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REAL ESTATE MERCHANT BANKING
On April 3, with little fanfare, the Fed’s Alternative Reference Rate Committee (ARRC) started publishing the Secured Overnight Financing Rate (SOFR) that is slated to replace LIBOR in the US. This is an important first step in the transition away from LIBOR that is scheduled to expire in 2021. It is estimated that the US financial markets have $200 trillion of debt with LIBOR exposure; of this, approximately $1.1 trillion is commercial real estate (CRE) debt and securitized CRE debt. This pervasiveness requires a complex multi-year transition, but there is uncertainty as to the extent of progress that can be made before 2021.
As the chosen alternate reference rate, SOFR’s implementation into the financial markets is under tight scrutiny. Future borrowers will need to be educated on the key differences between the SOFR and LIBOR rate calculations and how these differences will affect their loan products. For current borrowers with products expiring beyond the three-year window, it will be critical to understand the contract terms in-place and how the banks are planning to manage the transition.
LIBOR Background
The UK’s Financial Conduct Authority announced last year that by 2021 UK Panel Banks will no longer be required to submit the rates that are used to calculate LIBOR.
Although the FCA’s announcement came just last year, LIBOR has been under fire since the price-fixing scandals that came under investigation in 2012. The resulting backlash prompted financial regulators to scrutinize the flaws of LIBOR, and thus illuminating LIBOR’s liability and inaccuracies. Banks have shifted away from unsecured term lending (amongst themselves) following the financial crisis, and as a result interbank lending market volume has declined significantly whereby current lending volumes are insufficient to set the Benchmark Rate. This gives more control to expert judgement to set the rates rather than actual term pricing. Participating banks are keenly aware of the liability when submitting judgement based rates, in particular amid the current heightened regulatory climate. These concerns of inaccuracy and liability directly led to the ARRC’s decision to publish SOFR.
SOFR and the Path Forward
OFR is an overnight Treasury repo rate (repo, short for repurchase agreement, is a form of overnight borrowing by dealers in government securities) with underlying volumes larger than any other money market rate in the US. This robustness was critical in the ARRC’s evaluation, as this solves the critical flaw of LIBOR. With daily volumes recorded over $700 million in 2017, the SOFR market dwarfs LIBOR and other proposed alternate rates. Given the robustness of daily volume and representation from a wide range of market participants, SOFR is slated to be resilient over time and capable of underpinning trillions in contracts.
Challenges Facing Borrowers
here is a significant challenge that has the potential to impede conversions of longer-maturity LIBOR benchmarks. LIBOR rates are currently quoted for daily, 30-day, 90-day, six-month, and one-year terms. Because SOFR is an overnight rate, the ARRC proposed that lookback averages be used. This averaging makes the rate less volatile but slower to react to current market conditions. As well, it is important for borrowers to understand that Treasury repo rates (secured) are traditionally lower yielding than unsecured term rates like LIBOR that have a credit component and thus are not directly interchangeable. As a result, lenders may need to alter (widen) the credit spreads for loans associated with SOFR vs LIBOR. This transition from one index to another mid-loan term will be challenging to implement and likely cause friction between lenders and borrowers if not properly documented at loan origination.
While this is simpler to digest moving forward, financial market participants need to understand the complexities of rate conversion and the faults of fallback provisions as they currently exist in contracts.
Conclusion
Over the next three years, lenders and borrowers will need to become familiar with SOFR and the mechanics of it. This will be especially important for longer-term loans that will mature beyond 2021 and thus be exposed to an index change during the loan term. However, in the long term, SOFR should be regarded as an “upgrade” to LIBOR due to its inherent transparency that results from the significant daily trading volume in the underlying repo market.
This article originally appeared in the summer edition of CRE Finance World 2018.