Night of the Living Dead: LIBOR Playing a Zombie in a Reality Near You!

 

iStock / gremlin

LIBOR is going away, but that’s sort of old news at this point.  However, it has been received wisdom that only after the Bank of England stops imposing an obligation upon member banks to publish LIBOR quotes as at the beginning of 2021, would LIBOR go away and then we would need a replacement.  That’s troubling, but of course most of us have plenty of other more immediate things to worry about between now and 2021.  (NY Football Giant’s 2018 Season, impeachment, drone assassinations, hand size, etc.)

Here’s the deal. We’re not going to have all that time to get a LIBOR replacement right.  It’s nightfall in our zombie movie and it’s always a bad sign when the mostly dead are shuffling about.

At the Alternate Reference Rate Committee (ARRC) Roundtable at the Federal Reserve Bank a couple of weeks ago, I, at least, was shocked to find out how breathtakingly thin the actual data behind LIBOR is day in and day out.  Folks, it’s a $200 trillion market and the median daily number of actual borrowing transactions which are observable in the marketplace in Q2 2018 for 1-month LIBOR was five.  Five, that’s not a typo.  Five.  Now, we’ve always known that LIBOR is a bit of a shell game where reporting banks generally report the interest rate that they would borrower at if they did borrow, but of course, they don’t.  The LIBOR quotation process has always had a certain number of actually observed transactions floating like raisins in the rather odious blancmange of a made up data set, but only five actual quotations?  We’re moving trillions of dollars of cash and synthetic product based on that little bit of real news?

LIBOR has been in the news for quite a while, ever since we confronted the fact that it’s largely a fabulist invention.  However, the focus has been on prosecuting traders who allegedly diddled the process (Diddling data fields which, in the first instance are entirely made up, is sort of an interesting thought exercise, don’t you think?  Can you fake, fake news?)  Maybe justice must be served, but in the great scheme of things that was a distraction.  If we end up with a sloppy end of LIBOR without a transition to a new reference rate, it will be bad. This is not Y2K.

We have a process underway designed to replace LIBOR.  It’s deliberative and it’s gradualist and it’s linear.  At the ARRC roundtable, Fed officials even bragged that we’re about six months ahead of the schedule they set in their Paced Transition Plan, but remember that Plan contemplates the presumed successor to LIBOR will only be available on January 1, 2021.  Taking just in time inventory just a bit too far if you ask me.  This effort will be frustrated by a disorderly early collapse of LIBOR.  We need to take that risk seriously.

I’ve been saying in this commentary for some time that I thought a significant risk here was that LIBOR would go away before 2021 because it’s simply not a reliable measurement of any reality.  Now, that we have been forced to confront the fact, it should be almost intolerable to continue to rely upon this reference rate.  How do we justify waiting for 2021?

Andrew Bailey, the head of the UK Financial Conduct Authority (FCA) that is responsible for overseeing LIBOR, said in July that the FCA could declare LIBOR nonrepresentative if it thought LIBOR was no longer a reliable basis to benchmark trillions of dollars of transactions.  No longer reliable?  Was it really ever?  If the FCA declares LIBOR nonrepresentative then, under the EU Benchmark Regulation, supervised firms in the European Union, including financial institutions, exchanges, trading facilities and clearing houses, would only be able to use LIBOR for legacy contracts and not new business.   The Federal Reserve Vice Chairman for Supervision Randal Quarles in his prepared remarks at the ARRC meeting directed markets to take note.  Read the tea leaves folks: LIBOR is not making it to 2021.  And the only thing worse than a disorderly handoff from LIBOR to SOFR on a date certain is to have LIBOR and SOFR both published and used in tandem for a considerable period of time.  Can you imagine the dissidence in the borrower and counterparty community when efforts are made to switch to SOFR under these circumstances?  Winners and losers will abound.  Call the trial lawyers!

This all is very troubling because notwithstanding all of the committees, task groups, study groups and industry forums that have been organized to think about LIBOR, there’s very much more sound and fury than light right now.  We’re still fixing to address the problem with the sort of desultory absence of urgency long associated with southern climes.  A good process is fine when the risks are at a certain remove, but we no longer have that luxury.  The silver is all lined up neatly in the silver chest and all the chairs are put away, but we’re still on the Titanic.

We need an executable plan for LIBOR replacement now.  We need a plan that could be implemented as early as next year.  We’re not going to get any smarter.  It’s time to stop studying and start doing.  We need to make decisions.

While there may be other runners still in the game, the Secured Overnight Financing Rate or SOFR, a rate derived from overnight repos of treasuries seems the consensus choice as the basis for the new reference rate.  In some quarters, alternatives are still being considered.  This should stop.  SOFR is already trading in a semi-robust way and producing real pricing from real trades.  Shocking! We’ll actually price financial assets off real trades.  Let’s embrace SOFR and move on.

We’ve had some very productive conversations about how SOFR, an overnight, largely riskless rate, can be utilized to determine term rates and how to address a riskless rate as a reference rate.  Industry groups have come up with a pretty good answer.  We will use a hierarchy of SOFR derived rates based on what’s available at that time.  If we have published term SOFR, fine.  We’ll use that (maybe we will have a term SOFR sometime in early 2020…maybe).  If we don’t have term SOFR, then we’ll use interpolated term SOFR.  This could be derived from a futures product that exists now and is likely to grow more robust over the next few years.  If neither of those exist, we use spot quotes or average spot quotes.  Not perfect but it’s an answer.

There is lots of palaver on what triggers the swap out of SOFR for LIBOR.  There are two important questions here.  The first is when and the second is who says.  On the first, there are institutions saying we need to phase SOFR in over a considerable period of time but others say we need a hard date or a date certain. I don’t know the right answer here, but we need to get that nailed down.  None of these options are perfect, but it’s likely that all can be made to work.

Who drops the flag and commences the race to transition?  Will it be the Treasury?  Do we switch when the prudential regulators tell the banking community that it’s no longer prudent to price assets off LIBOR?  Maybe we should take our lead from the GSE’s.  Can we have industry groups get together and decide when to do it?  I don’t know the answer, but again – all will work.  No choice is perfect but we need to decide and decide now.

We’ve had lots of conversations about how to spread adjust SOFR to reflect something that looks like current LIBOR.  Remember LIBOR is a rate that has economic risk baked into it.  SOFR does not.  How do we adjust one to look like the other?  This is an important question for the legacy book, which no matter how many folks try to dismiss it as a real problem, remains a very real problem, and will continue to grow as a problem until the new rate is fully implemented.  Pick something and stick with it.

Finally, we are talking about the fact that our Zombie LIBOR may get even more zombie-like before we’re done.  A zombie of a zombie, if you will.  As mentioned above, it may be that LIBOR remains viable for legacy deals through 2021 while SOFR is used for new deals.  All of which may be happening against a backdrop of various regulators essentially continuing LIBOR, a no longer reliable reference rate.  One shudders to think of the chaos when borrowers are confronted with their lenders purporting to change the interest rates on their loans by using SOFR when something called LIBOR is still being published and used.  Wash, dry, fold and repeat!  Call the trial lawyers!

We also need to talk about operational difficulties.  In my securitization world, no one has adjusted the data collection or data transmission medium to account for a new index rate, a new spread and a new interest rate.  No one is really certain who will make the decision in securitization.  No one has really comprehensively reviewed their book to see what their existing alternate rate language is, let alone begin to install uniform industry-wide alternate rate language.

Progress has been made, but we’re nowhere near ready.  Look, unless we’ve decided to have the government somehow legally mandate a switch out of one rate into another, which seems both inadvisable and frankly, impossible, the decisions to change the reference rate are going to be deal by deal, instrument by instrument, participant by participant.  At best, that screams chaos.  However, if large segments of the market could move quickly and decisively to embrace a general consensus around the half dozen critical questions discussed above, some of that might be avoided.

Did you happen to see the FT’s article from Sunday, August 5th entitled “Banker warns of Herculean task to escape Libor’s tentacles by Joe Rennison and Robin Wigglesworth?  This article highlighted the problem that as our committees and study groups, bureaucrats and Wall Street types have been beavering away at the LIBOR problem, an awful lot of folks in the financial marketplace writ large have not yet noticed that LIBOR is going away.  Are all mortgage bankers, borrowers, service providers, the folks at our 7,000 sub-regional banks paying any attention?  Right now, recognition of the problem and the thinking about the fix seems to be largely confined to a small coterie of money center banks, major investors and Wall Street players.  That won’t work.  Even if we declare victory and agree on a new reference rate, agree on when the reference rate should be swapped in, agree on how to calculate that rate, agree on who tells us when the transfer will occur, it will be chaos unless the vast majority of participants in the financial marketplace are really tuned into the change and ready to move.  If we had two plus years to educate about the orderly transition to SOFR that might not be a terrible thing here in the dog days of summer 2018, but if I’m right and LIBOR is going away sooner, this lack of understanding across the marketplace about when LIBOR falls will greatly exacerbate the problem.

All that is a heavy lift and while, if we had two and a half years more to get this right then we probably would.  But now, I don’t think that’s true.  My guess is that someone is going to announce the emperor’s got no clothes and LIBOR is an inappropriate reference rate for market transactions sooner than that, and in that case those chomping zombies will be among us with a vengeance.

What’s to be done?  Accelerate the process of getting to a solution.  Eliminate self-congratulations for a good inclusive process, start to scramble for a solution and educate the markets.  If we don’t have a pretty good handle on a solution by the end of 2018, shame on us.

 

The Winter of Our Discontent May Be Over (If you are a Distressed Debt Investor)

You can never go wrong starting off a commentary with a butchered bit from the Bard, right?  “Now is the winter of our discontent” spake Richard III, an unamiable leader perhaps reminding us all today of our unamiable governing class.  Old Gloucester rhymed to presage war and chaos.  Apparently, all that happened because the poor dear couldn’t buy himself a date.  But hey, chaos, war, desolation, burning and pillaging, etc., aren’t all bad, that is, if you are equipped to enjoy the carnage.

And now, back to the market.  What am I rambling on about?  Distressed debt opportunities are coming back.  This is the silver lining, at least for some, in the cracks beginning to develop in our long, Goldilocks credit cycle.  A slowdown is not here yet, to be sure, but it’s time to sharpen the knives and begin to think about our opportunities.  Continue Reading

Repost: In Defense of Securitization – Unto the Breach or Close the Wall Up with Our Dead (with Apologies to Mr. Shakespeare)

We published the below commentary, In Defense of Securitization, last week and we are republishing it today as, let’s face it, we’re all getting very French, and many of us took most of last week off.  Enjoy, if that’s the right word.


Returning to the theme of my most recent commentary entitled God Hates Securitization, I want to elaborate on the point I made there (yes, if you stuck with me all the way through to the end, there was a point):  We need to fight the narrative that banking, finance and securitization are evil.  I am afraid that if we don’t do something here soon, we’ll wake up one morning (probably after the next cyclical downturn is underway) and find pitchfork-wielding villagers outside the gates thinking they have found Dr. Frankenstein’s monster.  Populist anger, whipped up by our critics demonizing the financial sector, unfettered from the necessity to defend these positions in the marketplace of ideas and the court of public opinion, is powerful.  That, coupled with our recent embrace of the weaponization of policy disputes enforced by both civil and criminal legal proceeding, should frighten all of us who make our living in the financial sector.  And, to be clear, it should frighten everyone who understands the importance of an efficient and liquid capital market for the continued success of the US economy. Continue Reading

In Defense of Securitization – Unto the Breach or Close the Wall Up with Our Dead (with Apologies to Mr. Shakespeare)

Returning to the theme of my most recent commentary entitled God Hates Securitization, I want to elaborate on the point I made there (yes, if you stuck with me all the way through to the end, there was a point):  We need to fight the narrative that banking, finance and securitization are evil.  I am afraid that if we don’t do something here soon, we’ll wake up one morning (probably after the next cyclical downturn is underway) and find pitchfork-wielding villagers outside the gates thinking they have found Dr. Frankenstein’s monster.  Populist anger, whipped up by our critics demonizing the financial sector, unfettered from the necessity to defend these positions in the marketplace of ideas and the court of public opinion, is powerful.  That, coupled with our recent embrace of the weaponization of policy disputes enforced by both civil and criminal legal proceeding, should frighten all of us who make our living in the financial sector.  And, to be clear, it should frighten everyone who understands the importance of an efficient and liquid capital market for the continued success of the US economy. Continue Reading

CREFC Annual Conference

Last week, the CREFC Annual Conference was back in its traditional New York venue, which benefitted not only the Manhattan hospitality market’s RevPAR but also provided for an exciting and lively location in Times Square.  Dechert’s bash on Monday evening was extremely well attended and the guests were treated to passed hors d’oeuvres and the (pro bono) musings of finance attorneys.  And while God may hate securitizations, we can at least thank her for beautiful spring weather that allowed the 400 Dechert party attendees to enjoy the event on the rooftop patio.

As usual, Dechert CRE attorneys were well represented at the conference with Laura Swihart serving on the Industry Leaders Roundtable and Rick Jones moderating a panel on Alt-Lending (which is less alternative than one might think as evidenced by an abundance of button-down shirts and not even one face or neck tattoo).

While I would never think to suspect Rick Jones of any arrière-pensée in writing the eyebrow-raising blog post titled, “God Hates Securitization?”, the Friday preceding the Monday start of CREFC, the article certainly provided much fodder for debate (whether intended or not) among conference attendees and was oft quoted. Although it would not be hard to predict that real estate finance professionals would generally agree with Rick’s assertion that “securitization is not an evil tool of perfidious bankers, but a critically important component of our economy”, the article proved to be a rallying cry for CREFC attendees to join forces and fight the narrative that securitization is evil.

Nowhere was this more evident throughout the conference than during the legislative and political panel “Fact, Fiction & Fake News.”  The FF&FN panel stressed how extremely unusual the political climate is today with the retirement of ten republican committee chairman, in addition to House Speaker Paul Ryan.  Changes to regulatory policies likely to affect the CMBS industry were also discussed at length, in the usual acronym heavy legislative speak.  If you missed the session, I’ll make a long story short:  The ARRC (brainchild of the FSB and FSOC) prefers the SOFR more than EFFR or the OBFR to follow LIBOR, however, there is concern that the FED won’t deliver a 1MO vs 3MO benchmark by 2021.  In addition, discussions included the HVCRE, FHLB, CECL and GSE Reform.  If you have any questions on the foregoing, you are clearly not from D.C.

Despite the optimistic remarks made in the welcoming speech highlighting the fact that CRE delinquency hit an all-time post-crisis low in May 2018 and CMBS issuance has risen from virtually nothing to a booming $100 billion industry, the CREFC attendees displayed a cautious and somber mien.    The one question that predominated the conference, and led to some fairly awful sports analogies, was “Where are we in the cycle?”  The panelists on the Rating Agency Roundtable, the “CRE-CLOs: Back in Style” panel and the “Alternative to CMBS” session provided answers that referred to innings anywhere from the sixth to the tenth. While I may not be a big fan of the sports ball, I know that when they stop serving beer, it’s time to go home…or is it?

While the buzzword for the Blockchain panel and keynote speaker Randi Zuckerman was “disruption,” the buzzword for lenders was “discipline”.  Banks and non-banks alike assured attendees that the lending practices were disciplined and controlled.  That lending was done based on the quality of the asset, not the exit strategy.  That, unlike smaller local banking institutions, they were passing on borrowers who pushed the envelope too far.  Even the attorneys noted that their clients were coming to them with questions on whether they were going too far, but the ideas were less avant-garde and more “mind-numbingly boring” than what they were being asked pre-crisis.

While the tenor of the conference indicated a creeping sense of anxiety, that feeling seemed to be based on the fact that everything is going well.  Survivors of the great recession, many of the panelists and conference attendees seemed to be suffering from an economic PTSD, which might be effectively preventing us from enjoying a stable and growing market.  Though it also might be what saves us from repeating 2007.  So what do you say, can we take this game out to the 19th inning?

God Hates Securitization?

The Wall Street Journal recently reported that the Papacy has denounced securitization characterizing it (in such an intellectually balanced way) as tainted by “predatory and speculative tendencies.

Good Lord!

Now, I’m not perfect — I can’t remember the last time I participated in a black mass, inverted a crucifix or committed any of the more striking of your basic mortal sins — but I did close a securitization last week and now I’m worried. Continue Reading

“Pop the Champagne but Don’t Get Too Drunk”: HVCRE Reform Passes the House

When House Speaker Paul Ryan announced earlier this month that the House would vote on S.2155, I wasn’t holding my breath (you know you’re on your last lame duck leg when a “senior GOP lawmaker” says you’ve “run out of juice”).

Miracles do happen AND sometimes I love to be wrong (but – shh…don’t tell my husband): In the spirit of deal making, the House just passed S. 2155 (the Economic Growth, Regulatory Relief, and Consumer Protection Act) with bipartisan support (Yup – the Dems and the Republicans did this in both the House and the Senate…maybe there is more to come!). The President still needs to sign the bill before it becomes law, which everyone expects will happen soon. Continue Reading

D.C. Circuit to CFPB: “Go forth and conquer!” CFPB Responds: “No thanks.”

In seven short years, the Consumer Financial Protection Bureau (CFPB) has managed to court controversy across the political spectrum.  Under the leadership of former Director Richard Cordray, the bureau (for better or worse) tested the limits of its jurisdiction and enforcement power in a wide range of areas, including the Home Mortgage Disclosure Act and Equal Credit Opportunity Act, student loan servicing, and let’s not forget the since-disavowed arbitration ruleEnter new Acting Director Mick Mulvaney, who, along with the rest of the Trump administration, is sending the clearest of signals that he does not intend to “push the envelope” at the CFPB.  In short, the CFPB’s mission has turned inward—instead of policing the markets, it’s policing itself and the regulatory state, and with about the same degree of fervor.

Continue Reading

Life in the Silo

We at Dechert had our annual business meeting last week in Miami (tough duty).  Nestled in the general atmospherics of bon ami and collegiality were sessions on collaboration and connectivity amongst the lawyers in our firm.  Apparently the data suggested that law firms make more money when the partners of the firm work together.  Flash.  The mathematical proof of the blindingly obvious perhaps, but just in case, we were stentoriously and with great seriousness told that these conclusions were based on rigorous and exhaustive academic research; research undoubtedly paid for by the American taxpayer, along with other studies of similar compelling import such as why Americans don’t like lice.

But the point here is (and I’m not for an instant suggesting that making money is not a valid point) that collaboration is now essential to getting anything done right because we have all become so damn specialized.

All professionals and business folks, including those of us in Big Law, are under enormous pressure to be intensely specialized yet issues are never so neatly defined by those specializations which all too often also mark the boundaries of our intellectual domains. Continue Reading

I Hear This Cries Out for Regulation!

As we all marinate in the difficulties of Mr. Zuckerberg, who, at the end of the day, can certainly salve any wounds with a net worth measured in the tens of billions of dollars, I was struck by the continued drumbeat for “REGULATION.”  Now, perhaps I am ill equipped to discuss Facebook, not being a participant and therefore never having clicked through a lengthy agreement on privacy (or the lack thereof), but I have some thoughts.  I’ll largely leave the ethics of the privacy contretemps to others, but I was struck by the parallels between the current kerfuffle over Facebook and privacy and the Dodd-Frank mess, lo these ten years past.

Let’s start with this dictum:  Beware the politician bearing new and comprehensive regulatory gifts for the American people. Continue Reading

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