Ain’t No LI (BOR), Bye, Bye, Bye
While the market has digested the FCA announcement on LIBOR with little initial impact on the markets, we believe this is because there are many country and industry complexities in assessing its potential replacement.
My second favorite past-time, after managing portfolios, is using lyrics from boy bands in the midst of serious financial research notes. So, when the Financial Conduct Authority (FCA) recommended the market ends using LIBOR as a benchmark by year-end 2021, it gave me the opportunity to reach into the past and grab some ‘N Sync lyrics.
“Don't wanna make it tough, I just wanna tell you that I had enough. Might sound crazy but it ain't no lie, bye, bye, bye.”, *NSYNC 2000.
By way of background the London Interbank Offered Rate (LIBOR) is one of the most widely used benchmarks for loans, financial instruments, and derivatives. LIBOR's primary function is to serve as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, credit cards; as well as derivatives such as currency and interest rate swaps, among many other financial products. It is currently quoted by 11 to 18 contributor banks, for seven different maturities in five different currencies.
Using estimates from Citi Research there are over $4 trillion in securities linked to LIBOR and over $7 trillion in loans linked to LIBOR, to say nothing of the derivatives market. The FCA reports more than $350 trillion in financial products are underpinned by LIBOR.
Clearly, LIBOR is an integral part of the markets:
So why are we saying good-bye?
LIBOR has recently been the subject of scandal and, as a rate calculated by “survey”, it can be manipulated. The FCA is concerned that the estimating of LIBOR, based on interbank lending which may be scant, is unacceptable. As for the 2021 year-end deadline, the FCA can only compel banks to estimate LIBOR through that period, post 2021 it would be optional.
This doesn’t mean that LIBOR as a benchmark will go away. It does however mean that, without a requirement to estimate interbank lending rates, the willingness of participants to provide estimates may decline. Let’s assume, for now, we are saying good-bye to LIBOR.
So what happens to the loans and the securities whose rates are tied to this index?
Documents, such as loan agreements or securities offering memorandums, are not necessarily standardized, but here are some generally common provisions.
- Mortgage loan rates tied to LIBOR generally have language that allows the servicer to choose an “otherwise comparable benchmark”, should LIBOR be unavailable. This is quite common. We expect that an industry standard is likely to be adopted. Amongst US floating-rate or Adjustable Rate Mortgages (ARMs), or hybrid ARM loans, the most common loan rate indexes are the 1-year Constant Maturity Treasury (CMT), 6-month LIBOR and 12-month LIBOR. Going forward, we expect new loans will likely reference 1-year CMT until an alternative index is more commonly accepted. However, we have not seen U.S. mortgage lenders stop quoting LIBOR indexed ARMS, at this point.
- Major U.S. banks hold a substantial amount (more than $3 trillion) in mortgage loans on balance sheets. A decent portion of these are ARMs. The decisions made for treatment of balance sheet loans is likely to be one standard by which non balance sheet loans (securitized loans) will be measured.
- Fannie Mae and Freddie Mac guaranteed securities or guaranteed loans generally provide broad discretion for Fannie Mae and Freddie Mac to select a new index based on comparability. Given the size of the mortgage universe guaranteed by Fannie Mae or Freddie Mac, we believe any choice they make with respect to replacement will likely represent an industry standard.
- On the MBS, CMBS, ABS securities side, the most common provision includes the following waterfall:
- Look for a LIBOR rate quoted by ICE.
- Use a “Reserve Interest Rate”, which is the mean of rates quotes by the London office of at least two leading banks, or the lowest rate if no such mean can be determined.
- Lastly, the prior month’s LIBOR rate.
This methodology would really recreate a LIBOR survey, which requires few participants, or it could fix the index at the last LIBOR rate observed (presumably in 2021).
A concern is that any difference in selection of a replacement index for loans, when compared to what is selected for securities, may lead to basis risk; a risk we feel the market is not currently pricing in.
So what’s the early consensus on the replacement?
We expect the market to come to some standard replacement protocol, a new “industry standard”, though this “standard” may be different by industry or by country (in the UK, SONIA may be the preferred option versus the US where the Broad Treasuries Financing rate (BTFR) may be the ultimate choice to replace LIBOR).
In the US, the early front runner for LIBOR replacement is BTFR; which is an overnight secured rate, calculated from observable trades in a fairly deep market. This BTFR would require / specify a method for determining which general collateral financing trades to scope into the average. Most US market participants see this BTFR plus some fixed spread as a likely successor to LIBOR.
The tenor of LIBOR based instruments is also a consideration, many that mature before year-end 2021 represent a lesser concern. But with LIBOR as an important component of interest rate swaps, the implications for LIBOR or swaps as a pricing benchmark for longer-term ABS and CMBS are a concern.
The levered loan market and its sister, the CLO market, use 1-month LIBOR and 3-month LIBOR rates extensively as indices. In recently issued (August) securitizations, language has already been provided to address an alternative index, using an outline including some of the terms below:
- the rate suggested as a replacement for LIBOR by the Alternative Reference Rates Committee convened by the Federal Reserve;
- the rate suggested as a replacement for LIBOR by the Loan Syndications and Trading Association or;
- the rate that is consistent with the replacement for LIBOR being used with respect to at least 50% (by principal amount) of;
- the quarterly pay Floating Rate Collateral Debt Obligations included in the Trust Estate or;
- the floating rate securities issued in the new issue collateralized loan obligation market since the Refinancing Date that bear interest based on a base rate other than LIBOR
Bye, Bye, Bye
It is worth noting that since 2014 the Fed has had an Alternative Reference rates Committee (ARRC), with the following stated goals, which we think align with the use of the BTFR.
The Financial Stability Oversight Council (FSOC) recommended in its 2014 Annual Report that U.S. regulators cooperate with foreign regulators, international bodies, and market participants to promptly identify alternative interest rate benchmarks anchored in observable transactions and supported by appropriate governance structures, and to develop a plan to accomplish a transition to new benchmarks while such alternative benchmarks were being identified. Greater reliance on alternative reference interest rates will make financial markets more robust and thus enhance the safety and soundness of individual institutions, make financial markets more resilient, and support financial stability in the United States. The Financial Stability Board (FSB) has also called for the development of alternative, nearly risk-free reference rates.
In response to the FSOC's recommendations and the objectives of the FSB, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) on November 17, 2014 in a meeting with representatives of major over-the-counter (OTC) derivatives market participants and their domestic and international supervisors and central banks. The ARRC was convened to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards such as the IOSCO Principles for Financial Benchmarks and to identify an adoption plan with means to facilitate the acceptance and use of these alternative reference rates. The ARRC was also asked to consider the best practices related to robust contract design that ensure that contracts are resilient to the possible cessation or material alteration of an existing or new benchmarks.
It is interesting to note the ARRC, a group formed by the Fed, is suggesting a new index set using the very repo market in which the Fed is a major participant (a 10% to 50% share). In effect the Fed gets a new, direct monetary policy tool, while LIBOR, set by private institutions in London, would go by the way side.
With the concerns over misleading and manipulation of LIBOR, regulatory and governing bodies have been looking for reference rates that are grounded in observable transactions. We believe the replacement of LIBOR is in line with this desire.
The current best idea is the BTFR plus a fixed spread. Given the size of the markets linked to LIBOR, either as an index or as a pricing benchmark, it is critical any transition is orderly. We believe this is an ambitious project, the scope of which is only beginning to be understood. The transition will likely require an embrace of a “market standard”. These standards can be driven by banks, Fannie Mae and Freddie Mac, important stake-holders, and by the government bodies like ARRC.
In some cases loan and security documents provide for the standard to be implemented, other securities may require a process for approval. We believe it is important to note that LIBOR is neither gone, nor forgotten. In the US most mortgage lenders continue to offer LIBOR-base mortgage notes to their customers today. Most of which will have maturities exceeding 2021.
In the meantime, it’s worth considering the impact to any security that has a maturity outside of the year-end 2021 window. In mortgage securities, or loans, there is typically amortization, reducing the exposure over time. We believe we should soon see more reluctance to price to a swaps-based benchmark in sectors such as ABS and CMBS with longer maturities. Ain't no lie, bye, bye, bye.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.