The Great Index Reformation is coming.  (I note in passing that the last Reformation led to the 100 Years War…just saying.)  This is a massive change to our market that did not bubble up from the great unwashed on the barricades demanding change, but something that has been driven from the regulatory heights.  More a Peter the Great and less a Lenin sort of thing.  This transformation of the entire floating rate market from LIBOR to SOFR is scheduled to arrive in a market near you on January 1, 2022.  After that date, with very few exceptions, the banks will neither give nor take LIBOR.  Of course, they actually could do so, as the FCA has said that one-month LIBOR will be representative until June of 2023, but the regulators have made it clear that to do so would be considered an unsafe, unsound banking practice and no bank is going to volunteer for that appellation.

On the other hand, this transition is not going well.  T-minus 70-ish days and counting.  Tick-tock and nothing, or at least not enough, is happening.  You can see the Fed is getting twitchy about this looming deadline in the face of broad, and what I’m sure appears to the regulated elite as almost willful, inaction in underlying lending markets.  Randal Quarles, the Fed’s chief cop on the block, gave a speech at the FSA conference two weeks ago where he told everyone to “pick up the pace.”  “Come on!” Our current President might say.

As we close in on the extirpation of LIBOR, numerous regulatory voices from the heights are making it clear that it’ll be SOFR all time.  They express concerns about the alternate indexes which have gained some traction and contain a credit component.  Apparently, the regulators consider them to be borderline representative and tainted with the fundamental flaws of LIBOR.  Even the threat that the regulatory community may find them to not be IOSCO compliant is already taking those alternate rates out of play.  So, it’s SOFR or nothing.

So, why aren’t we there?  What’s going on, of course, is that the underlying lending markets are not very keen to take up SOFR.  Many lenders really don’t like the absence of a credit component and many borrowers just don’t like it.  It’s change they don’t really understand, and consequently there will always more than a scintilla of suspicion that somehow it might not be good for them.  Hardly a shocking perspective, is it?  Frankly, many don’t even know it’s about to happen.

I have not yet seen a SOFR based loan, with the exception of GSE product and, of course, the GSE’s commitment to SOFR is more political than market-driven.

Where is everyone?  Is everyone waiting for someone else to be the first mover?  Don’t you get a gold star if you do?  Maybe a hug (and a stock tip) from a Fed governor?  Apparently, that’s not compelling.

Since loans made on term sheets issued this month are probably not going to close until mid or late November, we really need to strip off the LIBOR band-aid right now, don’t we?  No one can feel good about making a loan on LIBOR that will literally convert on the first monthly payment.

Arguably, the next bright line for a large part of the non-bank market is that the warehouse lending banks have all indicated that they are fixing to move their price differentials from LIBOR to SOFR…sometime soon.  We are running out of soon.  I haven’t yet seen a warehouse term sheet issued on SOFR, albeit most warehouses entered into in the past year plus do contain a SOFR alternative.  What we are now expecting to happen in the coming weeks is that many (most?) warehouse lenders will take the view a new facility must be SOFR-priced and any new assets financed on an existing facility will similarly be SOFR-priced; however, LIBOR-priced assets that had been previously added to the facility will continue to have a LIBOR-based price differentials.  Clear, right?  What happens when some of these warehouses hit extenders during the next year or so?  TBD.

So, for a while, most of the underlying loans, even those containing a SOFR alternative will continue to be priced off LIBOR.  (Most existing LIBOR-priced loans with a SOFR alternative will continue to be priced off LIBOR until LIBOR becomes unrepresentative, an event now scheduled for June of 2023.)  Yes, we do have some underlying loans in the market which have early adoption features, allowing the lender to swap SOFR for LIBOR at its discretion, but it’s fair to say that’s not the majority of the warehoused loans out there.

So, once the warehouse market moves, we’re going to have a basis mismatch baked into the facilities with many non-bank lenders receiving LIBOR and paying SOFR.  Right now, that’s a net negative as one-month LIBOR is at 9 bps, while overnight SOFR is at 5 bps.  But, with its ARRC-stipulated and approved adjustment factor, the SOFR index is equal to 16 bps or 7 bps wide of LIBOR.

What I’m really interested in today, is whether we are about to see the commencement of a two-speed floating rate market in commercial real estate and what that will mean.  The prudentially regulated banks have been threatened within an inch of their lives to only offer SOFR-based products starting on January 1, 2022, and that’s what they will do.

That’s not true of the non-bank marketplace.  As LIBOR will continue to be published and generally deemed representative through June of 2023, we have an 18-month window where non-bank lenders can continue to offer LIBOR.

It seems pretty clear what they will do is offer both.  But what do the borrowers want?  While many capital market junkies (which regrettably includes me) have spent considerable amount of time thinking, whinging and speculating about SOFR transition, the level of knowledge of this transition in the broader real estate capital markets is simply not there.  Except for the largest institutional borrowers who are quite obviously plugged in, the great bulk of the borrower marketplace (which I am sure the Fed might refer to, in an unguarded moment, as the disreputables), is just not fully clued into the game.  Since the change is being driven by the bank regulations, it’s not hard to see why some elements of the commercial real estate market might be hostile, assuming that somehow this is to their disadvantage (although one could argue with considerable conviction, that this transition is a net benefit for the users of capital).

So, what’s that all going to look like?  A very prudential lender offering SOFR might want to add a little something to the top of adjusted SOFR to take into account the potential of credit risk during the life of the loan.  But it “may” be hard to convince a borrower that the lender, which until recently was offering LIBOR plus 200, is now offering SOFR plus 196, plus something special on the top to deal with credit risk.  Adjusted SOFR is already higher than LIBOR.  Will borrowers tolerate an add-on?  I doubt it.

What will the alternate lenders do?  If they are offering both, there will be considerable transparency into the pricing differences between SOFR and LIBOR.  My guess is that a lot of borrowers will still want to stick with LIBOR, or if they aren’t agreeable to SOFR, they will strenuously object any so-called adjustment factor and want to see pricing on SOFR flat.  But, of course, with the same economic spread that they were used to, that they were offered on the LIBOR product.  This could all result in a substantial amount of spread compression if lenders succumb to market pressures and begin to squeeze the alternate adjustment factor out of SOFR which in turn could encourage folks who want LIBOR to demand a reduced economic spread.  So, in our super-heated competitive market, those who used to borrow on LIBOR will hear about lower spreads on SOFR at the country club and want the same spread off LIBOR.  That will in turn suppress the spreads on SOFR products and will go around and around until…when?  This may all be good news for borrowers, but it’s bad news for lenders.

And while we’re thinking this through, don’t forget about caps, collars and floors.  If you have a LIBOR loan with a LIBOR floor with an extension option, it may be difficult to buy a LIBOR floor in the derivatives market.  How do you feel as a borrower about a LIBOR pricing on your loan and a SOFR pricing on your floor?

Now what happens when the alternate lender securitizes?  It seems pretty clear that banks, in their capacity as placement agents, will be able to arrange and distribute securitizations with underlying LIBOR assets, but query whether the investor marketplace will want to buy LIBOR priced bonds or SOFR bonds.  If the marketplace demands SOFR pricing on the bonds, there will be a mismatch between the underlying assets of the securitization vehicle and its liabilities.  This negative arb will hit the PIKable bottom of the securitizations.  How fun will that be?  Do-able certainly, but surely complex.  A basis mismatch will need to be addressed both mechanically and in connection with the disclosure.  More work for lawyers (not an altogether bad thing, right?).

Let’s close by thinking of the management, administrative and reporting complexities of running a two-speed book as either a lender or a borrower.  At the very minimum, that’s just going to be complex, painful and expensive.  My suspicion is that a lot of folks simply aren’t prepared for the administrative headaches of the index change or managing this two-speed market, and certainly, this won’t be much fun.

None of this is good, right?  All of it is part of the chaotic, uncontrolled transition from LIBOR to SOFR that we’ve been worried about for so long and we’re about to enjoy in real time.

Some say this is all Y2K.  SOFR will just step into LIBOR shoes and off we go.  But even under the most amiable of circumstances, there’s still a lot of work to do here as we try to understand exposures, reprice loans, reprice warehouses and securitizations.  We’re on a two-speed book for the 18 months following January 1.

As with most things that I think, the only thing that I am certain of is that I’m probably wrong.  Predictions about the future are particularly difficult and my guess is that this will unfold in ways that will continue to confound expectations.  Oh, sure, we’ll get through all this.  Our bonds will price, lenders will lend and borrowers will borrow and there are no existential risks to the commercial real estate finance marketplace, but boy, this will be a pain in the…ARRC.