As the world copes with new norms, major market stress and future societal uncertainty, the London Interbank Offered Rate index transition, if briefly forgotten, still looms large on the financial horizon.
By the end of 2021, LIBOR will be officially ousted in favour of the Sterling Overnight Indexed Average. This quarter – even though we all have plenty to concern ourselves with due to covid-19 – is the prime-time for lenders to begin their preparations for one of the most significant shake-ups to hit the real estate credit market in recent memory.
LIBOR is calculated based on submissions from a selected panel of banks and is used to hedge the general level of interest rates. Conversely, the SONIA rate is based on the average of interest rates banks pay to borrow sterling from one another outside of market hours – in other words, actual transactions. LIBOR has been considered by most to be inefficient because it includes a term bank credit component that does not always correspond to the underlying risk and, as came to light in 2012, has been subject to manipulation.
The SONIA index is much more robust and less vulnerable to the kind of manipulation that plagued LIBOR. Since April 2018, SONIA has been published by the Bank of England at 9am GMT on each London business day after it has reviewed all the applicable transactions and data captured.
In preparation for the transition away from LIBOR, the Bank of England has recommended the cessation of all products linked to sterling LIBOR by the end of Q3 2020. For many lenders, that means transactions being structured from the summer of 2020 onwards will be impacted.
In addition to new loans having to move to SONIA, around $30 trillion of existing financial contracts currently linked to LIBOR, including real estate loans, will need to be transitioned away from the redundant index. Lenders therefore need to be examining their portfolios for legacy floating rate loans that are due to mature in 2022 and beyond and implement the changes necessary to replace LIBOR.
This presents its own challenges. Because SONIA is an overnight rate, as opposed to a term rate like LIBOR, lenders underwriting loans with typical monthly or quarterly interest calculation periods must consider how to price in a premium for the tenor risk. Also, SONIA is published on a backward-looking basis rather than the forward-looking basis used in LIBOR. This means that borrowers taking out SONIA loans will not know how much interest they owe until the day the payment is due, which could cause significant operational issues.
The most common solution seen in the market to date has been to compound the daily SONIA rate for the length of the interest period in question. Lenders should also allow for a lag period – typically five business days – in the calculation so all parties have time to calculate, notify and process the transaction. This method is starting to become a common alternative to LIBOR.
Lenders need to take action to prepare for the transition to SONIA. They should consider the following:
- LIBOR is embedded in many firms’ operating models and transitioning to alternative rates could affect how contracts are priced and how risk is managed. Existing underwriting systems must account for SONIA when evaluating new loans.
- Existing operating systems need to be updated to handle SONIA rate calculations through to maturity. The transition to SONIA may cause an additional workload operationally.
- Be sure to communicate interest due dates to each borrower once they have been calculated. Be sure your borrowers have sufficient systems and cash arrangements in place to cope with the structural differences.
- Determine what information counterparties will receive should they wish to view calculations.
- Assess the potential impact on hedging. Are SONIA swaps and options available?
- Consider the impact on the lenders’ distribution strategy. Some syndicate partners might not want to participate in SONIA linked loans.
- Review all existing loans to check whether they can be transitioned from LIBOR to SONIA. Consider what the potential cost or downside of not commencing the transition now might be.
- How prepared are the borrowers and third-party professionals, such as lawyers, for the transition? Will they be able to cope with the potential additional documentation and negotiations if multiple lenders request a transition to SONIA at the same time?
The real estate credit market is busy navigating the challenges presented by covid-19, but it is important that lenders do not lose sight of the impending cessation of LIBOR. Unlike covid-19, however, this change is both anticipated and timetabled, and can therefore be planned for. Now is the time to act.
Michael Delaney is director, credit and asset management for the EMEA region at Trimont, a commercial real estate credit services provider with offices across the US, Europe and Australia.