It is time to start originating Single Asset Single Borrower (SASB) large loans priced on SOFR. There, I said it. Not just LIBOR indexed loans containing a SOFR fall back when LIBOR inevitably goes away, but new loans indexed to Compounded SOFR, implementing all the necessary tweaks to documents, systems and processes to make that work now!
LIBOR is going away soon. Hopefully this isn’t news. Regulators have been pretty clear on how LIBOR will end. Most likely, just after close of 2021, a number of panel banks that currently support LIBOR will take up Mr. Bailey’s offer and stop making LIBOR submissions. When that happens, the Financial Conduct Authority (the FCA), LIBOR’s regulator in the United Kingdom, will announce that LIBOR is no longer representative. All prudentially regulated banks and probably most lenders which have not already stopped quoting LIBOR will move immediately to SOFR. While there is some risk of a zombie LIBOR in the market (which could particularly complicate dealing with the legacy book), ICE Benchmark Administration (IBA), LIBOR’s current administrator, has said that it is not in the business of publishing an unrepresentative rate and so, even if the IBA continues to publish a LIBOR rate after the beginning of 2022, it won’t be for long (i.e., a period of months, not years).
At this point, given how the regulatory constituencies have rallied loudly behind SOFR, there’s very little chance that SOFR won’t be the new across-the-markets index. Attempts at developing other rates have been stymied. Consider the IBA’s first draft of the Bank Yield Index, which enjoyed a resounding “meh” from members of the official sector and was subsequently taken back to the drawing board. While there are some other thoughts and ideas in circulation, it seems to us that this ship has sailed and SOFR is it.
When the market became aware a few years ago that LIBOR was going away, the most forward-thinking lenders began to adjust the boilerplate around the unavailability of LIBOR to the realities of the non-LIBOR world, often replacing considerably problematic “boilerplate language” that really was inapposite for the realities of a LIBOR termination. In many cases, this new language provided considerable flexibility to the lender to select an alternate rate.
In the past half year or so, however, large lenders are increasingly acknowledging that SOFR will be it. For instance, since August most floating rate securitizations have come to market with an explicit SOFR backstop, and we expect that trend to continue unabated in both the CRE CLO and the SASB floating rate marketplace.
At this point, the momentum around SOFR is growing. Freddie Mac has now sold bonds priced off SOFR (albeit backed by LIBOR-priced loans with the attendant mismatch that that could entail) and multiple large corporate debt deals have been done using SOFR as well. The SOFR-based derivatives market is growing quickly. Other LIBOR-replacement rates, like the SONIA rate in the UK, are also beginning to be widely used. Just within the past few weeks, the regulators on both sides of the pond have, reacting to an increased regulatory anxiety about the lack of progress on LIBOR transition, fired a shot across the bow to endeavor to get more attention on the issue. In late December, the New York State Department of Financial Services sent a letter to all regulated institutions (which is a rather broad category in New York) demanding that each institution deliver its LIBOR transition plans by February 7, 2020. This will come as a surprise to many institutions (practice point: If you operate in New York, please take a look at the applicable regulations to see if you are a regulated institution – it’s not just banks).
Across the pond, in early January the Bank of England and the Financial Conduct Authority demanded clear evidence of the engagement on the issue from all institutions subject to their writ.
And, Yikes! Pay attention to this: The BOE said it is “keeping the potential use of supervisory tools under review,” if it perceives the market is failing to make real progress toward transition. The stick is now in the velvet glove.
So everyone in the financial services sector, at this point, should be aware that, notwithstanding the relatively glacial progress made to address the LIBOR transition to date, the regulatory clock is tick-tocking away and LIBOR will be gone sooner than can be comfortably addressed given the progress the market has made to date. During the next two years, regulatory pressure will only intensify (and how much fun will that be?). More constituencies will begin to demand SOFR pricing and visibility to what SOFR pricing will do. And how about this – my suspicion is that some investors may, over the next couple of years, find that their inability to precisely define the coupon on a floating rate bond may be unacceptable, causing bonds with such indeterminacy to become ineligible assets. That’s going to have a negative impact on value and certainly will not be a positive for liquidity.
Consequently, not engaging now will only make problems of this transition process worse. Kick-starting change now will facilitate stable liquidity and develop stable mechanics for transition and that is an unalloyed good. If market participants are left to their own devices without leadership, there will be increasing pressure toward heterodoxy in transition mechanics and there will be more chaos as we get close to the deadline. None of that will be at all productive.
That’s why we think the market ought to begin to move now and not wait for the inevitable. While I’m as big a fan of procrastination as the next chap, it is generally considered prudent to pull the ripcord before you hit the ground.
To do a SOFR deal will, admittedly, require some heavy lifting. The currently available SOFR-based index is Compounded SOFR, a backward-looking rate, not determined until the end of the related interest period. How to calculate a spread is not clear. Only this week did the ARRC publish a consultancy paper on spread adjustment, asking the questions but not answering them. (But note, the ARRC’s consultation makes pretty clear that it has entirely given up on a dynamic adjustment factor. While not the topic of this screed, that is not good news at all. More on this later.) Deciding how to use this backward-looking rate, making a spread adjustment and doing all the myriad things necessary to rework the plumbing to make SOFR work, is going to require considerable rethinking of standard operating procedures. There is some help on documentation as the LSTA recently released a concept credit agreement which can serve as a jumping off point. Lenders will need to convince their borrowers to move. Servicers will need to change their systems. Bankers will need to talk to investors. You will have to talk to the back office to see if they can analyze credit and exposure based on SOFR as opposed to LIBOR. I have no idea whether systems are ready to do that or will be ready to do that any time soon, but I don’t think we can wait.
A forward-looking Term SOFR rate, when it is available, will solve some of these challenges. However, waiting is not a strategy. While ARRC has generally done well sticking to its timetables, even the ARRC admits that getting a functional and market acceptable forward-looking Term SOFR will not be easy and they may not get there any time soon. In any event, it’s not promised until sometime in 2021, and let’s all remember that Murphy’s Law is alive and well in regulatoryland. Hoping for Term SOFR and then scrambling to sort out how to deal with Compounded SOFR late in the 4th quarter of 2021 sounds like a bad idea.
Consequently, we urge market leaders to become early adopters of Compounded SOFR. There are significant benefits to the early movers. They will build a brand amongst the investors who either have already or will be embracing SOFR soon. Many institutional investors have already indicated a strong desire, if not an imperative, to move to SOFR pricing and the institutional borrower community who are users of large credit are sophisticated and can be as forward-thinking as the lender marketplace. Being first mover will create an experience base to facilitate maneuvering through the chaos of a hard stop in late 2021. However hard this is going to be to do, doing it in the chaos of late 2021 as the helicopters are leaving Saigon will be harder and is not the answer.
Also, there’s the bragging rights. There’s the ability to say you helped the market writ large get through this mess and the markets need help. It is not at all clear as to how and when the ordinary course market will permit a move. The middle market is far from aware of the issue. We remain unconvinced that transitioning the legacy book for the middle market to the new rate will be anything except extraordinarily hard.
Leadership from the large loan market can ameliorate some of these problems. It could raise the issue and raise the acceptability of the alternate rate. Someone is even likely to say thank you.
So it’s time to start working through the challenges and solve the operational issues. We need to press the system designers to provide operational back office support, work with the investors to agree to mechanics and start developing a stable and straight ecosystem around SOFR.
So there’s really good reasons to get this done now and while kicking the can down the road is a respected and hoary tradition, it’s time to fix this. We’re not really going to get a lot smarter between now and 2022, and any steps to avoid a chaotic transition in late 2021 will pay dividends.
So let’s embrace bragging rights! Early adoption SASB transactions will make it considerably easier for the rest of the market to move and might help the entire sector as some of the chaos around the 2022 cliff begins to be managed.
So, have at it folks. (And, of course, a shameless plug, we at Dechert will be delighted to help you do so!)
