Episode 25 (pt. 2): Michael Whalen - Later, LIBOR
In our last episode, we covered LIBOR’s history and reasons why it’s being phased out. Now, we dive into what’s next and LIBOR’s replacement: SOFR.
Michael Whalen, a managing director in BRG’s Washington, DC, office, explains different approaches to replacing LIBOR and what the next generation of benchmarks will be expected to handle.
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In this episode, we'll continue our talk with Michael Whalen, a managing director with BRG in Washington, DC. After covering LIBOR's history and the reasons for why it's being phased out in our last episode, we'll dive into what's next in LIBOR's replacement, SOFR. If you missed the first episode about LIBOR, make sure to check it out in our feed. And with that let's get started.
When a historical benchmark like this goes away, what should organizations do to prepare? Are there any precedents that corporations can look back on as a model for what is to come?
The Fed has taken a couple of stabs at trying to estimate the reliance of various transactions on LIBOR, and they have come out with estimates of up to 200 trillion financial transactions that are in some ways linked to LIBOR. A large portion of that is in the traded derivatives market, and that process is well underway. But LIBOR has been very pervasive. It's been pervasive in ways well beyond probably what was originally anticipated. It's a key benchmark for floating-rate consumer credit. It is a rate which is constantly referred to in various commercial agreements for trade credit or default provisions or anything which involves an evaluation of financial costs and interest costs associated with any type of cash-flow payment stream. In anything which is an infrastructure finance or corporate borrowing or a floating-rate note, it is probably the core benchmark which is referred to.
So for any institution trying to think about a change of this order of magnitude, my view is this 200 trillion is a lot of spaghetti code that's out there that needs to be fixed. It's a little bit like a—it's sort of a Y2K problem in a different framework. The first order of business is to make sure you have a full inventory of what the exposure is and what needs to be modified to reflect the reality of perhaps LIBOR being unavailable after 2021.
So if we turn to then what will happen next, the term that I've heard and that you've written about before is SOFR. Can you tell us a little bit about that and who's developed it?
So the new guy is Mr. SOFR. That was what was proposed by the Alternative Reference Rates Committee. Whereas LIBOR was the London Interbank Offered Rate, SOFR is a Secured Overnight Financing Rate. So it's very much similar to the rates you've heard quoted as being repo rates, which are essentially rates that are for the repurchase of securities.
So as you can tell by the name, there's some clear differences even in terms of what those rates represent. SOFR is a rate which is based on secured loans, the repos which are essentially collateralized by US Treasury obligations, bonds and notes from the US Treasury. So it's a secured rate. LIBOR was an unsecured rate.
SOFR is supposed to be kind of a nearly risk-free rate. You've got high-quality riskless collateral that underlies it in terms of US Treasury instruments. It's not designed to reflect the funding cost of a bank providing wholesale credit or receiving wholesale credit. So there's no bank risk premium that's embedded within SOFR. And that probably makes a lot of sense for the derivatives transactions that are traded that require a floating-interest rate benchmark. But it is going to be an interesting rate to incorporate in the context of corporate or other types of floating-rate borrowing where that's supposed to approximate a lender's funding costs.
Now is that because one's forward looking and one's rear looking? Because LIBOR was forward and SOFR is—
LIBOR was a forward rate, yeah. It had an overnight component, but I think the three-month was probably the most popular of the quoted rates. The risk-free element versus the risk element is just the reality of the Fed decided, "Hey, what's the most highly traded liquid market that we can look at to provide a reference rate?"
And the repo market has been around for a very long time, and it's widely quoted. And there's, I think, 800 billion in daily trading activity that they can look to to calculate the rates. US dollar LIBOR, by comparison, was just a mere fraction in terms of transaction volume for that versus the repo rate. But there is no forward rate associated with these overnight repurchase arrangements. So in order to be able to approximate LIBOR's forward-rate component, that's going to have to be developed and created. And the Fed is still in the process of working with market providers to be able to essentially come up with derivatives that give a version of LIBOR's forward-quoted rate basis.
So this change from LIBOR to SOFR, is it a good thing? It sounds like it was inevitable. But do you feel confident that it will work out for the better and help with the problems that have evolved since the financial crisis?
Well, the challenge for regulators is always that the problems you're trying to solve are possibly going to be different than the problems that give future heartburn. And there's always an element of fighting the last war when it comes to regulators making these changes. There's a lot of debate among the financial regulator community as to whether regulators should be the ones who impose or try and lay out this type of benchmark interest rate, because there was certainly an argument amongst a number of regulators that's really for market participants to decide and regulators shouldn't be in the business of structuring these benchmarks. Because if something bad happens and there's a failure in those benchmarks—and as we pointed out, LIBOR is linked to 200 trillion in transactions—who wants to be responsible for that? So if you're going to tinker with spaghetti code, you better be a pretty good programmer.
Having said that, the Fed and the Fed chairman very much took a view that these are public goods, these benchmark rates. And as they are public goods, they are things that, if there are problems with them, regulators essentially own those problems anyway. So therefore they needed to come in and provide a stronger framework for what these rates would be, so that they could be observable, so they could be based on a wide variety of transactions, so they could be transparent, and they would not be subject to manipulation.
Do I think it's a good thing? I think it's going to be a transition that many borrowers, corporate treasurers, as well as, frankly, many former banker colleagues that I quiz on this topic frequently have not fully thought about. And LIBOR has been with us for so long that I don't think the attention has been necessarily placed as to what the implications might be.
Some of the implications are there's going to have to be adjustments relative to what LIBOR was, and that may mean that SOFR will zig when LIBOR would have zagged. So that could have happened during times in which repo rates may be moving in an opposite direction than one would expect bank funding rates to be. And that could mean banks are upside down in their funding costs in providing credit which could have knock-on consequences. Repo rates have their own volatility. They tend to spike at quarter ends and year ends, as people are engaged in a lot of balance-sheet management activity at the end of reporting periods.
And until we get a liquid SOFR derivative market, we really don't have a forward-rate basis. So all of those are structural issues.
And then there's the fundamental issue of, as we try and come up with a way of adding back in the bank credit risk portion that was represented in the LIBOR rate, which is not in the SOFR risk-free rate, they're going to have to come up with a what they are calling a spread adjustment mechanism to account for this difference. And nobody has yet designed this spread adjustment mechanism.
But there should be concern among both borrowers and lenders, but particularly among borrowers, that these adjustment mechanisms that are going to try and look at the difference between SOFR's risk-free rate and the risk portion of lenders' funding costs—that it doesn't result in borrowers paying more than they would have under an equivalent LIBOR transaction.
And then I would say, then, the last issue which is out there is the derivative markets are going one direction relative [to] SOFR. The credit markets, what the Fed calls the cash markets—meaning where money is actually lent and borrowed—they may not be perfectly aligned relative to all of the swaps and hedges that are taken out to fix floating-rate LIBOR or its future floating-rate SOFR. And I think there may be a risk of misalignment between these hedging instruments and the underlying floating-rate benchmarks that are going to be used in the cash marketplace.
So Michael, one term that I've come across in my research, that I was hoping you might be able to comment on, is this idea of “zombie” LIBOR. How exactly does that work, and what exactly is that?
Well, zombie LIBOR is an expression that's been used to describe the dangers of there being undead agreements that are relying upon LIBOR at a time in which that rate no longer exists. And that, in fact, has been the discussion of—the market has been trying to implement to get better handle on how widely implemented is LIBOR? And are there things that are referring to LIBOR that parties may not be aware of and that require some LIBOR quotation at a time after 2021 when banks may no longer be even quoting LIBOR?
So for example, the ARRC, the Alternative Reference Rate Committee, did an assessment of syndicated business loan market. And they didn’t, in their forecast, they said, "We don't see any loans that mature beyond 2025 that rely upon LIBOR. That's six years away."
That may be true of the corporate loan market. Maybe. It may not be true of a variety of floating-rate notes or infrastructure project finance transactions. And there's some questions as to whether that survey is actually accurate or not. So the company that took over the process of surveying market participants on the LIBOR quotations is actually reaching out to get better visibility on how widely deployed LIBOR actually is, and that may lead to a better view of the scale of potential danger as to how big a zombie LIBOR might actually be out there. So if you can accept a Game of Thrones reference, it's a little bit like trying to figure out how large the army of the undead is out in the North to try and understand what the market is up against in trying to switch to a new rate.
Now I'd definitely be lying if that hadn't been running through my mind as you were talking about zombies [laughter].
Okay. So to an extent then, I guess the problem, as it currently constitutes, is we have an idea or at least there has been a survey done about how far LIBOR permeates into the future as part of different deals. But based on the results that have been given to the marketplace, people have questions that that might actually be true and that it could actually have much further—depending on what industry you're in; as you mentioned, infrastructure—it might actually be much further into the future and further removed from that 2021 date than has been reported so far.
It could be. This is a tricky act of replumbing, and it is possible that there may be a small grace period for LIBOR for it to continue. LIBOR is a product of evolutionary financial history, so it has evolved to meet the requirements of market participants. And at the end of the day, market participants are going to decide what benchmark rates they're going to use. And even if the Alternative Reference Rate Committee is saying, "You should use SOFR," it does no power to compel market participants to use that as their benchmark rate.
But I think LIBOR, maybe, at the end of the day, it may represent a prior time in which banks had more ability to self-operate and self-regulate, which is not really the current mood of global financial regulators who are really interested in getting a firm control over these benchmark rates as public goods.
We like to end our ThinkSet Podcast looking forward. As you note at the beginning of the conversation, LIBOR has been around for more than fifty years. If you were to make a prediction, is SOFR the answer for the next fifty years?
I think there will undoubtedly be learnings that will go along as SOFR is implemented. It's difficult to predict the popularity of any benchmark over the length of time that LIBOR enjoyed as being sort of king of the benchmark rates. I think the focus is going to be really in the near term which is how do you appropriately put into place amendments and arrangements to transition to the new rate, because there is going to be a lot of contract language, financial contracts and otherwise, that need to be adjusted.
And so there is a lot of discussion as to how that language should be put into place and what the fallback should be if SOFR it doesn't appear on the scene in an orderly fashion as it's expected to. So there's going to be a lot of legal activity associated with trying to amend agreements to make sure that these are appropriately structured to contemplate the discontinuance of LIBOR, whether or not it's actually going to have an available replacement rate which seamlessly fits into it.
My view is, going back to our Y2K analogy, this is necessary replumbing. If it's done well, everybody will look back and say, "Well, what was all the fuss about?" And if it is done poorly and institutions aren't prepared to do it well, then I think they may find they've got some key mechanisms that may not work the way they anticipated, and that may cause a lot of stress in organizations at times that they would prefer not to encounter that stress.
So time will tell. Well, Michael, thank you so much for joining us today on the ThinkSet Podcast. We'll look forward to chatting with you down the road.
Excellent. Thanks very much.
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I'm Eddie Newland and thanks for listening.
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