It probably goes without saying, but not all loan indices are created the same. Everyone can look at different risks or markets, and not all indices are “plug and play” for commercial loan transactions. As most have heard, LIBOR is set in several phases. The first phase being the termination of the 1-week and 2-month LIBOR rates as of December 31, 2021. The second phase interrupts the 1-month, 3-month, 6-month and 12-month LIBOR rates as of June 30. , 2023.
Banks and government entities feverishly researched various indexes and drafted examples of transitional language, and by the end of 2020 it emerged that in the United States the approved and most widely used replacement for LIBOR would be the guaranteed overnight rate (SOFR). . In recent months, however, many banks and borrowers have started to question whether SOFR is the best substitute and have started looking at other indices, particularly the Bloomberg Short-Term Bank Yield Index (BSBY) and the American. Interbank Offered Rate (AMERIBOR).
These indices and possible LIBOR replacements are not the same and are not equal. With just four months to go before the first transition, below you’ll find answers to some frequently asked questions to help you understand LIBOR replacements and the steps you need to take now.
Question: What are the main criticisms of SOFR?
Reply: The SOFR pioneered and became the first widely endorsed replacement by large banks, government entities, and private market committees formed by the Federal Reserve, such as the Alternative Benchmark Rates Committee. There are, however, some criticisms of SOFR. First, LIBOR incorporates banking risk; SOFR never will (that’s really the interest of the secure overnight finance rate – it’s a risk-free rate). Second, the SOFR is a retrospective index based on the cost of transactions in the overnight buyback market. While many banks and regulators preferred this as a replacement for LIBOR, many began to question whether a retrospective index was really comparable to LIBOR – which is a forward-looking index. The response to these concerns has been the creation of “Term SOFR”, a series of forward-looking SOFR benchmarks issued by derivatives exchange operator CME Group Inc.
Question: Why are the BSBY and AMERIBOR options attractive?
Reply: Despite the creation of Term SOFR (which may present other issues including potential product lags and interest rate swap calculations), some smaller national banks as well as community banks have continued to seek replacement. more suitable for LIBOR and have largely settled on BSBY and AMERIBOR. . BSBY and AMERIBOR are both unsecured rates (unlike SOFR which is a secure rate) which by definition carry higher levels of risk and therefore tend to generally provide a higher rate of return. Clearly, BSBY and AMERIBOR will generally be higher indices than SOFR, however, the increase in the index can be offset by the margin or interest rate spread – which is fully tradable. BSBY and AMERIBOR are both forward-looking rates similar to LIBOR, and both incorporate banking risk but may be subject to greater volatility and may consider a wider range of products to generate the rate. For example, BSBY takes into account certificates of deposit and larger deposits in order to achieve critical mass and may not have the LIBOR or SOFR term options. In comparison, AMERIBOR currently has a 30-day forward rate, but nothing beyond.
Question: Are other clues being studied?
Reply: There are several other alternative indices being considered by governments, government entities, central banks, national banks and community banks. Although many lenders and borrowers “shop” their index based on the lowest monthly payment or best rate of return, more focus should be placed on the long-term trends and costs associated with a particular replacement index (as well. than other factors, such as if there are discrepancies with the index selected during its permutation).
Question: What steps should commercial borrowers take now?
Reply: With some of the LIBOR indices set to cease at the end of 2021, and others on the horizon due to cease on June 30, 2023, borrowers must take an inventory of their commercial borrowings and determine which, if any, of these. Loans have interest rates based in whole or in part on LIBOR. If so, and if the borrower hasn’t started a conversation with their lender (or vice versa) about what will replace LIBOR-based borrowing, now is the time to have those conversations and figure out what is the best way forward for the lender and the borrower. During these conversations, it should be clearly communicated and documented what the alternatives are, what will be the cost of the alternatives for each party, and what changes need to be made to existing loan documents to implement these changes.
Question: What are the areas that borrowers should pay special attention to?
Reply: If any of the borrowings are subject to an interest rate swap, cap, tunnel, or other derivative, the above conversations should include which replacement index will come into play. force under the derivative and how that index will compare to the proposed replacement index under the promissory note. Be very careful in this analysis as index deviations can have very costly results. Additionally, if the commercial loan has a LIBOR floor (language of the promissory note indicating that LIBOR will never fall below a certain predetermined threshold), borrowers should be extra careful to ensure that any spread adjustment , when factored into the new (which may or may not have a floor of its own) results in the same or roughly the same monthly payment as with the LIBOR rate.
The bottom line is that the more options available to a borrower the better, but you need to be careful and deliberate in your consideration and final choice of a replacement rate because today’s cost may not be the cost of tomorrow.[View source.]