The ARRC Consultation on Spread Adjustment Methodologies for Fallbacks in Cash Products Referencing USD LIBOR is finally here.  How the spread adjustment from LIBOR to a SOFR index will be calculated is one of the more consequential open items on the ARRC’s to-do list.

The core question in the consultation is whether or not the methodology for determining the spread adjustment for cash products should be consistent with the methodology that is expected to be adopted by the International Swaps and Derivatives Association (ISDA) for derivatives.  That would mean adopting a fixed spread adjustment set on the business day before the related benchmark transition event, based on the median difference between LIBOR and the related SOFR index over a five year period.  The ARRC’s best argument here is that being consistent with ISDA might reduce “operational, legal, tax, accounting and similar issues between loans, securitizations and notes and any related hedges.”  Unfortunately, there is a real, continuing disconnect between cash products and derivatives since ISDA has not yet adopted a pre-LIBOR cessation benchmark transition.

The white paper also makes the case for a one-year spread adjustment transition period (which ISDA appears to have rejected after their last consultation), arguing that such a transition period could avoid an interest rate “cliff effect” if the difference between LIBOR and SOFR is historically high during the LIBOR transition.  The one year transition period is a big issue that everyone should look closely at before responding to the consultation.

Attached to the consultation is a white paper with about 30 dense pages of economic and policy arguments and a few interesting tidbits.  For example, the ARRC has not ruled out the possibility LIBOR could go away before January 1, 2022.  There are also a few gaps in the presentation.  Apparently, the ARRC is only considering making a recommended spread adjustment for those who have adopted the “hardwired” ARRC fallbacks, potentially leaving those in the industry who have been using the amendment approach the flexibility to use some other spread adjustment method.  The consultation also doesn’t address any potential spread adjustment recommendation for moving from one SOFR index to another, such as might happen in securitizations that move from Compounded SOFR to Term SOFR.

Market participants need to analyze this issue carefully and respond by the March 6, 2020 deadline.