No one was unduly surprised last July when the UK’s Financial Conduct Authority (FCA) signalled that Libor will likely be phased out by 2021, but the wider financial community is only now coming to terms with the scale and complexity of removing and replacing this long-established benchmark.
Deeply flawed, vulnerable to manipulation and mired in scandal, Libor is nonetheless the rate that worldwide determines an estimated $350 trillion worth of financial derivative contracts, mortgages, bonds and loans – not least commercial real estate.
Though the Bank of England moved swiftly to mitigate the FCA’s announcement with a white paper offering up Sonia, or the Sterling Overnight Index Average, as its replacement rate, the grim reality of the task ahead soon started to dawn on the City’s specialist Libor-watchers.
In her feedback to the Bank’s white paper, Clare Dawson, chief executive of the Loan Market Association (LMA) warned that using Sonia in the syndicated loan market “would create significant practical and operational problems” as well as uncertainty in terms of amending existing contracts.
Dawson was writing to the Bank in September last year. In the nine months prior, syndicated loan issuance based on sterling and dollar Libor totalled $2.23 trillion – 68.3 percent of total syndicated loan volumes. As Dawson pointed out, that “vast” number did not even include syndicated loans referenced to other Libor currencies, let alone simple bilateral loans.
Dawson also raised the problem of long maturity dates falling after 2021, which is particularly pertinent to real estate. Even corporate loans typically have a maturity of up to five years, which means that anything agreed today will need amending after 2021. If they are not already on the agenda, borrowers and lenders will soon be confronted with the challenge of amending ‘Libor legacy deals’ – a phrase destined to be part of the property lexicon very soon.
The LMA estimates that if Libor were to be discontinued on 1 January 2022, about $2 trillion of existing historical loan issuance would be impacted up to 31 December 2025 alone, and some 5,300 individual transactions would need to be amended on a bilateral basis.
Similar fears have been voiced in the US, where the authorities have devised the Broad Treasury Financing Rate (BTFR), also known as the Secure Overnight Funding Rate (SOFR), as the potential replacement for Libor.
In a letter to the Federal Reserve in October, Lisa Pendergast, executive director of the Commercial Real Estate Finance Council in the US, warned that the transition from Libor will “greatly affect” the US commercial real estate and multifamily sectors, given their reliance on Libor as a benchmark for floating-rate loans. The finance participants in both sectors, she wrote, are facing “significant uncertainty” and are “in search of solutions” for both Libor legacy loans as well as those loans being originated today with terms extending beyond the end of 2021.
Pendergast’s letter also reflected concerns on both sides of the Atlantic that the 2021 deadline may just be too soon for real estate lenders and borrowers: “A sufficient transition period will be essential to assess and respond to inevitable differences between regimes.”
The fundamental problem is that – as they stand now – both the 20-year-old Sonia and the as-yet-untested BTFR/SOFR – are risk-free rates more suitable for derivatives than real estate or the wider syndicated loans market. They are transaction-based indices – in principle less prone to manipulation than the judgment-based Libor – but also, by definition, overnight rates and backward-looking. Apart from anything else, Sonia and BTFR/SOFR would pose operational issues given that loan systems are not set up to process and calculate interest based on overnight rates.
More importantly for real estate, one attribute of Libor is that it is forward-looking and is an unsecured term rate quoted for different tenors. Libor also includes a term bank credit risk component, which is not reflected in the risk-free rates. Equally important is the certainty of cash flow required by borrowers and lenders alike, which a forward-looking term rate provides, as payments will be known in advance. By contrast, the LMA argues, the use of a compounded overnight rate such as Sonia for longer periods would create uncertainty in the loan markets as it would mean that the borrower and lender would not know the rate until the end of the interest period.
Ivan Harkins, a director at JCRA, the financial risk consultancy, points out that the Bank of England has at least started to look beyond derivatives at the broader financial markets and how they can transition to an alternative rate, and specifically how to incorporate a term rate – arguably the main requirement of real estate.
“That’s the task for 2018 – to figure out exactly how that term fixing will work and then start producing it, so essentially you get a track record before going live,” he says. “You don’t want the derivatives and lending markets to move out of sync with each other. I think that’s the biggest risk for real estate investors – you start to see a mismatch between how you can hedge and what your loan does. That mismatch can be either one is lagging a year or two behind the other or that the price impact from making the changes is different. Ultimately, unfortunately, that often leaves the borrower in a worse position if there is a differential in treatment between the two different markets.”
Assuming the Bank can address such concerns over the new benchmark, Harkins suggests that “long-term it’s probably a pretty neutral change” for real estate lenders. It’s a big assumption though, given that the next few years look potentially fraught with problems, not least because of what Harkins calls the “deadweight cost” around renegotiating and amending contracts to reflect the new benchmark.
In its letter to the US Federal Reserve, CREFC sounded an even more ominous note by expressing “some concern that Libor rates may cease to be published before the scheduled phase-out at year-end 2021 because of potential litigation risk surrounding inadequate transaction volume to support Libor”.
Real estate may yet benefit from a robust replacement for Libor, but right now it looks like the early winner will be the legal profession.
THE RISE AND FALL OF LIBOR
Published by the ICE Benchmark Administration (IBA), the London Interbank Offered Rate (Libor) has become a cornerstone of loan and derivative markets since its introduction in 1984, with more than $350 trillion of contracts referencing the rate.
The fundamental problem with Libor, however, is that the volume of business on which it is based has shrunk since the financial crisis, meaning that banks use their judgment rather than transactions to calculate the rate.
The potential for error is much higher – and manipulation, which reared its head in the rate-rigging scandal of 2008 and is being played out in the courts to this day.
In a July 2017 speech, Andrew Bailey, chief executive of the FCA, claimed that in some instances banks were estimating their costs of funding daily for currencies and maturities in which the actual frequency of transactions was fewer than 20 per year.
Though the IBA has indicated it may continue to publish the benchmark, Bailey stated that the FCA will no longer encourage or compel panel banks to submit to Libor post-2021.