Not Sofr away: Libor transition at a crossroads

The road ahead appears long and daunting when it comes to finding a solution for legacy floating rate debt denominated in Libor, which banks will no longer be compelled to report after 2021.

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Three panels on day two of Structured Finance Industry Group (SFIG) 2019 conference in Las Vegas all riffed on the theme of Libor transition, which has created a market-wide quandary since the move was announced in 2017.

A consensus arose among central bankers and regulators about the most substantial post-crisis reforms, that financial contracts should move away from Libor as a reference rate, given scandals surrounding rate manipulation and their connection to bank credit risk.

Libor is used in determining periodic interest payments for over $350tr globally in derivatives, futures, corporate bonds, mortgages and other financial products, according to ICE. Most Libor-based derivatives, loans and securitized products will mature by 2025, but that still leaves a potential four-year gap for floating rate debt.

In the US, the chosen alternative rate is the secured overnight financing rate (Sofr), a benchmark based on overnight repo market transactions collateralized by US Treasuries.

However, red flags are cropping up as Sofr’s shortcomings are becoming more apparent and contracts are being reexamined, and some counterparties are seeing an absence of contractual language that provides for switching the benchmark rate.

While there is a deep market for overnight repo transactions collateralized by US Treasuries, there is effectively no market yet that extends the overnight rate into term rates.

Some firms, including Fannie Mae and Toyota Motor Corp, have acted as good corporate citizens and issued Sofr debt to expand the term curve, and some suspect that Fannie Mae may start benchmarking its floating rate credit risk transfer deals to Sofr.

Relative to term Sofr, daily compounded Sofr is not considered by many to be an attractive option as it would not allow companies to efficiently provision for expected cash flows. 

“We need some specific version of compounding or averaging over some time period, I think before we can know what to turn to,” said Stephen Kudenholdt, head of structured finance at Dentons. “We also may not want for the perfect to be the enemy of the good, and for the cash market, finding a second fallback which might not be what’s being used in swaps.”

Besides the creation of a new term rate market, some investors who hold the risk are unhappy about the loss of exposure that Libor provided to bank credit.

Sofr is a credit risk free rate, but if we had a credit widening event, investors are not going to experience that spread widening,” said Rob McDonough of Angel Oak. “So if you’re used to getting rewarded for bank risk, you need to change your expectations.”

Furthermore, the proposed conversion set out by the International Swaps and Derivatives Association (ISDA) is almost certain to create winners and losers through value transfers between issuers and debtholders.

“In terms of mitigating the value transfers, it’s pretty much a single answer to that, which is, at the date of conversion, using some sort of touchback based on a historic average difference between what you’re going to and what you were using,” said Kudenholdt. “As far as I know, that’s the only known way to mitigate value transfer based on that data.”

Adding insult to injury, there are substantial concerns that amending existing loan contracts with consumer facing lenders may stir resentment and could even result in litigation.

“We need to do a lot of communication so Main Street doesn’t feel shortchanged,” said Jennifer Earyes, director at Navient.