credit-sensitive rates, and say they are monitoring market trends and performance of these index rates during market ups and downs.
Wells Fargo & Co. is researching the use of both Ameribor and BSBY in the commercial-loan market, said Treasurer Neal Blinde.
Goldman Sachs Group Inc. is also considering whether to offer the credit-sensitive rates based on client demand and the strength of the indexes, said Treasurer Beth Hammack.
Banks also will have to show regulators that they are moving quickly to adopt a new benchmark.
“Our real financial stability concern is to ensure that every contract has language making clear what happens when its chosen reference rate is unavailable, because any reference rate can die,” said Randal Quarles, chair of global standard-setter Financial Stability Board and vice chairman for supervision at the Fed.
Already, Securities and Exchange Commission Chairman Gary Gensler has said BSBY presents similar risks to financial stability and market resiliency as Libor. Both benchmarks are based on unsecured, term, bank-to-bank lending and are a modest market shouldering the weight of a substantial amount of transactions, he said during a speech to the Financial Stability Oversight Council in June.
“When a benchmark is mismatched like that, there’s a heck of an economic incentive to manipulate it,” Mr. Gensler said at the time. The SEC didn’t respond to a request for comment.
The timeline for when most major banks will decide about alternative rate offerings is unclear. “The focus of our company has really been all of the product launches and preparedness around SOFR,” Wells Fargo’s Mr. Blinde said. “It’s too early to say if we’ll be active in any of the other markets, but we’re certainly evaluating them.”
Fed Tells Judge Scrapping Libor Too Soon Would Spur Market Chaos
The Federal Reserve told a judge not to scrap Libor as requested by consumers in a lawsuit because it would pose a risk to financial stability and undermine years of global planning for a transition to a new benchmark for borrowing rates.
A staged transition away from the London interbank offered rate is underway globally, but immediately ending the London interbank offered rate by court order would likely harm consumers and businesses, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York said in a filing Friday in federal court in San Francisco.
But ending the benchmark now would likely disrupt the trading of financial contracts, upend consumer contracts like mortgages and student loans and create “an avalanche of litigation,” the Fed said in its filing. The central bank said about $223 trillion of financial products are tied to the U.S. dollar Libor rate.
“Without an orderly transition away from Libor, there would undoubtedly be confusion and uncertainty in all markets that currently rely on Libor on a day-to-day basis,” the Fed said in the filing.
Libor is derived from a daily survey of bankers who estimate how much they would charge each other to borrow. In the wake of the 2008 financial crisis, regulators discovered that lenders had been manipulating the rates to their advantage, resulting in billions of dollars of fines.
Regulators and market participants around the world are currently in the process of shifting to new benchmarks to replaced the scandal-plagued suite of Libor rates. In the U.S., new contracts tied to dollar Libor are supposed to end this year and the final settings should be phased out by mid-2023, according to current timetables.
The threat of an abrupt end to Libor has also drawn vigorous defenses from some of the world’s biggest banks.
The Fed’s filing echoed claims made in November by defendants including JPMorgan Chase & Co., Credit Suisse Group AG and Deutsche Bank AG, who argued an injunction abruptly ending Libor would wreak havoc on financial markets.
In June, the judge overseeing the case refused to move the suit from San Francisco to New York, rejecting an argument by big banks that the case belongs in Manhattan due to the decades of litigation there over the benchmark and court decisions it has produced.
Libor Should Die With A Whimper, Not A Bang
Sterling markets have been the quickest to abandon the discredited interest-rate benchmarks. Regulators elsewhere should pay heed.
The deadline for the finance industry to stop using Libor is fast approaching, but markets remain wedded to the discredited and soon-to-be discontinued suite of interest rates. Regulators may need to become fiercer in overcoming the institutional apathy toward new benchmarks, or risk troublesome market dislocations.
By the end of the year, banks are supposed to cease writing new financial business that uses the London interbank offered rate as the basis for calculating borrowing costs across different currencies and maturities. But there’s a massive legacy of contracts outstanding still attached to the rates; the U.S. Federal Reserve estimates that $223 trillion of financial products are tied to dollar Libor alone.
The demise of Libor became inevitable because of two issues — one practical, one reputational. First, as the wholesale funding market between banks evaporated in the wake of the global financial crisis, it starved the system of the underlying transactions needed to judge what the cost of money should be. Mark-to-market became mark-to-made-up.
Second, lawsuit after lawsuit has found that the traders that supplied the reference rates were rigging their submissions to enhance their profits. Banks have paid more than $9 billion in fines for lying about Libor.
Regulators in different jurisdictions have recommended alternative so-called risk-free reference rates 1 , including the Sterling Overnight Interbank Average rate in the U.K. and the Secured Overnight Financing Rate in the U.S. But Libor interest rates are still deeply embedded in the fabric of finance.
In the global interest-rate derivatives market, contracts tied to Libor still account for more than 85% of all trades, according to figures compiled by the International Swaps and Derivatives Association. While the percentage based on other benchmarks has increased in recent months, progress remains slow.
Libor is by far and away the dominant reference rate. On a risk-weighted basis, the old benchmark accounted for almost $23 billion of the $26.6 billion of derivatives traded last month. On a notional basis, just 12% of July’s $127 trillion of interest-rate derivatives trading was associated with the replacement rates.
It’s not just the derivatives market that’s dragging its feet. Libor is intertwined throughout the commercial system and still sets the borrowing costs for a swathe of products, including corporate loans, that are stuck using the old benchmarks.
Chatham Financial, a Pennsylvania-based consultancy firm, recently surveyed 100 corporate treasurers overseeing annual revenue of $1 billion to $25 billion. It found that 39% were “completely unsure” if they needed to take action in preparation for the end of Libor.
Earlier this week, U.S. regulators including the Treasury, the Federal Reserve and the Securities and Exchange Commission said they’re concerned that nonfinancial companies aren’t being offered alternatives to Libor in commercial transactions.
“The transition is at a critical juncture,” they wrote in a joint letter to the Association for Financial Professionals and the National Association of Corporate Treasurers. “We have stressed the importance of reference rates built on deep, liquid markets that are not susceptible to manipulation.”
Geographically, one market is further ahead than its peers. In the U.K., non-Libor derivatives trades surpassed those tied to the old benchmark in April for the first time.
And last month, almost 60% of trading in the sterling market was in contracts tied to alternative benchmarks. That still leaves a lot of activity tied to sterling Libor with less than five months to go until it’s supposed to die. But it’s progress.
As the guardians of Libor’s home market, U.K. regulators have been leading the charge to abandon the tarnished benchmark, and those numbers suggest they’ve been more successful than their counterparts elsewhere by adopting a more threatening stance.
In March, for example, the Financial Conduct Authority and the Bank of England suggested that progress on moving to new reference rates should be “part of the performance criteria” for determining bankers’ bonuses.
Inertia has proved to be a powerful disincentive to shifting away from the existing benchmark alignments. But the risk of contracts unraveling, hedges failing or interest-rate mismatches fracturing commercial arrangements increases as Libor’s endgame gets closer. Market overseers should consider a sterner approach to ensure that Libor expires with a whimper, not a bang.
Libor Transition Stokes Sales of Risky Corporate Debt
Managers of collateralized loan obligations are rushing to close deals ahead of the transition away from the London interbank offered rate.
Wall Street’s shift away from Libor is fueling sales in the red-hot market for bundles of risky corporate loans.
Managers of collateralized loan obligations—securities made up of bundled loans with junk credit ratings—are rushing to close deals ahead of the year-end move away from the London interbank offered rate. The interest-rate benchmark underpins trillions of dollars of financial contracts but was scheduled for phaseout after a manipulation scandal.
That is helping push CLO sales to records. U.S. issuance topped $19.2 billion in August, a monthly record in data going back a decade, according to S&P Global Market Intelligence’s LCD.
That record came during what is typically a slow month for the market, a sign that managers are pushing to finish deals ahead of Libor’s expiration, analysts said. Some CLO documents lack language covering the changeover to a new interest-rate benchmark, which could spark disruptions as the new year approaches.
For CLO portfolio managers on Wall Street, bringing deals forward allows them to lock in new revenue, rather than wait and see how the Libor transition affects the market. Investors who participate in the CLO deals can earn relatively higher fixed-income yields with familiar deal documents, sometimes including language that plans ahead for December’s deadline.
Rather than wait to see how the transition shakes out, CLO managers are taking advantage of recent investor demand and closing deals if possible, said Joe Lynch, global head of noninvestment grade credit at Neuberger Berman, which manages and invests in CLOs.
“Most managers plan to issue one more CLO before year-end and will likely pursue a deal in the near-term to avoid any potential disruptions that might come from the Libor transition,” he said.
A strong U.S. economic recovery and support from the Federal Reserve has improved the prospects for many low-rated companies borrowing through the leveraged loan market, which is often used by private-equity firms to finance acquisitions.
That marks a reversal after the pandemic’s outbreak fueled worries about mass defaults and sent prices for riskier debt plummeting in 2020.
The trailing 12-month default rate for the S&P/LTSA leveraged loan index fell to 0.47% in August—the lowest level since March 2012.
That recovery has helped spur investors’ demand for CLOs, which are the largest buyer of leveraged loans. As of August, sales of new CLOs in the U.S. in 2021 have surpassed $111 billion, according to LCD—on pace to pass 2018’s record of around $129 billion.
Many expect new CLO sales to remain elevated in September as issuers try to finish deals ahead of the transition, said Bank of America analysts in an August note. They expect new CLO sales tied to Wall Street’s preferred replacement, the Secured Overnight Financing Rate, or SOFR, to begin in the fourth quarter.
A wave of CLO refinancings this year allowed some managers to include fallback language shifting to SOFR in their documents, analysts said. But for other deals, CLO managers and investors must negotiate that changeover, which could create conflicts if they have different rate preferences.
Disruptions to the transition could increase the extra yield, or spread, that investors’ demand to hold triple-A rated CLO debt during the fourth quarter of this year, depending on how quickly the loan market transitions and how new CLO deals and investors position themselves, said Citi analysts in a June note.
SOFR is based on the cost of transactions in the market for overnight repurchase agreements, where large banks and hedge funds borrow or lend to one another using U.S. Treasurys as collateral. Unlike Libor, which tends to rise during periods of market stress, it doesn’t adjust for shifts in credit.
During last year’s spring selloff, the difference between three-month Libor and SOFR rose to 1.4 percentage points at its peak, according to BofA. That means CLO debtholders received a higher rate than what they would have if their bonds were linked to SOFR.
“This is particularly important for [triple-A CLO bondholders] where the reference rate [makes] up a significant portion of the interest rate,” said the bank’s analysts in a note.
The move away from Libor also means that some CLO securities may have a different benchmark rate from the loans in their collateral pool. That makes it more difficult for investors to protect their holdings against fluctuations in interest rates and underlying loan prices.
“We anticipate that it will take the market a little time to digest [new] issuance when the shift to SOFR occurs in the new year,” said Serhan Secmen, head of CLO investments at Napier Park Global Capital.
Big Milestone In Libor Demise Has Barely Budged The Loan Market
The next major milestone in Libor’s years-long demise is only 3 1/2 months away, but the vital loan market has done very little to show it’s ready.
After Dec. 31, new financial products can’t be tied to the London interbank offered rate, a consequence of regulators wanting to extinguish Libor following a rigging scandal a decade ago.
The leading heir for U.S. dollar loans, the Secured Overnight Financing Rate, has so far gotten little traction. Ford Motor Co. is doing the first syndicated U.S. corporate loan linked to SOFR, while the acquisition of chicken processing company Sanderson Farms Inc. will be funded with a loan that initially uses Libor but will automatically shift to SOFR in 2022.
That’s largely it for prominent new deals.
The slow process may be due in part to cost differences when selling debt tied to each benchmark. Investors are especially waiting to see how the $1.2 trillion leveraged loan market makes the switch with delays preventing corporate borrowers from getting a dry run with SOFR before Libor ends. That raises the possibility of widespread confusion in the market come January.
“One of our main concerns about the transition is a worry that we’ve had for a while now: inertia in the loan market, especially the syndicated loan market,” Michael Held, an executive vice president at the New York Federal Reserve, said this week. “Lending in alternative rates is not where it should be at this point.”
It’s not all gloom and doom. Trading in SOFR derivatives rose to 12.5% of the dollar-linked market in August from 7.4% in July, according to the International Swaps and Derivatives Association. The rest was in Libor contracts.
While still relatively tiny compared with the incumbent, signs of life in SOFR derivatives at least show the ecosystem for the alternative is picking up. This could help SOFR lending take off, since lenders like to manage their risks by using a derivatives market.
“For banks to feel comfortable making SOFR loans, they also have to be confident in the SOFR derivative infrastructure,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. “The SOFR derivatives market received an enormous boost in August,” he added. “Banks are certainly busy making the transition as we speak.”
That said, at least $976 billion of loans are unprepared for a smooth exit from dollar Libor, leaving banks and borrowers to hammer out a solution for most of them before the rate fully expires in mid-2023, according to estimates from research firm Covenant Review.
As far as new loan sales go, 92% of deals in August had hardwired fall-back language, according to Covenant Review. Yet 80% or so of leveraged deals in a key $1.2 trillion index lack such language from the Alternative Reference Rates Committee designed to shift them automatically to replacement benchmarks, Ian Walker, head of legal innovation at the firm, wrote in a July note. That leaves them facing an uncertain legal future when the benchmark ends, with challenges expected as companies look to refinance their debt.
There are other reasons for slow progress, said ING strategist Padhraic Garvey. He added that official endorsement of term SOFR — or versions of the rate with tenors beyond overnight — arrived relatively late and a dominant rate to replace dollar Libor hasn’t yet emerged.
“Should the regulator come in harder? I’d suggest that should be saved until Jan. 1, 2022,” he said. “From that date there are no excuses, but for now there are many.”
U.S. Companies Pick Up Adoption of Libor Alternative SOFR
Sports-vehicle maker Polaris is among the businesses beginning to use a replacement benchmark.
Major U.S. companies are dumping the London interbank offered rate ahead of a year-end deadline for abandoning the troubled short-term interest-rate benchmark.
Sports-vehicle maker Polaris Inc. recently selected Wall Street’s preferred alternative, the Secured Overnight Financing Rate, as its new benchmark rate to provide inventory financing to vehicle dealers as part of a business it runs with Wells Fargo & Co.
Polaris Chief Financial Officer Bob Mack said the company favors SOFR over other options because it is widely accepted by regulators. The Medina, Minn.-based company in June worked with several banks to include similar language for a $300 million credit-line expansion, he said, also part of its move away from Libor.
The shift to alternatives comes ahead of a year-end deadline to end the use of Libor, which fell into disrepute after a manipulation scandal. Banks, borrowers and lenders have been drafting plans to change over prior to Dec. 31, when Libor expires for shorter-dated dollar rates.
Libor underpins trillions of dollars in financial contracts, setting rates on everything from derivatives to consumer loans and corporate debt. The troubled benchmark is linked to nearly $200 trillion worth of derivatives alone, making a smooth transition imperative to avoid legal disputes or stranding borrowers without a rate to determine payments.
While hedge funds and asset managers have been quicker to phase out Libor, U.S. companies have been slower to choose a substitute.
Some said earlier in the year they were hesitant to switch because they wanted forward-looking rates, which arrived in late July from the group of banks, insurers and asset managers behind SOFR known as the Alternative Reference Rates Committee, or ARRC.
Companies have increased their adoption since the committee that month endorsed benchmarks administered by the exchange operator CME Group Inc. that could fix rates over longer time spans, said Gregg Geffen, head of North America corporate interest rate derivative marketing at JPMorgan. Year-to-date volumes of SOFR derivatives traded with corporate clients are up 800% and the bank has traded with four times as many clients compared with last year, he said.
“The fact that we are getting near the deadline forces peoples’ hands to be more focused,” said Mr. Geffen. “But the ARRC’s endorsement of CME Term SOFR has been the single largest contributor recently towards moving the agenda along.”
Alternatives to SOFR have also cropped up, spurring hesitancy among some companies to select a single benchmark. These include the Bloomberg Short Term Bank Yield Index and Ameribor, a rate that is sensitive to funding costs increases during periods of financial stress.
Some corporate treasurers and investors prefer these alternatives because they resemble Libor, making the transition easier from a systems and operational perspective.
The updated language for certain agreements at Polaris allows them to switch to another reference rate at any point. “We added a little flexibility in case, for some reason, some other standard gained popularity over SOFR,” said Mr. Mack.
Banks can’t issue new financial contracts using Libor after Dec. 31, but may continue to reference it for many existing debts through June 2023, an 18-month extension backed by U.S. officials to allow legacy contracts to mature.
Some companies are waiting until that deadline approaches to make the changeover. Cincinnati Financial Corp. , a property and casualty insurer, plans to switch its contracts to a new reference rate closer to three months before the 2023 deadline, said CFO Michael Sewell.
“We’re prepared to do it. It’s not like we’re scrambling, but I don’t think we need to rush it and do it this month or next month,” Mr. Sewell said, adding the Fairfield, Ohio-based company has few contracts based on Libor. Cincinnati Financial doesn’t have any new debt agreements or existing credit lines with payments coming due prior to the deadline.
Cincinnati Financial will most likely transfer to SOFR, in part because it appears popular with other businesses, he said. “We would want one where we would pay the lowest interest, but that’s kind of hard to tell based on actual transactions, so I think we’re just going to wait and see,” he said.
Tom Wipf, a Morgan Stanley banker who is also head of the ARRC, said he expects to see more headline corporate loans and syndicated deals using SOFR going forward as Libor usage continues to decline and regulators keep up the pressure.
“All the obstacles are out of the way now and it will be about economics in the end,” said Mr. Wipf. “It is just as easy to trade a SOFR hedge as a Libor one—the liquidity is there.”
Walker & Dunlop Getting First Leveraged Loan Tied To SOFR
Real estate lender Walker & Dunlop Inc. became the first company to announce a U.S. leveraged loan sale that fully embraces regulators’ preferred replacement for the London interbank offered rate, a milestone in the shift away from Libor that could finally unleash a flood of copycats.
The $600 million seven-year loan will be benchmarked to the Secured Overnight Financing Rate, according to a person familiar with the matter. Libor is being phased out because of the rigging scandal that came to light a decade ago, and SOFR is a leading candidate to fill its role.
Once 2022 begins, a wide range of newly issued financial products, including corporate loans, will no longer be able to reference Libor — a major challenge since the rate has powered these markets for decades. Those issued before Jan. 1, 2022, can still use Libor through mid-2023.
Leveraged loans have been slow to adapt to this new reality. Acceptance of SOFR was impeded partly by the lack of tenors beyond a day, whereas Libor has maturities up to a year.
Bankers, companies and investors had been waiting for the Federal Reserve-backed Alternative Reference Rates Committee to ratify one-, three- and six-month versions of SOFR. That occurred on July 29, but there wasn’t an immediate shift to issuing new loans in SOFR.
Previously, there was a $750 million leveraged SOFR loan funding the purchase of chicken processing company Sanderson Farms Inc. But it will initially be tied to Libor in 2021 before shifting over to SOFR next year.
Walker & Dunlop’s loan differs because it will never use Libor. Its interest rate will be based off SOFR plus some adjustments. The exact details will unfold as the deal is marketed to investors.
The company is using proceeds from its deal to fund the acquisition of Alliant Capital and to refinance existing debt. A lender call will take place on Tuesday and commitments are due Oct. 14, according to the person, who asked not to be identified discussing a private transaction. JPMorgan Chase & Co. is managing the sale.
Ford Motor Co. was the first company to use SOFR in any large-scale corporate loan when it decided to refinance its revolving credit facilities with the benchmark rate earlier this year. But that wasn’t a leveraged loan, a type of financing that is sold to a broad institutional investor base, rather than to banks.
Morgan Stanley’s Robot Libor Lawyers Saved 50,000 Hours of Work
Untangling trillions of dollars worth of loans and other financial contracts from Libor is a complex, expensive and time-consuming job.
So, finance giants are turning to artificial intelligence to simplify and speed up a task mandated by regulators — and spare human lawyers some serious drudgery.
Morgan Stanley figures it’s saved legal staffers 50,000 hours of work and $10 million in attorney fees by using robot Libor lawyers instead of only the human kind. Goldman Sachs Group Inc. says computer algorithms sped things up “drastically.” These banks aren’t alone in adopting AI, and the revolution likely won’t stop with the Libor transition — but the number of contracts involved in this shift provides an ideal testing ground for the machines.
The task would be grueling for paralegals, whose torture involves parsing dense clauses to sort out which govern in a post-Libor world. Does this paragraph decide how to replace the rate, or do these? They’d sweat floating-rate options, applicable periodic rates and substitute basis to sort out the new interest payment, and grapple with whether the legalese applies just to bonds or to loans and swaps as well.
Then repeat all that grunt work over millions of pages.
‘Army of Lawyers’
“We had a client that had 15 million queries and they were able to get all that answered within a quarter,” said Lewis Liu, chief executive officer at Eigen Technologies Ltd., which helped Goldman Sachs and ING Groep NV deploy Libor-analyzing software. “The alternative would have been literally an army of lawyers and paralegals over a year, or maybe two.”
This is all happening because a decade ago major banks were caught rigging Libor (full name: the London interbank offered rate). As a consequence, the benchmark is being switched off throughout the global financial system. Newly issued loans and other products cannot be tied to the rate after Dec. 31, and it will be retired for dollar-based legacy products after June 2023.
So here come the bots. But even with AI, examining old legal documents to figure out how they change when Libor is swapped out for another interest-rate benchmark is costly.
Major global banks are each spending at least $100 million this year on the job, according to Ernst & Young. And humans still need to check their work and make final decisions; once banks discover which contracts need to be renegotiated, they must sit down and haggle with their counterparty.
“A person has to look at the documents and come up with a strategy,” said Anne Beaumont, a partner at law firm Friedman Kaplan Seiler & Adelman LLP, who views AI as an enhancement rather than a threat. “It probably makes a lot of paralegals and lawyers happy that they don’t have to waste time.”
The experience is reshaping broader attitudes toward large-scale administrative tasks, pushing other cumbersome jobs to AI. JPMorgan Chase & Co. has asked its Libor robots to expand their remit and grapple with other hard tasks in the company’s corporate and investment bank, a spokesman said.
Of course, a broader industry shift to more AI could mean fewer jobs for humans in certain areas.
Feeling The Pain
Libor is keeping the bots plenty busy, though. Morgan Stanley’s software digested 2.5 million references to Libor, according to Rob Avery, a managing director at the bank. The algorithm — based on neural-network models and known as Sherlock — rifles through contracts, digging out clauses that identify how a collateralized loan obligation or a mortgage-backed security will transition to replacement rates.
It categorizes them so Morgan Stanley can determine how their value will change depending on the replacement rate. That helps the bank decide whether to keep or sell the asset. The software operates “in a fraction of human processing time to assess the impact of potential rate-change scenarios,” Avery said in an interview.
Goldman Sachs, meanwhile, has seen AI “accelerating the project timescales drastically,” Managing Director Donna Mansfield said in a testimonial published by Eigen.
ING used AI to decide whether more than 1.4 million pages of loan agreements needed revision, said Rick Hoekman, a leader in the bank’s wholesale banking lending team. “It was a big success” that eliminated a lot of manual work, he said. The company’s data scientists may eventually use the software to approve the credit of clients.
That’s not to say that everyone is piling in. NatWest Markets Plc was approached a couple years ago by consultancies offering AI, but turned them down. “We sensed it would involve a huge project to get it to work and would consume lots of time when we just wanted to crack on,” said Phil Lloyd, head of customer sales delivery. “We felt it might help but it wouldn’t be a nirvana.”
Plenty of other banks and asset managers have struggled with such software and are instead hiring offshore lawyers and paralegals to do the work after seeing the large amount of training and technology required.
But there’s likely no stopping AI from spreading throughout banking.
Bank of New York Mellon Corp. is working with Google Cloud to help market participants predict billions of dollars of U.S. Treasury trades that fail to settle each day, and with software company Evisort Inc. to manage contract negotiations.
“When your 12-year-old and my 12-year-old are our age, they’re not going to do finance the way we do — you can see their impatience with technology,” said Jason Granet, chief investment officer at BNY Mellon and the former head of the Libor transition at Goldman Sachs. “You’re not going to beat them, so you’ve got to join them.”
While some parties have moved swiftly to adopt a replacement for the interest-rate benchmark, low-rated borrowers and CLOs have been slower to adapt.
The global $1 trillion market for collateralized loan obligations is lagging behind in the transition away from the London interbank offered rate.
While some companies, lenders and markets have moved swiftly to adopt a replacement for the scandal-marred interest-rate benchmark, low-rated borrowers have been slower to adapt. That is causing headaches for managers of collateralized loan obligations—pools of low-rated corporate loans bundled together into securities.
CLOs, the largest sources of demand for speculative-grade loans, have been one of Wall Street’s hottest products. Sales hit a record $131 billion earlier this month, topping the previous full-year record, with investors attracted to the debt’s relatively high yields. But a typical CLO comprises hundreds of loans pegged to already-varied rates, making the market one of the most difficult to shift.
Libor helps set interest costs on trillions of dollars in financial products but was slated for replacement several years ago after a manipulation scandal. Officials, regulators and banks have since been navigating one of the largest technical transitions facing financial markets, all while trying to avoid legal disputes or leaving borrowers without a rate to determine payments.
The looming Dec. 31 expiration leaves CLO managers at risk of holding loans tied to a variety of short-term benchmarks, increasing the potential for interest-rate volatility that could damp returns. The move could also leave some CLO securities with benchmarks different from the loans in their collateral pool, making it harder for investors to protect their holdings against fluctuations in rates and underlying loan prices.
“This is a huge mosaic that needs to come together; it’s not a flip of a switch,” said Tal Reback, head of the Libor transition at private-investment firm KKR & Co.
Libor underpins about $500 billion of CLOs, while business loans referencing the expiring benchmark totaled around $5 trillion as of the last quarter of 2020, according to data compiled by the Federal Reserve Bank of New York.
Many borrowers plan to switch to Wall Street’s preferred alternative: the Secured Overnight Financing Rate, or SOFR. Other benchmarks including the American Interbank Offered Rate and the Bloomberg Short Term Bank Yield Index are also in the running. Legacy debt will reference Libor until June 2023, an extension granted by U.S. officials to allow existing contracts to mature.
CLOs themselves have payments tied to short-term interest-rate benchmarks. A wave of refinancings this year allowed some CLO managers to include fallback language shifting to SOFR in their documents, analysts said. For other deals, managers and investors must negotiate that changeover, which could create conflicts if they have different rate preferences.
Meanwhile, the rush to close deals before the year-end deadline helped spur a record $144 billion of new CLOs this year as of Oct. 22, according to S&P Global Market Intelligence’s LCD. Some analysts expect sales of SOFR-linked CLOs to begin in the final months of the year.
“In CLOs, you are trying to set up a Libor transition that leads to the fewest possible mismatches between assets and liabilities,” said Bradley Rogoff, head of credit research and strategy at Barclays.
Mr. Rogoff said that in a worst-case scenario, projected equity returns would fall to low double-digit percentages, but that volatility in CLO pricing could actually help. “I think there is a higher chance the transition provides a boost in the short term,” he said.
Some expect the transition away from Libor to slow issuance next year as the CLO market adjusts. JPMorgan Chase & Co. estimates that sales of new CLOs will decline by as much as 20% in 2022 compared with 2021.
Rishad Ahluwalia, head of CLO research at JPMorgan, said fluctuations among the new benchmark rates will likely cause investors to pause while CLO managers gauge how to handle hedging costs. While CLO managers have always dealt with small differences in interest rates between loans, he said increased uncertainty regarding the transition could push money managers to trim CLO holdings after this year’s pile-in. He also expects demand to cool as investors seek to diversify their portfolios.
Companies Cling To Libor As Key Deadline Nears
Banks can’t issue new loans using the troubled rate after Dec. 31, so some companies are looking to pull off one last deal before then.
U.S. companies need to give up the London interbank offered rate for new debt at the end of December. Many want to close just one more deal before that.
Come Jan. 1, banks won’t be able to issue new loans or other financial contracts using Libor, which underpins trillions of dollars in corporate loans, derivatives and home mortgages. They will, however, be able to keep referencing Libor for debt issued before the year-end deadline through June 2023.
Financial authorities decided to phase out Libor in 2017 after traders at large banks nudged the rate up or down by submitting false data. Banks in return paid billions of dollars in fines and several traders went to prison.
Lenders have increasingly come under pressure from regulators to wind down their own and their clients’ exposure to Libor. Still, in recent weeks, businesses such as consumer-credit giant TransUnion LLC, crane-components maker Columbus McKinnon Corp. and sports-apparel retailer Fanatics Inc. have launched new leveraged-loan deals using Libor.
Libor, which dates back to 1986, remains attractive to companies for a variety of reasons, such as favorable rates and familiarity with its behavior, according to executives, lawyers and advisers. Executives have gotten comfortable with using Libor, they said.
Low interest rates and strong investor demand for higher fixed-income yields have spurred record sales of riskier corporate debt tied to Libor such as leveraged loans, which private-equity firms use to finance corporate buyouts. Total leveraged-loan sales have already set a yearly record in 2021 at over $585 billion through November, up from $288 billion during the prior-year period, according to S&P Global Market Intelligence’s LCD, a data provider.
Chicago-based TransUnion used Libor for two leveraged loans totaling $3.74 billion to help finance the acquisitions of information-services company Neustar Inc. and digital-identity-protection company Sontiq, both of which closed Dec. 1. A $3.1 billion loan will expire in 2028, while a $640 million loan carries an eight-year term, TransUnion said. That means the company will have to make changes to the rate quoted in its loans once the June 2023 deadline approaches.
Many companies plan to switch to the Secured Overnight Financing Rate, or SOFR, the preferred Libor replacement of U.S. regulators and Wall Street, analysts and executives said. Others are weighing credit-sensitive options such as the Bloomberg Short Term Bank Yield Index and Ameribor, which reflect lenders’ funding costs and bear a similarity to Libor.
“When Libor is no longer available, we have the option to use SOFR or other benchmarks,” TransUnion Chief Financial Officer Todd Cello said.
Columbus McKinnon recently raised a $75 million loan due 2028 to finance its acquisition of industrial-machinery maker Garvey Corp. The Getzville, N.Y.-based company used Libor because it didn’t want to amend the language in its existing credit agreement, which would have required approval from its creditors, Chief Financial Officer Gregory Rustowicz said.
“It was simpler to continue to roll with Libor,” he said.
Mr. Rustowicz plans to update the company’s credit agreement before the 2023 deadline and expects to replace Libor with SOFR the next time his company needs to refinance debt.
Fanatics Inc. likely saved money by using Libor for a $500 million leveraged loan it secured last month due to the difference in spread between that rate and SOFR, CFO Glenn Schiffman said. The Jacksonville, Fla.-based company, which is privately held, did the deal to diversify its funding sources and further invest in its online platform, he said. The loan has backup provisions for eventually moving to SOFR.
A lack of familiarity with the replacement rates is motivating some companies to finish one last deal tied to Libor before Dec. 31, said David Duffee, partner at law firm Mayer Brown LLP. “Companies know it’s their last clear chance to do something Libor-priced,” he said.
Most companies will have to update their systems to handle compounded-interest calculations given that those weren’t needed on a frequent basis prior to SOFR, said Amol Dhargalkar, managing partner and global head of corporates at Chatham Financial Corp., a financial-risk adviser. These upgrades often require additional time and money for corporate treasury teams, he said.
Closing new Libor deals presents financial and potentially other risks for companies, banks and the market overall, said Tom Wipf, head of the Alternative Reference Rates Committee, a group of major banks, insurers and asset managers that is working on the transition away from Libor alongside the New York Fed. Liquidity in U.S. Libor-linked markets can only diminish over time, Mr. Wipf said. Investors define liquidity as the ability to buy and sell securities without significantly shifting prices.
“While there will be some new Libor activity around year-end, the momentum to SOFR is strong and we expect progress to only accelerate,” said Mr. Wipf, who is also a Morgan Stanley banker.
Many U.S. companies have been sluggish to transition away from Libor. Around $10 billion worth of junk-rated corporate loans sold this year through November have been tied to SOFR, according to LCD—or just 1.7% of this year’s total sales of $595 billion.
Walker & Dunlop Inc. was the first U.S. company to issue a leveraged loan tied to SOFR this year. The commercial real-estate financing provider in October closed on a $600 million loan due 2028 to finance the acquisition of Alliant Capital, a tax-services provider, which is expected to close before the end of this quarter.
The loan pays investors an extra yield, or spread, of 2.25% over SOFR, plus an adjustment of 0.1% to 0.25% based on the monthly term. Mitchell Resnick, the company’s senior vice president and treasurer said creditors had different viewpoints about the so-called credit adjustment rate. “That was the most interesting part. It was good to have engaging conversations with lenders and eventually come to an agreement,” he said.
The transition from Libor to SOFR was an easy one for the Bethesda, Md.-based company, Mr. Resnick said, because finance workers were familiar with the new reference rate due to the mortgage business. Government-controlled mortgage companies Fannie Mae and Freddie Mac switched from Libor to SOFR in 2020.
“SOFR is not something [that is] unusual to us. It seemed like a logical transition,” Mr. Resnick said. “If you have to explain to folks internally what SOFR stands for and how to look it up, you will get a lot more hesitancy around it.”
Ex-UBS Trader Hayes Loses Bid To Appeal Libor-Rigging Case
* He Spent Almost Six Years In Prison After 2015 Conviction * U.K. Commission Rejects Application To File With Appeals Court
Tom Hayes, the former UBS Group AG and Citigroup Inc. trader who became the face of the sprawling Libor scandal, has lost his bid to appeal his U.K. criminal conviction.
The Criminal Cases Review Commission, which probes suspected miscarriages of justice, rejected his request for a referral to the Court of Appeal almost five years after Hayes argued that his conviction and 11-year sentence should be quashed.
He’d cited the lack of consideration at trial for his Asperger syndrome as well as fresh evidence that wasn’t presented to the jury.
“Following a detailed and thorough review of Mr. Hayes’s 2015 convictions for conspiracy to defraud, the CCRC has reached a provisional decision not to refer his case to the Court of Appeal,” a spokesperson for the commission said by email on Tuesday.
Hayes, 42, can now respond to the commission’s provisional view and make any further arguments before a final decision is taken, the commission said. Hayes has until February to make further submissions, which he said he will do.
The former trader was the most high-profile conviction in a crackdown on the rigging of the London interbank offered rate in the wake of the financial crisis a decade ago.
He was freed from prison in January after serving half his sentence. At his trial, Hayes was described by prosecutors as the “ringmaster” of a global network of traders and brokers who manipulated Libor, while some saw him as the fall guy for what had been until then a common practice at the world’s biggest banks.
“We are disappointed and surprised by this decision, which is based on the false admissions given during interviews to the SFO in order to avoid extradition to the U.S.,” Hayes said by email, referring to the U.K. Serious Fraud Office. “Had I not made such false admissions, I would not be in this invidious position.”
He added, “I will continue to fight to clear my name.”
Hayes was convicted following a two-month London trial where he was found guilty of working with traders and brokers to game Libor to help his own trading positions. He had been a star performer at UBS in Tokyo from 2006 until 2009, when he joined Citigroup. He was dismissed by the American bank less than a year later as the Libor scandal began to widen.
The SFO closed its seven-year rate-rigging investigation in 2019 after securing three guilty verdicts and a guilty plea against bankers at Barclays Plc.
The prosecutor’s results were mixed, however, with eight people being acquitted in various Libor-related cases. Only a handful of other bank employees have faced criminal charges globally and several of Hayes’s alleged co-conspirators were acquitted.
Karen Todner, Hayes’s lawyer, said she was “hugely disappointed by the decision and will continue to fight this miscarriage of justice.”
Libor Fix Wins House Support In Drive To Avert Market Chaos
* Bill Would Protect $16 Trillion Of Deals That Can’t Transition * Senate Should Now Move Quickly On Law, Says JPMorgan’s Pluta
The U.S. House approved legislation designed to protect trillions of dollars of assets from chaos when Libor expires, in one of the final key steps aimed at guaranteeing an orderly transition from the discredited benchmark.
By a vote of 415-9, House lawmakers on Wednesday backed provisions to switch the most troublesome contracts, including mortgages, business and student loans, to a replacement benchmark in an effort to prevent a flood of litigation when dollar Libor retires. The bill will now head to the Senate, where its fate is uncertain.
Bankers, investors and regulators see such proposals as crucial to ensuring that a large swath of the U.S. financial system isn’t disrupted. The move follows similar legislation in New York state to protect Wall Street that passed in March, and a regulatory decision to extend key dollar Libors until mid-2023 to allow trillions of dollars of contracts to die off naturally.
“Federal legislation is vital to the success of the transition,” Tom Wipf, chairman of the Alternative Reference Rates Committee, the Federal Reserve-backed body guiding the process, and vice chairman of institutional securities at Morgan Stanley, said in a statement.
Federal legislation, such as this bill, is needed to protect some $16 trillion of deals outside New York that may survive beyond 18 months — and which could pose a threat to financial stability.
These products are especially challenging because many were drawn up before anyone knew Libor would end, and lenders must secure consent from borrowers for the switch, which can be difficult to obtain.
Regulators are phasing out Libor following major manipulation scandals and the drying up of trading used to inform the rates, which are linked to everything from credit cards to leveraged loans.
The House legislation would automatically shift contracts that would otherwise face a cliff-edge scenario to a new benchmark, with the aim of preventing disputes over which rate should apply, how interest is calculated and how much is owed. It also includes so-called safe-harbor provisions, designed to deter lawsuits seeking damages.
“We really appreciate this great bipartisan support,” said Thomas Pluta, JPMorgan Chase & Co.’s global head of linear rates trading. “Now we need the Senate to move quickly.”
Lawmakers gave their backing after the bill’s sponsor, Democratic Representative Brad Sherman, backed down in a dispute over the treatment of tax. Language has been removed from the draft that would have explicitly prevented the Internal Revenue Service from recalculating firms’ tax liability, a move that in theory could eat into banks’ profits.
Sherman said the Senate is still weighing his bill. He said Republican Senator Pat Toomey of Pennsylvania had a concern the bill will coerce business to use specific rates, but that nothing in the bill authorizes regulators to demand businesses use specific reference rates.
Regulators have said repeatedly they want firms to primarily use the Secured Overnight Financing Rate, the main dollar Libor replacement.
“The report language was drafted with Senator Toomey in mind,” Sherman said, adding that business groups support the bill and don’t view it as government interference.
The U.K. hasn’t faced the same complications around sterling Libor, partly because of its different exit strategy. Libor’s administrator will publish a “synthetic” Libor number, which doesn’t require trading data from panel banks, to help contracts avoid a cliff-edge scenario at the end of 2021 when the U.K. benchmark will retire.
The U.K. Financial Conduct Authority said in March that it is considering a similar arrangement for dollar Libor.
“Now we just need to make sure the post-Libor world can function well with the Secured Overnight Financing Rate,” said Priya Misra, global head of interest-rate strategy at TD Securities and a member of the ARRC.
As Libor Goes Away, U.S. Replacement Makes A Big Trader Uneasy
* SOFR Is Not A Great Hedge, According To DRW’S Don Wilson * ‘The Time It Really Falls Apart Is In A Crisis,’ He Said
Dollar Libor’s fate is set: It will no longer be available for new loans and other products starting on Jan. 1, mostly replaced by the benchmark that regulators want.
But that doesn’t mean everybody loves the Secured Overnight Financing Rate, the leading U.S. alternative.
Take Don Wilson, founder of Chicago-based trading firm DRW, which will play a big role in the Libor-to-SOFR transition since his company trades derivatives tied to both rates. He thinks regulators made a mistake promoting SOFR as the right solution for everyone.
The problem, according to Wilson, is that SOFR will do a poor job hedging risks in turbulent times.
“For somebody who wants to hedge their borrowing costs, it leaves a lot to be desired,” the 53-year-old said in a recent Zoom interview from Miami, after his sailing team Convexity had just again won a world championship there. “It’s a great product as long as credit spreads remain static. The time it really falls apart is in a crisis.”
The early days of the pandemic help illustrate that. When Covid fear ripped through markets in 2020, three-month Libor spiked as lending markets locked up. But the comparable SOFR fell, dragged lower by the Federal Reserve slashing interest rates. In other words, SOFR didn’t reflect just how challenging credit markets were.
Wilson’s critique isn’t new and he’s not alone. But he’s a prominent voice on the subject as Libor winds down. DRW is one of the biggest Chicago-based trading firms. It’s a major market maker in eurodollar derivatives, which are tied to Libor, and also trades SOFR contracts.
DRW — which also has cryptocurrency, venture capital and real estate divisions — employs more than 1,200 people and, according to people familiar with the matter who spoke earlier this year, generated about $750 million in earnings before interest, taxes, depreciation and amortization in 2020. Wilson started his career in the Chicago Mercantile Exchange’s eurodollar trading pits before founding DRW in 1992.
SOFR has been dogged with complaints since the Fed-backed Alternative Reference Rates Committee anointed it as the new benchmark for key dollar markets more than four years ago.
U.S. officials continue to stand behind their choice. “SOFR is a robust rate built on a durable base of overnight transactions,” Nathaniel Wuerffel, a senior vice president in New York Fed’s markets group, said in an Oct. 27 speech.
SOFR is calculated using transactions on overnight repurchase agreements, or loans collateralized by U.S. Treasuries. (The median daily volume underlying SOFR was $1 trillion in 2020, according to Wuerffel.)
As a result, it tends to follow whatever the Fed is doing with interest rates, ignoring — to some extent — whatever stresses there might be in credit markets.When the Fed cuts rates, as it often does during a crisis, that should pull SOFR down.
But that means it won’t really work for someone trying to hedge credit risks. Libor tends to jump during a crisis, meaning it’s useful for that purpose.
“When there is stress on the financial system, that’s when it’s really going to fall short,” Wilson said. “Which, of course, if we’re concerned about the resilience of the system, we need to make sure that your hedging products especially work during that period. Because that’s when they’re most critical.”
Regulators, he said, have “decided they want everyone to use SOFR. I cannot explain it.”
The Bloomberg Short Term Bank Yield Index, known as BSBY, is administered by Bloomberg Index Services Ltd., a subsidiary of Bloomberg LP, the parent of Bloomberg News. It competes with other benchmarks such as SOFR, ICE Benchmark Administration’s Bank Yield Index and American Financial Exchange’s Ameribor.
“We have seen recent innovation in reference rates, including those with credit-sensitive properties,” the New York Fed’s Wuerffel said in the October speech. “It is understandable that credit-sensitive rates could be conceptually appealing for certain use cases, but it appears that at least some of the attraction is that credit sensitive rates behave very similarly to Libor,” he added. “Choosing reference rates only because of their similarity to Libor could very well end poorly.”
Deutsche Bank Fined For Weak Controls On Rate Data
Germany’s financial regulator BaFin said the bank didn’t do enough to tighten controls after $3.5 billion in earlier fines related to rate rigging.
Deutsche Bank AG was fined nearly $10 million by Germany’s financial regulatoron Wednesday for not having strong enough controls around data submissions that help set a European interest-rate benchmark.
Deutsche Bank “at times did not have in place effective preventive systems, controls and policies to ensure the integrity and reliability of all contributions of input data to the administrator,” the regulator, BaFin, said.
The weaknesses found by BaFin related to Euribor submissions in a 2019-2020 time period, according to a person familiar with the matter.
Deutsche Bank said there is no indication it actually submitted any incorrect data, and that it is taking measures to improve the controls. The bank said it wouldn’t contest the fine, which was €8.66 million, equivalent to nearly $10 million.
“It remains a top priority for us to identify and address potential weaknesses in our control processes,” a Deutsche Bank spokesman said.
The penalty revives one of the darkest chapters for Germany’s biggest bank by assets. Last decade, Deutsche Bank paid around $3.5 billion to settle allegations by U.S., U.K. and European authorities that its traders for years manipulated Euribor and other global interest-rate benchmarks.
It was the most heavily fined bank over the rate rigging, and has since sought to improve its culture and systems to prevent any repeats.
The Wall Street Journal previously reported that a whistleblower who helped U.S. and U.K. regulators investigate rate manipulation at Deutsche Bank received nearly $200 million for assisting that probe.
A series of Journal articles in 2008 raised questions about whether global banks were manipulating the interest-rate-setting process by lowballing a key interest rate to avoid looking desperate for cash amid the financial crisis.
Regulators investigated, and found traders at banks and brokers for years conspired to manipulate benchmark rates. The rates are set based on oral submissions by banks and not on actual transactions.
Like other banks, Deutsche Bank was accused of letting employees nudge rates up or down slightly to benefit their trading positions.
The practice was harmful, authorities say, because the rate benchmarks are used to determine interest paid on everything from mortgages to corporate loans to complex financial derivatives. The most widely used rate, Libor, is in the process of being replaced.
Libor’s Decades-Long Dominance Of Rates Is Over, Axing Liquidity
* Many Libor Rates Will Be Published For The Last Time Friday * Three-Month Dollar Rate Endures, With Competition From SOFR
The time has come for John Williams to put away the Libor countdown clock.
The Federal Reserve Bank of New York’s president for more than two years has been counting down the days until Friday, when most versions of the London Interbank Offered Rate — with the notable exception of three-month U.S. dollar Libor — will be published for the last time.
It’s the beginning of the end of its decades-long reign as the preeminent tool of the financial system, more than a decade after bank manipulation was first alleged.
For regulators, it’s celebration time. For U.S. traders, the outlook remains muddy, as the painful slog of integrating replacements for Libor goes on.
“Once the calendar turns, the big question will be liquidity in Libor markets, cash and derivatives,” said Priya Misra, global head of interest-rate strategy at TD Securities. Those markets also include swaps and loans. “There is no doubt that liquidity in Libor-linked contracts will be worse than in 2021, but not clear if it will be problematic early on.”
The surviving Libors have expiration dates in June 2023, and are continuing mainly to avert trouble for contracts that reference them. U.S. regulators have strongly discouraged new contracts tied to the old benchmarks.
While yen, euro, Swiss franc and pound investors will have straightforward replacements, the U.S. remains a contest in which the Secured Overnight Financing Rate is favored. Calculated under the auspices of the New York Fed, it’s based on repurchase agreements for Treasury securities.
Derivatives exchange operator CME Group Inc. — whose eurodollar futures and options referencing three-month dollar Libor remain its biggest product — has designated its much newer SOFR futures in the conversion mechanism for eurodollar contracts if and when the Libor rate ceases to exist.
Beginning in January, anyone trading a Libor derivative with a bank will need to document whether it’s hedging a legacy contract or qualifies as a risk-reduction, which TD’s Misra said could introduce friction and gum up trading.
That’s particularly true for syndicated loans, where in November SOFR lending was 53% of Libor lending for investment-grade, and 17% for leveraged, according to a progress report by the Federal Reserve-backed Alternative Reference Rates Committee.
Resistance to SOFR reflects lender interest in a rate that, like Libor, embeds credit risk, for a better match with their cost of funds. So while 2022 may bring greater adoption of SOFR and fewer Libor-based transactions, inroads are possible for a slew of lesser-known rates.
“We continue to believe the market is headed to a multiple reference-rate world where SOFR is the initially dominant derivatives rate but where credit-sensitive rates co-exist,” Bank of America U.S. interest-rate strategists led by Mark Cabana, wrote in a note. “The future USD benchmark world is still a work in progress.”
Hot Demand For Loans Weakens Key Part Of Libor Transition For Investors
* Issuers Are Reducing Or Eliminating Credit Spread Adjustments * ‘Borrowers Have The Upper Hand,’ Says Lsta’s Meredith Coffey
Blazing demand for leveraged loans is allowing companies to reduce borrowing costs by tinkering with a provision many viewed as key to weaning the industry off Libor.
U.S. leveraged loans are shifting to a new rate benchmark known as the Secured Overnight Financing Rate. Unlike its predecessor, Libor, SOFR does not tend to spike when credit markets get stressed — a potential shortcoming for those who want to hedge their risks.
So, SOFR loans have included a “credit spread adjustment,” which tacks on a few basis points to the deal’s interest rate to compensate for a lack of credit-market sensitivity that tends to keep it below Libor.
But demand for loans is incredibly high at the moment as the Federal Reserve prepares to hike interest rates, and that’s given borrowers and their banks leeway to remove the CSA or have the same CSA across all tenors, instead of offering a higher rate for longer terms.
“There is a lot of money looking to be invested in loans, so borrowers have the upper hand, including with respect to Libor transition,” said Meredith Coffey, executive vice president of research and public policy at the Loan Syndications and Trading Association.
When JPMorgan Chase & Co. launched a $4.4 billion SOFR loan for software maker McAfee’s buyout, the pricing was proposed with a flat adjustment of 10 basis points for one, three and six months. About $2.7 billion of loans priced last week with a similar structure, led by either Credit Suisse Group AG or Bank of America Corp.
It’s a major contrast with how things worked just a few months ago. In October, investors scored a win by pushing back on the CSA for Walker & Dunlop Inc.’s $600 million loan, which many thought would set the standard for SOFR loans. It added a 10-basis-point CSA for one month, 15 basis points for three months and 25 basis points for six months.
Leveraged loan investors are now looking like the losers in the $1.3 trillion market’s transition away from the discredited Libor.
The whittling down of CSAs shows the balance struck last fall was an uneasy one and underscores how much investors have weakened their position as a result of their seemingly insatiable demand for leveraged loans as the Fed gets close to raising rates.
“So far, the majority of SOFR based primary loan issuance has been based on a 10/15/25 CSA construct. In the past week however, we have seen two of the larger transactions in the market, Tropicana and McAfee, announce flat adjustments of 10 basis points regardless of term,” said Roberta Goss, senior managing director and head of the bank loan and CLO platform at Pretium Partners LLC. “We expect the market to continue to move in this direction as the timing of Fed rate hikes becomes clearer over the coming months.”
Issuers are sometimes adding clauses to deals that stipulate if other borrowers issue their own loans with better CSA terms, their loan will automatically shift to those, according to people familiar with the matter who aren’t authorized to speak publicly.
Some loans don’t have a separate CSA, instead incorporating it within the traditional spread that floats above the benchmark.
Without an explicitly stated CSA, these loans may see more volatile prices; when there’s less transparency, there’s often more turbulent trading,according to a report from Bank of America.
In addition, Bank of America says some deals have no CSA whatsoever, and the spread is the same as if the loan had used Libor. “In these cases there is an unmistakable transfer of value from investors to issuers,” credit strategist Neha Khoda wrote in a report.
The use of multiple CSA structures in the market shows that issuers still have a fair amount of discretion, said Tal Reback, who leads the Libor transition at KKR & Co.
“This is a lever being used in the price discovery process, which begs the question, should new risk just be priced differently?” Reback said. “Going forward, I strongly believe the significance of what a credit spread adjustment represents will diminish in value.”
Libor Was Made Up Anyway
The way that global financial markets worked for decades is that trillions of dollars of floating-rate loans and interest-rate derivatives were indexed to Libor, the London interbank offered rate. And the way Libor worked was that someone — at the time relevant to our story it was the British Bankers’ Association — would call up a group of big international banks and ask them “how much would you have to pay right now to borrow dollars for one month,” and they’d answer, and the BBA would take some trimmed average of their answers, and that was one-month dollar Libor. And there were other Libors for other currencies and tenors, computed in the same way.
Most important financial benchmarks do not work this way. The S&P 500 index is not calculated by calling some banks and saying “hey how much would you pay for these 500 stocks” and averaging their answers.The S&P 500 index is calculated based on the last trade of each stock on a public stock exchange. Most indexes are based on actual trades.
But Libor was invented because it was very useful, for the floating-rate loan business, to have an index of banks’ unsecured borrowing costs, and unsecured short-term bank debt did not really trade on a transparent public exchange. It traded in an informal, telephone-based interbank market, and the easiest way to find out what trades banks were doing was to call them.
Also, though, they didn’t do trades in every Libor tenor and currency every day. If you wanted to know how much a bank would pay to borrow Danish kroner for two months — which was a real Libor rate — you could not compute that every day based on how much each Libor bank actually paid to borrow kroner for two months that day. Big international banks did not borrow kroner for two months every day.
Certainly not every day at exactly the time the BBA called them to ask. But a bank which had borrowed kroner for one month an hour ago, and borrowed dollars for three months five minutes ago, and had a general sense of the curve of its various short-term borrowing costs, could probably give you a good guess at how much it would have to pay to borrow kroner for two months right now. So you could just call it and ask it for that guess. Libor was “the rate at which banks don’t lend to each other,” people said.
The problem is that Libor also became the rate underpinning trillions of dollars of derivatives contracts, and the banks traded those derivatives and built up large positions. And some days it would be good for the derivatives traders to have a low Libor — they had to pay Libor on a bunch of contracts resetting that day, so a low Libor would let them pay less — and other days it would be good for the derivatives traders to have a high Libor.
And the derivatives traders realized that, if it was worth $1,000,000 to their bank to have Libor be one basis point lower, then it was worth $200,000 to their bonus to have Libor be one basis point lower, which meant that it was worth calling up their bank’s Libor submitter — the person who answered the phone when the BBA called — and saying “hey mate I’ll buy you a case of Champagne if you submit a lower Libor.”
And then the BBA would call the submitter and say “where can you borrow yen for three months,” and the submitter would say “oh 0.525” when in his heart of hearts he knew that the real answer was 0.545, and the BBA would average that in, and 3-month yen Libor would be a smidge lower than it would otherwise have been, and the bank would make money on the derivatives, and the derivatives traders would get their bonuses and the submitter would get his Champagne.
This Went On For A While And Eventually Regulators And Prosecutors Noticed It And It Became A Huge Huge Huge Scandal 3 And:
* Banks Were Fined Billions And Billions Of Dollars For Rigging Libor; * Bank Regulators Decided To Get Rid Of Libor And Replace It With Other Rates That Are Harder To Rig; And * Various Derivatives Traders Were Arrested And Prosecuted For Rigging Libor.
Point 1 is sort of self-explanatory. In the post-crisis period, if banks do shady stuff and get caught, they pay big fines. Point 2 is quite complicated, because the issues we discussed above — that banks do not actually borrow unsecured in every tenor and currency every day, that the bank funding market is not very transparent, etc. — remain true. The way regulators in the U.S. have addressed these issues is to replace Libor with a benchmark interest rate called SOFR, the Secured Overnight Financing Rate, which reflects the cost of borrowing money for one day secured by Treasury securities.
That rate can be calculated based on actual transactions in a liquid market. I should say, regulators are in the slow process of replacing Libor with SOFR; I am talking about Libor in the past tense but that is a bit misleading and it is still in wide use despite being phased out. This is partly for reasons of inertia, but also because using an overnight secured rate raises its own issues for floating-rate lending, etc., which we have talked about before but will not talk about again here.
Here we will talk about Point 3. Some bank traders were prosecuted for rigging Libor. In the U.S., they were prosecuted for “wire fraud,” the crime of lying to people to make money.
There is something a little bit odd about this, if you think about it too hard. The BBA would call up a bank’s Libor submitter and say “where could you borrow yen for three months” and the submitter would say “0.525” when the correct answer was 0.545.But what does it mean to say that the correct answer was 0.545? It does not mean that, as the submitter was saying “0.525,” he was simultaneously entering into a three-month unsecured borrowing agreement to borrow dollars at 0.545%.
It means that the submitter’s unbiased best guess about what the bank would pay, right that minute, to borrow a reasonable amount of dollars for three months, was 0.545%, but he said 0.525% due to impure motives.
But of course the submitter’s unbiased best guess was just a guess about a hypothetical question, and for most Libor tenors and currencies on most days that guess would not line up precisely with a contemporaneous actual transaction.
And so you could not prove that that best guess — 0.545% here — was “correct,” that it reflected the true answer to the BBA’s question, which was to submit “the rate at which [the bank] could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to [11 a.m. London time].”
Which means that you also could not prove that the biased, dishonest, Champagne-induced guess — 0.525% here — was false. Could the bank have borrowed yen for three months at 0.525% around the time that the BBA called?
I don’t know! Perhaps you could go back and find proof that, right around that time, the bank was looking to borrow yen for three months, and it got a range of offers, and they were all in a range of 0.543% to 0.548% and the 0.525% was a lie. But there is no obvious reason to think that would always be the case; for the most part these were judgment calls and you won’t find a smoking gun proving that the 0.525% was a lie.
More to the point, no one, uh, looked? These cases were brought based mainly on really bad chats. What happened is that prosecutors would investigate a bank’s Libor dealings and find electronic chats like this:
* Derivatives trader: Hey what Libor are you submitting today?
* Submitter: I think the right number is 0.525%.
* Derivatives trader: It would help me out a lot, in terms of profiting on my derivatives, if you would lie and submit a higher number.
* Submitter: What if I lied and submitted 0.545%, which is not what I think is the right number?
* Derivatives trader: Perfect, I appreciate it, in exchange for your dishonest criminal conduct I will happily pay you a bribe of one case of Champagne.
* Submitter: Your bribe is acceptable to me, pleasure doing crime with you.
* Derivatives trader: Hope we don’t go to jail!
* Submitter: Lol. We should, though, what with the crimes we’re doing!
And then they would charge the trader with wire fraud, and the jury would look at the chats and be like “well yes this sounds like wire fraud” and convict them. Seriously the chats are bad!
Two former Deutsche Bank AG traders named Matthew Connolly and Gavin Black were convicted in a New York federal court of wire fraud for manipulating Libor, and they appealed their convictions, pointing out that there was no proof that the numbers they submitted were wrong.
And last week the U.S. Court of Appeals for the Second Circuit agreed with them and tossed out their convictions. Maybe the numbers were right! Who can say? The numbers were necessarily subjective, and anyway the prosecutors forgot to prove they were wrong.
Here is the Second Circuit’s opinion. Connolly and Black traded interest-rate derivatives and cash products, and were accused of pressuring Deutsche Bank’s Libor submitters to submit wrong Libors. Two Deutsche Bank Libor submitters cooperated with the government and testified against them.
These were James King and Michael Curtler, who worked on a cash money market trading desk, “borrowing money in the interbank market in order to fund DB’s cash needs.”
The way the cash desk worked is that it would borrow money in the interbank market and then lend it to other Deutsche Bank units to fund their operations; the cash desk would show a real, live, market-based price to those other units.
King and Curtler had little spreadsheets (called “pricers”) that they used to decide what that price would be, and they would use that price — the price that they charged Deutsche Bank’s other units — as the basis for their Libor submission.
Though sometimes they’d bump it up or down a bit based on their market judgment. From the opinion (citations omitted):
In addition to the above alterations in the pricer, King each day consulted, inter alia, five interbank cash brokers before settling on DB’s LIBOR submissions.
He testified that it was logical to “change the [LIBOR submission] rates . . . so that they lined up with what the brokers were predicting” because “the brokers have access to all the banks, they know where we can borrow money or they think they know where we can borrow money.”
But King said that while sometimes the rates the brokers were suggesting were all similar, “there [we]re periods when the rates are vastly different”; and then “[we] have to come up with something that we feel is a fair reflection of our rate.”
Thus, in submitting LIBOR rates, “some days [King] went with the pricer, some days [he] went with the broker, [and] some days [he] went with the middle.” King testified that he believed that the reference to “reasonable market size” in the BBA LIBOR Instruction–a term the BBA did not define–“gave [him] flexibility as to where [he] could actually submit his LIBOR.”
So he made up a number based on his feel for the market, his own borrowing activity in the interbank market, his own lending activity in the intra-bank market, and calling some interbank brokers and getting their feel for the market.
And Then He’d Sometimes Change That Number To Benefit The Derivatives Traders:
King testified that “Gavin Black occasionally asked me to manipulate the rates or to put in a submission that was higher or lower than I would have done to benefit his trading position,” and that “Matthew Connolly on occasion made requests for me to change our LIBOR rates and to benefit the trader’s position.” …
The government also introduced other emails and electronic messages to DB’s LIBOR submitters requesting modifications of the LIBOR submissions in order to benefit DB’s existing trading positions.
They included one from Black on May 15, 2008, requesting a low 1-month LIBOR rate because he was “paying on 18 [billion]”; another from Black on February 21, 2005, requesting a high 6-month LIBOR rate; one from Connolly on November 23, 2005, requesting that 3-month LIBOR “be as high as possible”; and an August 12, 2007 email from Connolly stating, “[i]f possible, we need in NY 1mo libor as low as possible next few days….tons of pays coming up overall.”
As a result of this last request, King’s DB submission to LIBOR on August 13 was the lowest by any panel bank; and the DB submission on August 15 was four basis points below his estimate of what LIBOR would be.
As Libor-manipulation emails go these are not particularly bad — they don’t mention Champagne, or prison — but they clearly fit the prosecutors’ narrative of “banks submitted wrong Libors to make money on derivatives.” Also it sounds bad. Also the Libor submitters said — on the witness stand, at trial, after signing non-prosecution agreements — that it was bad:
All three cooperators testified that they “knew” the practice of altering DB’s LIBOR submissions to benefit DB trader positions was “wrong” at the time they engaged in it. King stated that “[i]t’s intuitively wrong because we are, you know, as I say, taking advantage of the position.
We are benefiting. There was a counterparty on the other side who doesn’t know what we’re doing and is being affected negatively by what we’re doing.” Parietti testified that “even if [LIBOR is] imprecise, hard to estimate, or vague, . . . it’s still wrong to base your submission on your bank’s position instead of information about the cash market.”
All three cooperators testified that they never contemporaneously told anyone that they thought the practice was wrong.
But at trial Connolly and Black said, well, but you haven’t proven that the actual rates they submitted were wrong. Maybe Deutsche Bank could have borrowed at those rates! It’s all subjective guesswork anyway, why not. The trial judge didn’t buy it:
The [trial] court stated that “the question for the jury was whether Defendants made LIBOR submissions that reflected something other than honestly held estimates of the rate Deutsche Bank would have accepted in order to borrow funds.” …
The court stated that “whether Deutsche Bank could have borrowed funds at a submitted rate is not dispositive of the falsity of its LIBOR submissions.” It ruled that the government was not required to prove “that Deutsche Bank could not have borrowed funds at a rate submitted to the BBA” in order “to establish the falsity of its LIBOR submissions,” and that “[a]s a factual matter, even if Deutsche Bank could have borrowed funds at a submitted rate, that would not prevent the submission from being false and misleading.”
The court stated that even “evidence that Deutsche Bank could have borrowed funds at a submitted rate would not have rendered the Defendants’ statements truthful.”
If the BBA had called up Deutsche Bank and said “hey what is the rate at which you could borrow funds, were you to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 11 a.m. London time,” and Deutsche Bank had said “0.525%,” and it could in fact have borrowed funds at that rate in the interbank market just prior to 11 a.m.
London time, but its submitter incorrectly thought that it would have had to pay 0.545%, then its Libor submission would be “false,” in the sense that the submitter was trying to be dishonest, even though he gave a factually true answer.
In fact it didn’t even matter whether the submitter thought the bank could have borrowed at that rate: What matters is that the submitter’s motive was to make money on derivatives rather than to answer the hypothetical question in the usual unbiased way. Or so said the trial judge.
The Second Circuit Disagreed:
The precise hypothetical question to which the LIBOR submitters were responding was at what interest rate “could” DB borrow a typical amount of cash if it were to seek interbank offers and were to accept. If the rate submitted is one that the bank could request, be offered, and accept, the submission, irrespective of its motivation, would not be false.
Defendants, of course, had no burden to produce any evidence. The burden was on the government to provide evidence to show that the LIBOR submissions made by King or Curtler after receiving requests from Connolly or Black were untrue. … Yet none of the witnesses testified that DB could not have borrowed a typical amount of cash at the rate stated in any of DB’s LIBOR submissions.
And It Noted That Actually There Were A Lot Of Different Rates At Which Deutsche Bank Could Have Borrowed:
Most importantly, the one-true-interest-rate theory was also belied by the evidence that loans may have different rates of interest simply because they involve different amounts of principal. King testified that the cash desk would “borrow money every single day,” and that “[t]here were periods where I need to borrow some $20- to $25 billion a day.”
He said that “[o]ften it costs you more to borrow more cash than less cash,” and thus loans in various principal amounts could be at varying rates of interest.
Similarly, Curtler testified that “there were days where there would have been a wide range of offered rates.” He said that “[i]f two counterparties were willing to lend to you, I believe I would borrow the cheapest money first”; but “[y]ou wouldn’t borrow one or the other. You would borrow both . . . .” And the BBA LIBOR Instruction does not say which of those two prices should be submitted.
So in theory on any particular day there could have been a wide range of answers to the question “what is the rate at which you could borrow funds in reasonable size,” and if the submitter pushed his number up or down by a few basis points to favor a derivatives trader’s positions, he might still end up with a number in that range — a number that was a factually correct answer to the question.
What a great opinion. Intuitively this makes a lot of sense. Libor asked banks to make up a number. The banks made up numbers. Prosecutors decided in hindsight that some of these made-up numbers were “true” and fulfilled the abstract purpose of Libor, while others were “false” and constituted criminal fraud for which people should go to prison.
But all the numbers were made up! They were all guesses, and the distinction between guesses that were good and guesses that were crimes had nothing to do with their correspondence to objective truth; it was just about which guesses came with embarrassing chats and impure motives.
In other ways it is a strange result. Libor is impossible to manipulate, the opinion suggests, or rather impossible to manipulate criminally. Because it was made up, you could make up anything with any sort of nefarious purpose and that would be fine.From the Wall Street Journal:
“In some ways, these reversals underscore what a screwed-up benchmark Libor was to begin with, when you are not being asked to submit actual offers or bids, but just hypotheticals,”said Aitan Goelman, a former director of enforcement for the Commodity Futures Trading Commission, a civil regulator that fined many banks for Libor violations. “It almost begged to be manipulated.”
But what is most interesting to me is not that it might be impossible ever to prove that a bank made a false Libor submission on any given day, but that the prosecutors didn’t try. You can sort of understand where they were coming from. This looked bad. The banks paid billions of dollars in fines for it.
If you stand up in front of a jury of normal people and said “these bank traders made a number higher so that they could make more money” the jury will jump up and shout “guilty” before you can finish the sentence. There is a popular narrative of corrupt bankers secretly conspiring to make money by nefarious means, and this story fits that narrative so completely that the prosecutors didn’t even think they had to prove that the bankers were lying!
SOFR Leads Race To Replace Libor As Interest-Rate Benchmark
Sales of corporate loans and derivatives tied to rate have picked up, with Crocs among recent issuers.
U.S. companies and financial institutions are starting to settle on a new interest-rate benchmark to replace the troubled London interbank offered rate, which underpins trillions of dollars of financial contracts.
Sales of corporate loans and derivatives tied to the Secured Overnight Financing Rate, or SOFR, have soared in 2022, with borrowers including Crocs Inc. and NortonLifeLock Inc. accelerating the shift away from issuing new debt tied to Libor.
Large U.S. financial institutions, meanwhile, have largely replaced Libor with SOFR—regulators’ preferred choice—for matters such as low-rated corporate loans and derivatives on future debt sales, analysts said.
Financial authorities started phasing out Libor in 2017 after the discovery that traders at large banks manipulated the rate, which helps set borrowing costs on financial contracts such as mortgages and corporate loans.
Starting this year, U.S. banks can’t issue any new debt linked to Libor, while around $200 trillion of existing interest-rate derivatives and business loans tied to the benchmark are set to expire by June 2023.
Regulators have worked with banks to promote broader adoption of SOFR. But the changeover has been slower than some expected, raising concern that an unruly transition would spark legal conflicts and spawn a complex mix of competing benchmarks.
Companies, banks and traders said they picked SOFR—which is based on the cost of transactions in the market for overnight Treasury repurchase agreements—in part because its stability during the Covid-19 pandemic’s market swings demonstrated it is robust enough to support large numbers of financial arrangements.
“There seems to be a clear No. 1 candidate for most deals,” said Amol Dhargalkar, managing partner and global head of corporates at Chatham Financial, a financial-risk adviser.
SOFR has gained traction since a Dec. 31 deadline that prohibited U.S. banks from issuing new debt tied to Libor. U.S. companies in January sold 61 leveraged loans tied to SOFR totaling over $66 billion, according to Leveraged Commentary & Data, a unit of S&P Global Inc. That is up from around $3.9 billion raised across four deals in December.
Shoe maker Crocs said last month it sold a $2 billion SOFR-based leveraged loan to acquire Hey Dude, a casual-footwear brand, for $2.5 billion in a deal that closed last week. Crocs decided to switch to SOFR because “it’s what has been dictated by the market,” said Chief Financial Officer Anne Mehlman.
NortonLifeLock, a Tempe, Ariz.-based cybersecurity software provider, sold in January a $3.69 billion loan to fund its merger with Avast PLC, which is expected to close in April. NortonLifeLock CFO Natalie Derse said primary lender Bank of America Corp. advised the company to switch to SOFR, citing its traction in the market.
NortonLifeLock plans to switch over its remaining $2 billion in Libor-linked debt when it refinances, or pays it off and needs new loans, said Ms. Derse.
“We were OK with Libor,” she said. “If we were in complete control, I don’t know that we would have pushed for a change from Libor.”
The weekly count of derivatives trades tied to SOFR surpassed that of Libor for the first time in the week ended Jan. 21, when the former totaled 8,200 compared with the latter’s 6,815,according to a Chatham Financial review of market data.
Average daily trading of SOFR-based derivatives has grown as well. Over $1.4 trillion of futures and options contracts tied to SOFR changed hands daily during the month through Feb. 15, according to exchange operator CME Group Inc., compared with $237.6 billion in February 2021.
Some small or midmarket businesses are considering other benchmarks, such as the Bloomberg Short Term Bank Yield Index, known as BSBY, and American Financial Exchange’s Ameribor, which they say better reflect lenders’ funding costs and account for the risks from short-term lending.
BSBY derivatives trades totaled 21 in the week that SOFR first topped Libor. A spokeswoman for American Financial Exchange said the electronic marketplace didn’t have a tally of the loans tied to the rate, but said Ameribor is a “true plug-and-play” replacement to Libor.
Some borrowers have held on to Libor, despite the Dec. 31 deadline. Last month U.S. companies launched 10 leveraged loans tied to Libor, seeking to raise $2.9 billion, on top of $9.9 billion from the previous month.
Most of the Libor-linked leveraged-loan transactions this year were so-called add-on loans, in which companies raise additional funds as part of an existing borrowing contract. Companies can also issue Libor-linked debt established before 2022 but set to close this year.
Companies with loans that expire before the June 2023 deadline—when products both existing and new must cease referencing Libor—will likely look into refinancing debt at a SOFR rate, said Jamie Spaman, managing director at the advisory firm and investment bank Stout Risius Ross LLC. Those whose loans don’t expire before then might still wait to evaluate their options.
“It’s still a little bit of wait and see,” he said.
Congress Passes Legislation On Libor Fix As Part Of $1.5 Trillion Spending Package
The provisions would automatically switch certain older financial contracts to a new benchmark rate.
Congress late Thursday passed legislation to help companies and lenders switch certain financial contracts to a new reference rate away from the London interbank offered rate.
The measure cleared the Senate in a 68-31 vote as part of a $1.5 trillion spending package that includes emergency aid for Ukraine. The nondefense portion of the bill passed the House in a 260-171 vote on Wednesday. It now heads to President Biden for his signature.
The bill’s Libor provisions, which are based on legislation that the House approved in December, concern so-called tough legacy contracts, such as floating-rate notes that require holders to agree on a new reference rate. Lawyers have said these agreements are often challenging to reach. The provisions would automatically switch these contracts to a new benchmark rate.
Finance executives will no longer have to set aside funds to cover potential lawsuits filed by bond investors or consumers who didn’t consent to changes in these contracts, said Amy McDaniel Williams, a partner specializing in structured finance at law firm Hunton Andrews Kurth LLP. “With this legislation, most of the arguments that they would have, have fallen away,” she said.
Libor underpins about $16 trillion worth of these financial contracts, according to the legislation, which was introduced by Rep. Brad Sherman (D., Calif.) in July. “It’s amazing to see Congress solve a big problem so early that nobody but very technical people were aware that it was a problem,” Mr. Sherman said.
U.S. companies and lenders are starting to settle on the Secured Overnight Financing Rate as the new interest-rate benchmark to replace Libor, which is set to be completely phased out by June 2023. Financial authorities started the process in 2017 following manipulations of the rate by traders at large banks.
Companies, banks and traders said they picked SOFR—which is based on the cost of transactions in the market for overnight Treasury repurchase agreements—in part because of its stability during pandemic-induced market swings, which demonstrated it is robust enough to support large volumes of financial arrangements.
U.S. banks haven’t been able to issue any new debt linked to Libor since the start of the year. Roughly $200 trillion of existing interest-rate derivatives and business loans tied to the benchmark are set to expire by June 2023.
Businesses and lenders can switch tough legacy contracts to SOFR once the Federal Reserve has completed the relevant rule, which it is required to do within six months of the bill’s enactment.
Junkiest Loan Issuers To Feel Pain As Libor Blows Through 1%
* Libor And SOFR Are Exceeding Interest Rate Floors For Loans * Could Add Millions Of Dollars Of Interest Expense For Issuers
High-risk companies that tapped the $1.4 trillion U.S. leveraged loan market have been largely insulated from rising short-term rates. Now they’re about to feel the pain.
A key lending benchmark, the three-month U.S. dollar London interbank offered rate, topped 1% on Tuesday, the highest since April 2020. That’s above the minimum level many junk-rated borrowers agreed to pay when calculating interest payments on their loans. So until recently, an increase in rates might not have had much real impact on these corporations, but now this expense will likely rise over time for most borrowers.
Increases in these costs could push the weakest loan borrowers to the point where their businesses aren’t generating enough cash to cover all their expenses, known as negative free cash flow, said Steve Hasnain, who invests in leveraged loans at Pinebridge Investments. Many of these companies are already facing pressure from surging commodity and labor costs, he said.
“It seems like the perfect storm,” Hasnain said. “The borrowers that were not generating a lot of free cash flow to begin with may actually go free cash flow negative in the near term.”
These companies usually have credit ratings in the CCC tier, the lowest typically seen in loans. That ratings level, plus the levels below it, account for a little more than 5% of the roughly $1.4 trillion market, or about $72 billion worth, according to S&P Leveraged Commentary & Data based on the S&P/LSTA Leveraged Loan Index.
These CCC rated companies have been generating just enough earnings to cover their interest expense, said Neha Khoda, head of loan strategy at Bank of America Corp.A growing economy may translate to higher earnings for these companies, covering some extra costs from rising interest rates, according to Khoda.
“But in a stagflationary environment, the CCC issuers will be most at risk, and maybe to an extent B3 rated issuers as well,” Khoda said.
Companies have a trick to avoid bearing the full brunt of rising rates: switching from three-month Libor to one-month, which was 0.46% on Tuesday.
But even so, many companies will probably still have to pay higher rates in the coming months. About 24% of outstanding leveraged loans tied to Libor have contractual minimum rates of 0.5% for the benchmark.
Another 18% of loans have floors of 0.75%, according to Barclays Plc. And around 12% have floors of 1%, while about 45% have floors of 0%. Corporations pay additional interest on top of the benchmark, known as a margin.
For most companies in the leveraged loan market, rising rates won’t be catastrophic. Overall, companies in the space that are publicly listed are generating about four times as much earnings as their interest expense, based on a measure known as earnings before interest, taxes, depreciation and amortization, BofA’s Khoda said.
If the Fed increases short-term rates by another 2.75 percentage points, after starting hiking rates earlier this month, that ratio will still be about three times on average, still a reasonable level, she said.
The Federal Reserve has signaled six more hikes this year and that could mean a rapid increase in short term rates including Libor and the newer Secured Overnight Financing Rate. Most leveraged loan payments are structured as a margin above those rates.
The market is in the middle of a transition away from Libor. The discredited benchmark could no longer be used in new deals starting in 2022, and most new loans have been issued with SOFR so far this year.
About 85% of loans tied to the new benchmark have floors of 0.5 percentage points, with three-month term SOFR now at 0.65%, and one-month term SOFR standing at about 0.31%. But the bulk of existing loans still use Libor, which is due to be officially retired mid-2023.
Many businesses have used the extra-easy money environment of the last two years to refinance debt at lower rates and push out maturities, said Jeff Darfus, a credit research analyst at Barclays Plc. Plus, the most stressed borrowers defaulted in 2020, and the stronger companies survived, leaving the market on relatively good footing.
“Generally, these companies will be able to handle the beginning of these increases in interest expense and then that obviously just comes down to what’s happening with growth,” he said.
But the overall improvement in corporate credit fundamentals is not mirrored in lower-rated leveraged loans, according to a recent report by UBS Group AG strategists led by Matthew Mish. “The key risk is rising funding costs and slowing growth could reinvigorate CCC downgrade fears,” they wrote.
The Fed’s efforts to clamp down on inflation mean that rates are rising faster than in previous cycles. By the end of 2022, JPMorgan Chase & Co forecasts that three-month Libor will be around 2.25%, and one-month trailing average SOFR will stand at roughly 1.65%.
Companies Keep Libor On The Books Despite Push To New Benchmark
Many businesses continue to hedge debt tied to the troubled interest-rate benchmark, which is set to expire in June 2023.
Companies are hanging onto the London interbank offered rate for existing loans and derivatives despite a push from regulators to abandon the troubled interest-rate benchmark, whose demise is about a year away.
Financial authorities started phasing out Libor in 2017 after traders at large banks manipulated the rate, which underpins trillions of dollars of financial contracts, such as mortgages, corporate loans and interest-rate derivatives. The benchmark is set to expire by June 30, 2023.
Since Jan. 1 of this year, companies have had to link new debt to benchmarks other than Libor, as U.S. banks could no longer issue Libor-linked loans, with most of them picking the Secured Overnight Financing Rate, or SOFR.
But there are still a lot of existing loans tied to Libor on the books, and companies are trading Libor derivatives to hedge financial risks stemming from high inflation and interest rate increases, corporate advisers said.
“We’re going to see Libor-based hedging as long as there is Libor-based debt to be hedged,” said Amol Dhargalkar, managing partner and global head of corporates at Chatham Financial, a financial-risk adviser.
Companies usually replace Libor when they refinance their loans. But they might decide against refinancing now, possibly because they did so last year and want to avoid the incremental cost of doing it again, Mr. Dhargalkar said.
Companies didn’t have to swap out Libor in financings completed in 2021, so many companies simply stuck with it when they refinanced, adding language that allows for a transition to SOFR if necessary, he said.
Average daily trading volumes of Libor-based derivatives continue to exceed that of those linked to SOFR. Over $2.33 trillion of futures and options contracts tied to Libor changed hands each day in May, down from $2.99 trillion in May 2021, according to exchange operator CME Group Inc. About $1.9 trillion in SOFR-based derivatives were traded in May, up from $189.36 billion a year earlier.
“Some companies don’t want to wait until they have SOFR-based debt to hedge their exposure,” Mr. Dhargalkar said. “They say, ‘I’m just going to hedge my Libor exposure right now.’”
Among the companies doing that is retirement-home operator Brookdale Senior Living Inc. The Brentwood, Tenn.-based company typically buys interest rate caps related to its variable debt to reduce potential rate volatility, said Chief Financial Officer Steve Swain. Brookdale still has Libor-linked loans amounting to 91% of its variable-debt stack, he said.
The company placed most of these loans, which carry seven- to 10-year maturities, before the Libor phaseout was announced, he said. “We have expanded our monitoring of forward rates to include SOFR,” Mr. Swain said. The company expects these loans will be transferred to SOFR as of the deadline, he said.
Companies across industries often enter into interest rate swap or cap agreements to limit their exposure to interest rate terms on their variable-rate loans. Tanker operator Pyxis Tankers Inc. has interest rate caps covering part of the $70 million it has in outstanding Libor-based bank debt, CFO Henry Williams said.
The Maroussi, Greece-based company, which is listed on the Nasdaq, last July purchased a four-year cap to cover the $9.5 million balance of a ship loan, he said.
Asked when Pyxis Tankers will switch its loans to SOFR, Mr. Williams said the company will coordinate with lenders, as the transition is already baked into its loan agreements. “Our two principal banks still use one- and three-month Libor,” he said, referring to Alpha Services & Holdings SA and Vista Bank.
Pyxis will consider purchasing SOFR caps, swaps or collars, which are essentially swaps with a range, to hedge interest-rate risk after the switch, he said.
Trading volumes for SOFR derivatives have far outperformed those of other benchmarks, excluding Libor, indicating it is the preferred alternative. Some small or midmarket companies are considering the Bloomberg Short Term Bank Yield Index, for example, but the volume for instruments linked to that standard is much lower.
“We did see for a brief period more interest in people exploring credit-sensitive alternatives, but that really has gone away and the impulse seems to be, even in the middle market, SOFR,” said J. Paul Forrester, a partner at law firm Mayer Brown LLP.
Companies in recent years have added fallback language to most loans allowing for a switch to a Libor replacement in June 2023. The International Swaps and Derivatives Association Inc., a derivatives trade group, in 2020 issued guidance on fallback language for derivatives.
There can be cases in which companies’ legacy instruments don’t allow for a fallback to SOFR and therefore would use the prime rate, the rate at which banks lend to customers with good credit, Mr. Dhargalkar said.
President Biden in March signed a law allowing certain older financial contracts to automatically switch to SOFR or another rate.
The volume of Libor hedging is expected to decline as more companies make the changeover ahead of the deadline, advisers and regulators said.
Businesses’ new debt issuances linked to SOFR, for example, have been picking up speed. U.S. companies in May sold 13 leveraged loans tied to SOFR, compared with zero in May 2021, according to Leveraged Commentary & Data, a data provider.
Still, regulators want companies to link their loans to SOFR sooner rather than later to ensure a smooth changeover. “We probably have to get a little closer to the end before that sense of urgency overtakes the market,” said Tom Wipf, head of the Alternative Reference Rates Committee, a group of financial institutions handling the transition with the Federal Reserve Bank of New York. “We just hope people don’t get too close to the end.”
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