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Phase-Out of LIBOR: Revising Floating
Rate Loans to Implement Alternative
Reference Rates, ISDA Revisions
Today’s faculty features:
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WEDNESDAY, JULY 24, 2019
Presenting a 90-minute encore presentation featuring live Q&A
Gary A. Goodman, Partner, Dentons, New York
Stephen S. Kudenholdt, Partner, Dentons, New York
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LIBOR: The Way Forward
Presentation by:
Stephen S. Kudenholdt
Gary A. Goodman
July 24, 2019
5
• London Inter-bank Offered Rate (LIBOR) was developed and launched in
the mid-1980s by the British Bankers Association
• LIBOR is derived from submissions by panel banks, stating the rate at
which they could borrow funds from other banks in London, in various
currencies and tenors
• In practice LIBOR submissions have proven to be subject to
manipulation and tampering, as evidenced by the rate rigging scandal
that came to light in 2012
• Administration of LIBOR was shifted to the ICE Benchmark
Administration (IBA) in 2014
• In July 2017, the UK Financial Conduct Authority (FCA) announced a
potential phase-out of LIBOR by the end of 2021
A Brief History of LIBOR
6
• LIBOR is currently produced on a daily basis in 5 currencies: US dollar,
Euro, British pound sterling, Japanese yen, and Swiss franc
• 16 major money center banks are on the panel that contribute rates to
USD LIBOR. The banks are based in various jurisdictions and all have
operations in London
• LIBOR is calculated in various tenors including overnight, 1 week, 1
month, 2 months, 3 months, 6 months, 12 months
• IBA has taken significant steps to improve LIBOR, by establishing
oversight, surveillance and validation procedures designed to reduce the
possibility of manipulation
LIBOR Today
7
• Panel banks have an understandable reluctance to contribute rates to
support LIBOR, given the risk of future liability based on claims of
manipulation, notwithstanding improved internal controls and procedures
• Since the credit crisis, the actual reliance by banks on the interbank
lending market for funding operations has declined substantially
• As a result, at this time submissions by panel banks are to a large extent
based on “expert judgement” or estimates of the rates the submitting
banks would be charged, rather than actual or comparable transactions
• LIBOR therefore suffers both from reputational concerns and from an
absence of robust underlying market data, and is disfavored by policy
makers
Disadvantages of LIBOR
8
• LIBOR is forward looking, and is designed to predict a bank’s actual cost
of funds over a given time period in the future corresponding to the
relevant tenor
• If LIBOR were accurate, then a bank could reasonably price loans on a
forward basis by simply adding a margin reflecting the banks cost of
operations and profit margin as well as borrower risk
• LIBOR as an index also gives the borrower certainty of payment. For
example in a loan with 6 month LIBOR as an index, the rate would reset
every six months and the borrower would know its exact cost for the
upcoming period
• In contrast, if the borrowers rate were based an overnight index, its
borrowing cost would be far less certain
Advantages of LIBOR
9
• In July 2013 the International Organization of Securities Commissions issued its
Principles for Financial Benchmarks, following on the LIBOR rate rigging scandal
• The Principles are generally designed to address conflicts of interest, promote
internal controls, and improve governance and oversight
▪ Principle 6 indicates that Benchmark design should consider the “relative
size of the underlying market in relation to the volume of trading in the
market that references the Benchmark”
▪ Principle 7 recommends that a Benchmark be “based on prices, rates,
indices or values that have been formed by the competitive forces of
supply and demand” and “anchored by observable transactions entered
into at arm’s length between buyers and sellers in the market”
▪ Principle 8 provides a hierarchy for data inputs, ranking a submitter’s
own concluded arms-length transactions first, and expert judgement last
• Policymakers and industry participants in various countries, including the US,
have been working towards the development of new Benchmarks that follow the
IOSCO principles
IOSCO Principles
10
• The UK FCA is the regulator that has the power to direct panel banks to
continue to submit rates to IBA to help generate LIBOR, inasmuch as the
rate submission activity takes place in London
• In July 2017, head of the FCA Andrew Bailey indicated in a speech that
panel banks would no longer be compelled or encouraged by the FCA to
submit rates in support of LIBOR, effective at the end of 2021
• Notwithstanding recognized improvements in the production of LIBOR,
this policy is based on the absence of an active substantial underlying
market, inter-bank unsecured lending (see IOSCO Principle 6)
• This announcement does not mean that LIBOR will definitely cease to be
produced at the end of 2021; however, continued LIBOR after 2021
would be dependent on the willingness of a sufficient number of panel
banks to voluntarily continue to submit bids
What Mr. Bailey Said
11
A Visualization of Financial Stability & LIBOR
Priced off $500 million or less of underlying
daily transactions
USD LIBOR is estimated to be
referenced in $200 trillion worth of
financial contracts (equivalent to 10 times
US GDP).
Most of this exposure (95 percent) is in
derivatives, but USD LIBOR is also
referenced in an estimated:
o $3.4 trillion business loans
o $1.8 trillion in floating rate debt
o $1.8 trillion in securitizations
o $1.3 trillion retail mortgages & other
consumer loans
$200 Trillion
of USD LIBOR-Based Contracts
12
Data source: Alternative Reference Rates Committee,
Second Report, March 2018. Data as of year-end
2016.
• In the US, the leading new alternative reference rate under development
is the secured overnight financing rate (“SOFR”), which is produced by
the Federal Reserve Bank of New York
• SOFR is a rate, calculated and published daily, based on an average of
reported overnight repurchase transactions in US Treasury securities,
captured from several sources that report actual transaction data to the
NY Fed. The sources capture the vast majority of actual transactions of
this type
• The NY Fed commenced publication of SOFR in April 2018
• SOFR meets the IOSCO criteria in that the underlying market (US
Treasury repos) is extremely broad and robust, and there is very
substantial actual reported transaction data available based on market
transactions
SOFR
13
• SOFR underlying data is not limited to bank-to-bank lending, but rather is based
on transactions among participants in the broad US Treasury repo market who
may be banks, broker dealers, insurance companies, pension funds, private
equity funds, corporations, etc.
• SOFR is an overnight rate only; we understand that the data submitted to the NY
Fed is nearly all based on overnight transactions, and that it does not contain
data from which term rates could be derived
• For SOFR to be used as a lending rate to replace LIBOR, it will be essential for
term rates to be derived from SOFR
• SOFR is essentially a risk free rate, because the underlying transactions are fully
secured by high quality liquid collateral
• In contrast, LIBOR is an unsecured borrowing rate, and includes a component
that reflects the borrowing bank’s creditworthiness, especially as to longer tenors
• Unlike LIBOR, SOFR is a backward looking rate
• Because of these differences, SOFR can be expected to perform differently from
LIBOR
SOFR Attributes
14
15
Source: Alternative Reference Rates Committee, Second Report, March 2018.
Money Talks…
• In November 2014, the Alternative Reference Rates Committee (ARRC)
was convened to consider new US dollar risk free reference rates
• ARRC members include a number of major banks and industry groups,
and ARRC obtains input and participation from a broad range of market
participants as well as US regulators
• In June 2017, ARRC announced that it had selected SOFR as the
preferred alternative US dollar risk free reference rate, and as its
preferred alternative to USD LIBOR
• In March 2018, ARRC published its "Second Report", its most
authoritative and comprehensive publication to date regarding the
transition away from LIBOR
ARRC Implementation Plan
16
ARRC Implementation Plan (Continued)
• ARRC's Second Report outlines its “Paced Transition Plan,” which
would result in a forward SOFR curve from which term SOFR rates
could be derived The timeline contemplates the following completion
dates:
▪ End of 2018: trading begins in futures and uncleared swaps
referencing SOFR
▪ 2019 Q1: trading begins in cleared swaps that reference SOFR
▪ End of 2021: creation of term SOFR reference rate based on
SOFR derivatives market, provided the market has developed
enough to provide a robust rate
17
SOFR Futures Trading
• In May 2018, CME Group launched quarterly and monthly SOFR futures contracts, listed by CME and available for trading by CME Group clients
• The quarterly contract references daily compound SOFR over a future 3 month reference period. The reference periods end in March, June, September and December and are available up to 5 years out
• The monthly contract references average SOFR over a calendar month, and these contracts are available up to 7 months out
• It has recently been reported that there are now over 130 participants in the CME SOFR futures contract market with average daily trading volume running in the range of $68 billion notional, and with open interest at $479 billion notional
• Trading volume could be expected to increase significantly to the extent that market participants begin to incur financial obligations linked to SOFR, and therefore require SOFR futures contracts for hedging purposes
• At this time it is not yet clear that trading in SOFR futures will be robust enough to produce forward SOFR term reference rates that would meet IOSCO standards
18
• SOFR appears to be a very high quality, well designed reference rate for new transactions
• However, as an index to replace LIBOR in existing contracts without causing material economic gain or loss to either party, SOFR has these issues:
▪ SOFR is a risk free rate; it is unknown whether a market convention will develop to add a spread to SOFR to reflect the bank credit risk embedded in LIBOR
▪ SOFR is an overnight rate only; it is not known for certain that a term SOFR curve based on derivative trades will develop and will be accepted as a market convention
▪ Even if a term SOFR curve develops, under the ARRC timeline this will not be completed until the end of 2021, just when LIBOR would be phasing out, leaving no margin for error if there is a delay
Transition Risks
19
• Structured Finance Industry Group (SFIG) and other thought leaders have advocated that for the cash markets (including floating rate loans), there should be a true forward looking term SOFR derived from overnight SOFR.
• Forward looking term SOFR would predict SOFR over a future accrual period, based on market transaction inputs, and would be available at the beginning of the accrual period. It would be comparable to forward term LIBOR minus a credit component.
• However, the vast majority of LIBOR based transactions that might convert to SOFR are derivatives, which reference an overnight index and do not require a forward looking term index.
• For this reason, policymakers have discouraged use of a forward term replacement index for derivatives, and the ISDA consultation does not include a forward term SOFR.
• In line with this trend, and in light of concerns about the volume of SOFR futures trading, ARRC leadership has indicated that there can be no assurance that a forward looking term SOFR will actually develop
Will There Be a Term SOFR?
20
• While SOFR itself is an overnight rate, SOFR can be derived over a
given accrual period (e.g., 30 or 90 days) through a number of
approaches.
• “in advance” means SOFR for a given accrual period is calculated at the
start of the period, but based on overnight SOFR over the period ending
on or about the start of the period. In other words the observation period
is the period prior to the accrual period. For example, if the accrual
period is 2Q 2019, the rate is determined at the start of the accrual
period but based on actual overnight SOFR over 1Q 2019. Thus the in
advance approach is based on backward-looking or “stale” information,
but has the benefit of being known at the start of the accrual period.
In Advance or in Arrears SOFR
21
• “in arrears” means SOFR for a given accrual period is calculated at the
end of the period, based on overnight SOFR over the accrual period. In
other words the observation period is the same as the accrual period. For
example, if the accrual period is 2Q 2019, the rate is determined at the
end of the accrual period based on actual overnight SOFR during 2Q
2019. Thus the in arrears approach is based on actual rate information
during the accrual period, but has the disadvantage of not being known
at the start of the accrual period.
• When using the in arrears approach, the observation period may be
pushed back by a few days, so that the rate can be calculated a few days
prior to the end of the accrual period.
• The in arrears approach is favored by ISDA, and may be suitable for
corporate debt, but is viewed as not appropriate for consumer debt.
In Advance or in Arrears SOFR (continued)
22
• “compounded” means the daily overnight SOFR rate is compounded on
a daily basis over the observation period. This results in a slightly higher
rate for the observation period due to the effects of compounding, and is
thought to at least to some extent convert SOFR from an overnight rate
to a term rate.
• ISDA favors the compounded in arrears approach, which fits in well for
overnight indexed swaps over a fixed contractual time period.
• However market participants in the cash markets may find the calculations for
compounding to be burdensome.
• An alternative to compounding would be to simply average overnight
SOFR over the relevant observation period, and add a margin to adjust
the average overnight rate to a term rate.
• In the capital markets, a number of corporate debt issuances have been made
that reference SOFR. Generally, these transactions use averaging (not
compounding), in arrears.
Compounded or Average SOFR
23
• Because overnight SOFR is a risk free rate, whereas all tenors of LIBOR
include a bank credit component, when using SOFR as a replacement for
LIBOR it may be desirable to add a spread adjustment in order to
minimize any value transfer.
• Minimization of value transfer at time of conversion is deemed desirable
in order to avoid gains and losses.
• The spread adjustment would add on a factor to account for bank credit
risk over the relevant accrual period.
• The spread adjustment also would take into account the difference in
tenor between the tenor of LIBOR being replaced and the form of SOFR
being applied. This difference is greatest with overnight SOFR, and least
with forward looking term SOFR.
• Spread adjustment is not dynamic. It is a fixed amount that minimizes
value transfer at the point of benchmark replacement.
Spread Adjustment
24
• ISDA is planning to amend its 2006 Definitions so that its floating rate
options provide new fallbacks that would replace LIBOR (and other
IBORs produced in other jurisdictions) in the event of a permanent
discontinuation of LIBOR. ISDA published a multi-jurisdictional
consultation in July 2018 for comment on proposed fallbacks for various
IBORs.
• Under the ISDA consultation, the fallbacks for each relevant IBOR would
be triggered on the occurrence of:
• A public statement by the IBOR administrator that it will cease publication of the
benchmark, or
• A public statement by the regulatory supervisor of the administrator, or other
authorities with jurisdiction over the administrator, that the benchmark will
cease to be provided
ISDA Consultation
25
• In each case the effective date of the conversion to the fallback will be
the actual date of discontinuance of the relevant LIBOR.
• The consultation requested comment on proposed fallbacks including:
• Spot overnight reference rate, and convexity-adjusted overnight rate
• Compounded setting in arrears
• Compounded setting in advance
• The consultation also introduced three concepts for a spread adjustment:
• Forward Approach: At the time of IBOR cessation, on a one time basis a
forward spread curve would be generated based on observed market prices for
the forward spread between the relevant IBOR and the replacement reference
rate. This fixed curve would be used to determine the spread adjustment on
each future date.
ISDA Consultation (continued)
26
• Historic Mean/Median Approach: The spread adjustment would be a single
number that would be the historic mean or median spot spread between the
relevant IBOR and the replacement reference rate, over a 5 or 10 year
lookback period from the time of IBOR cessation. There would be a one-year
phase in from the current spot spread to the historical spread.
• Spot-Spread Approach: The spread adjustment would be simply the spot
spread between the relevant IBOR and the replacement reference rate at the
time of conversion, or over a brief period
• ISDA announced its summary of responses in December 2018,
indicating that the preferred combination is:
• Compounded Setting in Arrears with Historic Mean/Median Approach
ISDA Consultation (continued)
27
• ARRC working groups in late 2018 published separate consultations for
fallback contract language, for new cash products including: Bilateral
Business Loans, Syndicated Business Loans, Floating Rate Notes (notes
offered and sold to investors), and Securitizations.
• The ARRC consultations are informed by the ISDA Consultation which
preceded them, but seek to develop alternative approaches where
warranted that reflect the needs of market participants in cash products.
• These consultations do not address transitioning away from LIBOR for
legacy assets, which will be addressed separately
• Under the consultations, “Relevant Governmental Body” means the
Federal Reserve Board, the Federal Reserve Bank of New York
(“FRBNY”) or a committee established by the Federal Reserve or
FRBNY such as the ARRC.
ARRC Consultations
28
• This consultation was published September 2018 with final
recommendations published April 2019.
• This consultation provides two alternatives:
• Amendment approach: establishes protocols for amending loan documents to
transition from LIBOR, but does not specify the replacement rate. This
acknowledges that much is not known today about the replacement
benchmarks, and may be preferred for large balance loans.
• Hardwired approach: sets a prescribed waterfall for the replacement rate. May
be preferred for administrative ease with portfolios with large numbers of loans.
Also, both the ISDA Consultation, and the ARRC Floating Rate Note and
Securitization Consultation, use only the hardwired approach.
• Triggers: transition to a replacement rate would be triggered by
• Cessation triggers: the same trigger events as under the ISDA consultation,
authoritative public statements that LIBOR publication will cease. Triggers are
effective upon actual cessation.
ARRC Consultation - Syndicated Business Loans
29
• Pre-cessation triggers: a public statement by the regulatory supervisor for the
administrator of LIBOR announcing that LIBOR is no longer
representative. Can be effective prior to the actual cessation of LIBOR
• Additional “early opt-in” trigger events are provided separately for each of the
amendment approach (loans in the market are replacing LIBOR) and the
hardwired approach (other syndicated loans are priced over term SOFR)
• Amendment approach:
• Replacement reference rate would be an alternate benchmark agreed between
Borrower and Administrative Agent, giving due consideration to
recommendation by Relevant Governmental Body or market convention
• Spread Adjustment would be as agreed between Borrower and Administrative
Agent, giving due consideration to recommendation by Relevant Governmental
Body or market convention
• Approval mechanism would generally be negative consent by majority Lenders,
or affirmative consent by majority Lenders for the early opt-in triggers
ARRC Consultation - Syndicated Business Loans
(continued)
30
• Hardwired approach:
• Replacement benchmark determined under a waterfall (whichever is first
available):
• 1a. Term SOFR (corresponding tenor of LIBOR tenor being replaced)
• 1b. Next Available Term SOFR (next shorter tenor)
• 2. Compounded SOFR, or alternatively Simple Average SOFR, which in either case may be in
arrears with a lookback period, based on conventions:
• Recommended by Relevant Government Body, or
• Observed in the market
• 3. As agreed between Borrower and Administrative Agent, giving due consideration to
recommendation by Relevant Governmental Body or market convention
• Spread adjustment determined under a waterfall (whichever is first available):
• As recommended by Relevant Governmental Body
• As selected by ISDA
• If no form of SOFR as listed above is available, then as agreed between Borrower and Administrative
Agent, giving due consideration to recommendation by Relevant Governmental Body or market
convention
• Approval mechanism: no amendment is needed unless
• If none of the SOFR waterfall steps are available, then negative consent by majority Lenders
• If additional triggers applied, then affirmative consent by majority Lenders
ARRC Consultation - Syndicated Business Loans (continued)
31
• This consultation published December 2018 also provides amendment
and hardwired alternatives.
• Main differences from the Syndicated Business Loan consultation as
published September 2018 are that:
• References to Administrative Agent, Required Lenders instead are to the
Lender
• Under the amendment approach, alternatives are provided whereby Lender
can select the replacement reference rate and spread adjustment, subject to
negative consent of the Borrower.
• Under the hardwired approach:
• Waterfall step 3 (Overnight SOFR) is omitted in light of ISDA’s announced preference for
Compounded SOFR
• If no form of SOFR is available, then Lender selects replacement reference rate and also
determines spread adjustment
• No amendment is needed unless no form of the SOFR is available, in which case negative consent
by Borrower is required.
ARRC Consultation - Bilateral Business Loans
32
• Prior to 2019, there were some indications that IBA might endeavor to
continue publication of LIBOR following 2021, with further enhancements
and improvements
• In January 2019, IBA published for comment a report introducing a new
benchmark, the U.S. Dollar ICE Bank Yield Index (BYI). The proposal:
• Expressly acknowledges that LIBOR faces an uncertain future.
• Indicates that overnight risk free rates (such as SOFR) are in most instances
well suited to the derivatives market
• Observes that lenders, borrowers and other cash market participants generally
prefer a forward looking term reference rate that represents average unsecured
funding costs of a group of large banks
USD ICE Bank Yield Index
33
• The BYI is based entirely on actual arms-length transactions
representing senior, unsecured, uninsured USD borrowing costs of a
group of large banks. The transactions include:
• Primary wholesale market funding transactions (including inter-bank deposits,
institutional CDs, and commercial paper), with data sourced directly from a
group of large international banks (including most of the USD LIBOR panel
banks) on a daily basis, minimum transaction size $10 million
• Secondary market bond transactions, as reported on TRACE, in bonds of a
larger group of internationally active banks, minimum transaction size $2 million
• The BYI methodology gathers data on transactions of varying maturities
up to approx. 1 year, and buckets them into maturity ranges. The
methodology targets at least 10 transactions per maturity range.
USD ICE Bank Yield Index (continued)
34
• The transaction data are then used to generate a yield curve, from which
1 month, 3 month and 6 month rates would be plotted and published.
• The curve plotting aspect of the BYI methodology means that
transactional inputs with a wide range of maturities are incorporated into
the analysis, not just transactions with maturities corresponding to the
publication tenors
• IBA tested the BYI over a 12+ month period beginning January 2018,
and found that:
• The index was based on an average of 153 transaction inputs per day, with the
majority being bond transactions
• The transaction target was met on each day in the testing period, for the
maturity ranges corresponding to 1 month, 3 month and 6 month
USD ICE Bank Yield Index (continued)
35
• The resulting BYI generally correlated closely with reported LIBOR over the
testing period, with some exceptions
• IBA is planning to further refine the BYI methodology, and to publish
further modelling and testing results later in 2019.
• IBA currently plans to launch the BYI in 1Q 2020. However IBA cautions
that there is no guarantee it will launch BYI, and advises that market
participants currently using LIBOR should not rely on the availability of
BYI.
USD ICE Bank Yield Index (continued)
36
• Based on the minimum transaction size and average number of daily
inputs during the testing period, assuming the average transaction size is
not more than twice the minimum transaction size, it appears that a very
rough estimate of the average daily volume of transactional inputs for the
BYI is in the range of $1 to 2 billion. This is a rough guess, not provided
by IBA.
• This would be a much less robust data set than underlies SOFR ($754
billion), or even the Overnight Bank Funding Rate ($197 billion) (see
slide 11).
• It is unclear whether the BYI will ultimately be viewed as IOSCO
compliant, or what the consequences of not being IOSCO compliant
would be in terms of using this index.
Observations re the USD ICE Bank Yield Index
37
• On the positive side, the BYI is based only on market transactions, not
expert judgement, and does capture a market based indication of large
bank funding costs (including a bank credit component) on a forward
term basis, with reported tenors that would match the most widely used
USD LIBOR tenors.
• To the extent that a requirement for a LIBOR replacement is that it be a
successor index based on comparable information, BYI is arguably more
comparable to LIBOR than SOFR is.
• To the extent that it can confirmed that BYI (with any further refinements)
correlates closely to LIBOR, then replacing LIBOR with BYI in any cash
asset or contract would be close to value neutral over its remaining term.
• In contrast, Spread Adjustments applied to SOFR are designed to be
value neutral on the date of substitution only, and being static are not
designed to assure correlation to LIBOR at any future date.
Observations re the USD ICE Bank Yield Index
(continued)
38
• Basis risk: given ISDA and cash products may be taking different
approaches, swaps used to hedge cash exposures may convert
differently than the cash exposures themselves resulting in an imperfect
hedge
• Tax risks: replacing LIBOR in any asset with a new benchmark may be
a modification resulting in a tax recognition event and other tax risks
including cancellation of debt income and loss of grandfathered FATCA
status
• Such modifications could also affect a securitization entity by impairing grantor
trust or REMIC status
• SFIG has submitted a letter to Treasury and IRS requesting guidance to avoid
these risks
• Accounting risks: Under hedge accounting, a hedge must be
designated and documented at inception. Changes in a hedge may
result in dedesignation. ISDA and FASB are working on this issue.
39
Additional Risks
• Historically, such loans have included provisions to the effect that if
LIBOR is unavailable, the index will convert to Prime
• If such provision were triggered, borrower and lender would likely want
to renegotiate a replacement index
• New production loans typically have additional provisions for replacing
LIBOR with an alternative rate
• A replacement would be triggered if lender determines there will be a
replacement for LIBOR due to the actual or potential phase out of LIBOR
• The replacement alternative rate would be based on the index generally used
by US lenders as a replacement for LIBOR on floating rate commercial
mortgage loans, as determined by lender in good faith
• In many cases the above determinations are made solely by lender, although
this may vary from deal to deal
• There would not necessarily be a spread adjustment
• New production loans are not yet including language similar to the
hardwired approach under the ARRC Bilateral Business Loan
consultation
40
CRE Floating Rate Loans
• For certain asset types there is less risk of conversion from LIBOR to another
index due to: replacement protocols being developed for that asset type; assets
being shorter term and “burning off” before 2022; assets of a bilateral nature that
can be readily amended
• For other asset types there is more concern about conversion away from LIBOR,
in particular:
▪ US LIBOR indexed residential mortgage loans: such loans typically reference
LIBOR as published at a specific location, and may state that if LIBOR as so
published is no longer available, the substitute index will be based on “comparable”
information
▪ US LIBOR indexed student loans: such loans typically provide that if LIBOR is no
longer available, the lender or holder will “choose a comparable index”
▪ At this time, it is by no means clear that SOFR would be appropriately viewed as
“comparable” to LIBOR or whether a margin could be added to the SOFR rate to
reflect equivalency with the bank credit risk embedded in LIBOR
• For any legacy asset that is amended to replace LIBOR with an alternate index,
there will be a concern as to whether the amendment constitutes a “significant
modification” that could trigger gain or loss recognition for tax purposes
Legacy Assets
41
• Legacy ABS that have notes or certificates indexed to LIBOR have a wide variety of
provisions in the event that LIBOR is no longer available
• CMBS and SFR deals typically switch to Prime; however the provisions may not take into
account the typical spread between LIBOR and Prime
• Some legacy transactions, including many CLOs, simply revert to the latest published rate
in the event LIBOR is no longer published, in effect converting a floating rate instrument to
fixed rate
• Some legacy transactions, in particular RMBS and many ABS, require that if LIBOR is no
longer published, 1) a transaction party must obtain quotes for interbank deposits from a
number of banks, and use the average for the index, and 2) if such quotes cannot be
obtained, then the last published LIBOR is used
• If LIBOR is discontinued, transaction parties who are required to obtain quotes (as in 1)
above) may find that there is no way to avoid their contractual obligations to do so absent
litigation
• Amending a legacy securitization transaction to convert from LIBOR to another reference
rate would be problematic, because such amendments may require consent from each
investor affected
• Also note risk of basis risk mismatch between LIBOR based legacy securities and
underlying assets
Legacy ABS
42
• New ABS transactions continue to be issued that reference LIBOR
• Some new transactions contain provisions designed to smooth the transition to a
new index, if LIBOR is discontinued
• As an example, new transition provisions might:
▪ Define a LIBOR termination event (events that demonstrate that LIBOR
has been discontinued),
▪ Allow for an alternate reference rate to be selected from among
reference rates that are officially recognized or that have come to be
used in new similar transactions,
▪ Provide a mechanism to set a margin to reflect the anticipated spread
between the new rate and LIBOR, and
▪ Specify a notice and approval procedure that limits the number of
investors required to consent
• There is a need for near term focus to develop standardized transition provisions
of this type across asset classes
Interim ABS
43
• Efforts to create new risk-free rates based on extremely robust market
data are laudable
• Market participants generally should be planning to transition away from
LIBOR as it continuance cannot be assumed
• Key questions that market participants face include:
• Will there be a forward looking term SOFR?
• As a fallback, what other form of SOFR would be acceptable in the cash
markets? (Compounded vs average, in advance vs in arrears)
• Will there be authoritative guidance on spread adjustments?
• How best to contingency plan for the absence of authoritative guidance on
spread adjustments?
• For new contracts should the amendment or hardwired approach be used?
• Will the USD ICE Bank Yield Index be launched and become accepted as a
replacement for LIBOR?
• Will another alternative replacement for LIBOR emerge?
• What can be done to mitigate risk on legacy assets and securitizations?
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The Way Forward
Contact Us
Stephen S. Kudenholdt
Partner, New York
1221 Avenue of the Americas
New York, NY 10020
D +1 212 768 6847
steve.kudenholdt@dentons.com
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www.dentons.com.
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Gary A. Goodman
Partner, New York
1221 Avenue of the Americas
New York, NY 10020
D+1 212 768 6916
gary.goodman@dentons.com
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