Here’s the headline which I don’t think has gotten the visibility it deserves:
LIBOR will largely end at the end of this year and not in the misty remove of June 2023.
At that point, the regulated banking sector will no longer be able to lend or borrow on LIBOR index financial assets next year. Seven short months. Ready?
The banking regulators told the regulated some time ago that banks should start the transition from LIBOR in June of this year and should be OUT of LIBOR entirely come January 2022. Okay, there will be some exceptions and some vestigial LIBOR activity in the legacy book, but not making the switch will be deemed inconsistent with prudent banking, which I think in regulatory land means you better not do it!
This is big, isn’t it? And, frankly, we really don’t even have the seven months between now and January 2022 to get all this right. The transition is starting now. We should expect the banks, at the behest of their regulators, to begin to pivot out of LIBOR soon after June of this year and by the early fall, the banks will surely begin to largely offer only SOFR pricing. It will probably happen first in the SASB space, but will also hit the general bank loan space, because the banks have been warned not to let LIBOR activity run right up to the doorstep of January 2022, and in any event, who wants to book a loan in LIBOR for a couple of months and then immediately switch to SOFR?
All existing warehouse facilities, whether repo or loan-on-loan, will convert to adjusted SOFR or something else come no later than January 1, 2022. Even if conversion is not hardwired into the documents, the discretionary nature of advancing, under most repo documents would oblige the borrowers to agree to a change in the index. That means baking in basis mix match across wide sectors of the alternate lending space which is a heavy user of repo. Also, late this year, or at least latest in January 2022, US banks providing derivative products, caps, collars, floors, etc., may feel compelled to offer only SOFR based products, even if the underlying loans are LIBOR. Finally, while it’s pretty clear banks won’t have to disgorge assets which are LIBOR based, it is not entirely clear whether and to what extent the banks can continue to make a market in securities with LIBOR pricing. Even if that’s not actually disallowed, it might be the type of activity that’s likely to attract adverse regulatory attention, and who wants that in this time and place, right?
As we said last week, this accelerates the need to answer a number of very basic questions. First, are you okay with the current ARRC immutable 11.5 bps LIBOR adjustment, or do you want to bake in something will contain a credit component? That’s a real choice to be made. It’s a real choice because this transition to ARRC is not a done deal yet (notwithstanding protestations from the land of ARRC). Lots of chatter out there about alternative credit sensitive rates as competitors to the ARRC formulation, including Ameribor which has real traction and add-ons as published by Bloomberg, Markit and ICE. As I said in my commentary the other week, if we now commit to a cohort of loans with full metal jacket ARRC and then watch LIBOR blow out in response to credit conditions in the market, it will not be pleasant. We suggested some fixes to this, both in terms of adding early adoption features and requiring the chosen SOFR alternative to be consistent to then market convention, but the pressure to go unmodified ARRC is quite intense.
We assume that as we move to SOFR that it will be SOFR in advance using, roughly, the same determination date as we now use for LIBOR, but are the back offices really ready? One would think yes, since we spent years anticipating the switch to SOFR in January 2022 (until the powers decided to kick that can down the road to June 2023), so we should be ready. Are we? My guess is that it’s all A-OK for the big banks but perhaps not for the smaller banks or the alternate lending space. Time for all C-suiters and the MBs with the fat promotes to check in with their back offices to make sure ready really means ready.
What’s it going to be like if the alternate lending space continues to lend on LIBOR and the regulated banks cannot? Do we have a two-speed market out there? What will the alternate lending space think about lending on LIBOR and borrowing on SOFR? How about if your underlying hedge products are SOFR based when the loan is not? These mismatches okay?
We need to think about whether underlying loans that permit early adoption of SOFR should be triggered. Is that a good thing, a bad thing? If we’re going to do it, some communication with the borrowers is probably in order rather soon.
Bottom line: The banks should get clarity from the regulators. Everyone should get clarity from the derivatives market as to how that’s going to work. All lenders need to get SOFR documentation ready and to make sure their back offices really are ready to administer SOFR loans. Finally, a broad educational effort needs to be commenced right now to prepare borrowers, mortgage bankers and other participants about the transition. It is upon us! There was a brief moment when it felt like the horizon was far away and we all took a LIBOR nap, but it’s not, it’s here and it’s starting. Time to gear up.