United States: The End Of Days (Or At Least LIBOR)

Last Updated: August 1 2017
Article by Richard D. Jones

You know, sometimes life's problems smack you against the side of the head like a 2×4, and sometimes it's just a multiplicity of middling offenses that become so annoying that you might just want to roll over and die. Think anything involving a conversation with the DMV or the phone company. Today, we're talking the death of a thousand paper cuts brought to us by those well-meaning folks who are beavering away to replace LIBOR.

LIBOR is about to become the late lamented reference rate. After the LIBOR fixing scandal, government regulators and major banks have been intent upon replacing it with something less vulnerable to diddling or the appearance of diddling (it really is a word; check the OED). And, of course, once LIBOR moved to center stage, and with hindsight, the methodology by which it has been set since time immemorial indeed seems whacky. LIBOR, in brief, is the rate at which a bank would potentially have agreed to borrow money if it had indeed agreed to borrow money, averaged among the major banks which might have, but probably didn't borrow money. You following that? Who made that up? In any event, recently a group of major money center banks acting through something called the Alternative Reference Rates Committee under the auspices of the Federal Reserve Bank of New York has started the process to replace LIBOR. The leading candidate is a rate based on repo trades backed by Treasury securities while the runner up is a rate based on overnight (actual) lending amongst major banks.

Presumably, whatever gets chosen will have the credit characteristics of the LIBOR we've come to love and presumably will broadly produce outcomes indistinguishable from the LIBOR index. The new rate still has to go through a lengthy process to be birthed, including public hearings, but at some point in 2018 or fairly soon thereafter, we're going to have a new reference rate.

And a new rate is going to matter a lot. More than $350 trillion in derivatives and other financial products are tied to LIBOR in addition to nearly every floating rate commercial real estate loan.. Consequently, when the new index arrives, those trillions of dollars will, over time, be repriced to the new index. Once that all happens, and is a done deal, things will be swell. But what happens before that happy day?

Most loan agreements and other credit documents stipulating a floating interest rate include an alternate reference rate in the event LIBOR is unavailable (they had better or there's been a serious oops). There are a large swath of financing documents that reprice in the event LIBOR unavailability to prime or some form of the FHLBA rate and frankly those will work as designed. Borrowers may be miffed when they discover those alternate reference rates don't behave exactly like the LIBOR that they modeled and that there will be some loss of transparency in the rate set, but, while pouty, these borrowers will be getting the benefit of their bargain.

But how about on the innumerable credit documents that propose an alternate reference rate based on interbank lending?

This is going to be a problem. In the waning days of LIBOR, we had better take a look at all credit documents with a tenure extending beyond 2018 and make sure that they stipulate an alternate reference rate, and make sure it will actually work. Let's face it, the alternate reference rate language is boilerplate. What's boilerplate mean? It means no one has look at it in an age and probably didn't spend a great deal of time thinking about it in the first place. Hey, it's boilerplate for God's sake.

Picking up recent documents perhaps not at random, but close to random, I came across the following formulation of the alternate rate.

  • "The rate as determined by Administrative Agent from another recognized source or interbank quotation."
  • Another offers up, "the arithmetic mean of the offered quotation of rates obtained by lender from the reference banks for one month's deposits in dollars to prime banks in the London interbank market"...
  • Yet another proposes "the arithmetic mean of the offered rate posted in US dollars for a month period."
  • Or how about "the arithmetic mean of quotes provided at the principal London office of any four major reference banks in the London interbank market selected by lender to provide such banks offered quotations to prime banks...for deposits in US dollars for one month period."
  • Finally, another version, "Lender shall request any three major banks in New York City selected by lender to provide such bank's rate for loans in US dollars to leading European banks for a one month period."

You get the idea. And those are all from relatively sophisticated loan documents and relatively large loans. I shudder a bit to think about the variability that might exist in less sophisticated documentation.

Look, nothing here is the end of the world, but all of a sudden everyone is going to have to find new reference rates until new loan documents with the new reference rate structure are in currency. Put aside for the moment the conflict and controversy resulting from disagreements as to how rates will now be set, when it's no longer as easy as flipping to Reuters and grabbing today's published rate. Cast your mind forward to the administrative headache of implementing multiple imprecise and largely bespoke alternate reference rates.

Every single bank in America, from the biggest to the smallest is going to discover that its floating rate credit products describe a LIBOR replacement in different ways, both small and large. Different law firms use different forms, the language drifts over time as various constituencies briefly focus on the index rate paragraph in loan document and tweaks it. The alternate index is going to diverge across products and even within products. It's going to vary across time and might even vary across geography. Some human being has got to look at every one of those documents, figure out what the alternate rate is, calculate that rate and then, by the way, calculate that rate every 30, 60 or 90 days until that loan goes away.

Is there an easy solution to this administrative headache? I don't really see one. Put our head down and soldier on? Simply name the new index "LIBOR"? (I don't see that happening.) Prepare in advance? Perhaps a little. If an institution has regular programmatic documents that cover large swaths of its book, it can probably begin to build programs to calculate and harvest the rates based on those alternate structures. But for institutions that use multiple forms of loan documents or use various law firms that have their own set of loan documents, and institutions who use difference forms of the floating index formulation across many of their credit products, this is simply going to be painful. Finally, should we consider baking in the new index the Alternate Rate Reference Committee is beavering away on right now? That could at least mitigate the problem. Do we have enough confidence around how that rate will be calculated and what it is to do that yet? I don't know, but it's a good question.

Sounds like a headcount uptick to me for the back office. For the financial sector whose teeth and tail ratio has been skewed and going the wrong direction for quite a while because of the growth of the regulatory state, this is more tail and even less teeth.

Maybe I'm talking my book here, but this little thing with arguably little economic impact from a chalkboard perspective is going to be a major headache. But hey, that's next year. We've got plenty to do right now, right?

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