In the words of Jerry Garcia, “You don’t want to be the best at what you do, you want to be the only one.”
For over two decades, the London Interbank Offered Rate (LIBOR), the interest rate banks offer to lend funds to each other in the international market for short-term loans, has been the index predominantly used worldwide as a benchmark for financial instruments including floating-rate loans on real estate mortgages. There are over $350 trillion of global financial products that use LIBOR as a benchmark (from 30-day to a one-year term). What is truly mind-boggling is that the daily trading volume of LIBOR is less than $1 billion a day. To compound the thinness of the market, LIBOR is manually set by using an average of 18 member banks’ daily submission to the Intercontinental Exchange. The fact that LIBOR is both thinly traded and manually set is why it is prone to manipulation. This has been the subject of lawsuits and rigging by banks to enhance their books. Billions in fines were paid due to the LIBOR rigging scandal and one former UBS and Citigroup trader even went to prison for 11 years as a result. After 2021, about one-half of the member banks aren’t even going to be required to submit LIBOR rates daily. Therefore, the Alternative Reference Rates Committee (ARRC) was formed in 2014 and is recommending alternatives to LIBOR being used at the end of 2021. This has widespread implications that has only been scantily reported despite the wide-reaching ramifications for, among others, real estate owners.
While ARRC has focused on three possible indices that can replace LIBOR, the strong favorite at the moment is SOFR (Secured Overnight Financing Rate). It is liquid (nearly $800 billion of daily trading) and is secured by Treasury securities, so it is effectively a risk-free trade that is overnight (for now). The rate has essentially mirrored LIBOR over the past couple of years (though it is consistently a few basis points lower than LIBOR) with less of the gyrations than LIBOR experiences during exogenous shocks. Note that the changeover from LIBOR to SOFR is not yet a done deal. Critics state that the collateral price of even a secure instrument like SOFR could fail in a crisis and that it should incorporate the credit quality of the Treasury collateral pledged, and not the price of that collateral. Meanwhile, some banks could resist and use the Prime Rate or the Federal Home Loan Advance Rate as alternative. Switzerland is using its own alternative—SARON—the Swiss Average Rate Overnight.
Why should you care? Well, in many cases, there is no fallback language within current loan documents for loans that have maturities after 2021. For those that have any language at all, banks commonly state that any LIBOR replacement will be “determined by [the] lender in its sole judgement” and “if there is any ambiguity, [the] lender’s judgement will be dispositive.” That certainly doesn’t inspire a warm, fuzzy feeling and could expose borrowers from unanticipated interest rate spikes. As an adviser, you should examine your clients’ financial contracts to determine which documents reference LIBOR. Preferable language would be similar to what Fannie Mae recently used on documents that specifically recognized the end of LIBOR. It stated that if LIBOR “is no longer widely accepted or has been replaced as the Floating Rate Option for similar financial instruments,” they will “use a new Floating Rate Option taking into account general compatibility.” The Fannie Mae language further claimed that it could include a “credit spread adjustment” that I would certainly try to eliminate or minimize, if advising the borrower.
Dan E. Gorczycki is a senior director with Avison Young and specializes in arranging all tranches of the capital stack—debt, mezzanine and joint venture equity.