In 2012, the financial world was shaken when news came to light that the London Interbank Offered Rate, or LIBOR as it is commonly known, was being manipulated. LIBOR is a rate based on the nightly quotes of the largest global banks for what borrowing rate they are willing to accept from other large banks. From at least 2005 to 2012, bulge-bracket banks such as Bank of America, JP Morgan, and Credit Suisse, colluded with each other, reporting artificially high or low interest rates for profit. In 2017, the global financial system agreed to transition away from LIBOR. UK’s Financial Conduct Authority, which regulates LIBOR, has made it clear that the publication of LIBOR is not guaranteed past 2021.
Alternative Reference Rates
A smooth transition to a new, floating-rate benchmark is crucial, considering that LIBOR is embedded in over $300 trillion worth of global financial products. According to financial solutions firm, Finastra, the shift away from LIBOR could cost financial markets worldwide more than $8 billion. However, cost is not the biggest obstacle. LIBOR is used worldwide, but the alternative reference rates (ARRs) that are replacing the former benchmark, differ country-to-country (see table below).
Secured Overnight Financing Rate (SOFR)
In the United States, the Secured Overnight Financing Rate, or SOFR, is supplanting LIBOR, becoming the new standard for measuring short-term borrowing costs. SOFR is calculated using a median of rates that measure the cost of borrowing cash overnight, utilizing Treasurys as collateral. Unfortunately, the differences between SOFR and LIBOR are substantial and complicating the transition process.
SOFR Versus LIBOR
First-off, SOFR relies solely on transactional data, while LIBOR is partially set on what the International Exchange Benchmark Administration (IBA) calls “market and transaction data-based expert judgement.” Secondly, SOFR only has an overnight rate, whereas LIBOR has seven varying-rate terms from one day to one year. Finally, unlike LIBOR, SOFR has virtually no credit risk component because it is backed by the U.S. Federal Reserve. However, the rate fluctuates with monetary policy and generally acts differently than LIBOR. For example, when the Fed cut the federal funds rate to zero back in March 2020, SOFR declined while LIBOR increased.
Impact on Commercial Real Estate
To compensate for the aforementioned discrepancies, every LIBOR-based contract needs to be renegotiated to include SOFR plus a spread. The issue here is that estimating a fair market spread for such a nascent reference rate is challenging, given the lack of market data. Therefore, PwC’s US LIBOR Transition Leader John Oliver urges borrowers to shop around and obtain bids from multiple lenders.
While some may be tempted to wait, procrastinating on floating rate renegotiations could result in a wider spread, costing the borrower more than if he had acted sooner. With everybody running to the banks at the same time, the volume of debt being renegotiated could be overwhelming. The Mortgage Bankers Association (MBA) values the CRE floating-rate financing market at $1-$1.5 trillion or 30-50% of total outstanding CRE debt.
In order to mitigate risk, Moody’s Senior Vice President-Manager Anthony Parry recommends including standardized “fallback” clauses in new contracts. These clauses should specifically state how LIBOR and SOFR discrepancies will be handled. Looking ahead, the greatest obstacles facing the adoption of alternative reference rates are the establishment of sufficient liquidity and market standards. If these issues are left unresolved, both existing and new LIBOR-linked contracts face an augmented likelihood of credit negative effects such as inadequate hedging and elevated costs.