COVID-19 has driven anxiety over the LIBOR transition right off almost everyone’s top-of-mind list and yet the crisis is taking no notice of that lack of regard and soldiering on.  The ARRC continues to beaver away, generating guidance and advice and otherwise proselytizing the need to get on with it and be ready for transition on January 1, 2022.

But are the markets listening?  Look at our ardor!  Except for special situations, the use of SOFR, to date, has been a political and not an economic decision for those who have elected to use it.  There is little take-up in the real world and little enthusiasm for doing so.  And what’s with the huge whoops a few weeks ago when SOFR’s March to the Sea was interrupted when the Fed backed off using SOFR in the Fed’s new $6 billion aid program for small and mid-size businesses?  Run away! Run away!  Back to LIBOR!

For those of you (me included) who haven’t been paying sufficient attention to the LIBOR conversion process these past eight weeks and feel a bit guilty, let me catch you up on what’s happened.  The FCA pushed some interim transition milestones back but reiterated that “Day T” is unlikely to move.   The ARRC announced its spread adjustment methodology and moved up the schedule on Term SOFR production to the first half of 2021.  That’s progress.  It looks increasingly like the derivatives market will embrace the same pre-cessation transition trigger mechanics recommended by the ARRC, which is an unalloyed good thing.  Compounded SOFR data sets have been regularly published since March.

But the really hard stuff hasn’t been sorted, and there are problems with SOFR that can’t be fixed.  One of the problems yet to be resolved is that there is no real consensus around whether the cash market will quote SOFR in arrears or SOFR in advance, notwithstanding the clear views of some members of the ARRC (in arrears).  In the apparently unfixable column, no one has come up with a solution for the absence of a credit risk component to SOFR and while the denizens of the ARRC don’t seem to think it’s a big problem, it is indeed a big problem, particularly in the cash, primary lending marketplace.

Finally, SOFR has periodically behaved quite badly and spiked several times over the past year.  Is that okay because the index will be based upon lengthy data sets, or because the Fed will be relied on to step in and fix it if it goes wrong again?  Either seems to be an entirely amiable solution to the problem.

And let’s not dismiss the legacy conversion process, the process of communicating all this to the borrower community, the operational problems associated with the complete overhaul of the back office of thousands of lenders across the United States, and the need to amend thousands of legal documents, which in many cases may see us facing somewhat uncooperative counterparties.  All TBD.

We’ve now lost the better part of eight weeks in any transition effort and dimes to dollars, LIBOR transition is not going to get back to the top of the to do list as long as COVID-19 dominates our thinking and in fact dominates the marketplace.  Let’s face it, we’re not really going to have bandwidth to think about LIBOR in a real actionable way until the pandemic recedes and we begin to get back to work.

For those of us who have been consistently warning that the transition was going to be hard and a lot of work would need to get done if we were going to make the transition anything other than a chaotic mess, this hiatus in the transition process is troublesome.  I don’t know about you but, tick tock, if we’re not engaged in a significant way on LIBOR transition until sometime in the mid-fall, with a hard transition date barely more than a year away, that’s a real problem.

Now I understand that for many, long-term planning is lunch on Friday (God, do you remember actually going to lunch with actual people…in a restaurant?)  So, 2021 still seems like a long way away, but we are rapidly getting to the point when transition will almost certainly be disorderly (or more so than it would be no matter how well prepared for it we were).

BlackRock recently put out a report on LIBOR transition and the takeaways, which may have been intended to be reassuring, are, in fact, actually rather distressing.  Key points in the report:  Time to focus, the market is not ready, the market is not educated, basis risk is a problem without a solution, global coordination is important (and not really there).  Could we please have legislation to fix the legacy contracts problem?  All this amounts to the same to do list we had a year and a half ago and frankly not many things have been checked off at this point.  We may have already passed the point where anything other than a chaotic transition is not possible.

In prior commentaries on LIBOR I often had a throwaway line that said this is going to be hard but it would be super hard if we had to do it in a recession.  My, my.  Looky what we got here.  All our anxieties about LIBOR transition are magnified.  All the transition problems will be more intractable.  All our operational problems will be worse.

I suspect some in our industry are still embracing a strategy of hope; hope that this transition thing will be deferred or go away; the Hail Mary approach to the problem.  While Doug Flutie (obscure, ancient historical football reference) is one of my faves, as we always say, hope is not a strategy.

But…and at the risk of never being invited to an ARRC cocktail party ever again, are we at the point where we need a rethink?  Is it time for the industry to essentially say, “This is not working?”

A while back in a screed against the transition I asked why we are punishing the entire world economy because a couple of London bankers diddled the index for their own pecuniary benefit in an isolated number of incidents.  Isn’t that a little bit like using an atom bomb to fix a cockroach infestation?

Seriously, should we start to think about pushing for a delay, or indeed a real fix?  While the ARRC apparently doesn’t like to think about this much, there were alternatives in the early days of the ARRC process.  For whatever reason, the panjandrums of the ARRC cut off any conversation about alternatives long ago (before most folks in the industry were paying any attention at all to the LIBOR transition issue).  Meanwhile, there are parts of the official sector continuing to express doubts.  The Office of the Comptroller of the Currency started a working group to discuss other potential LIBOR alternatives.  Jerome Powell said to Congress that the Fed is exploring other “suitable” rates for credit sensitive LIBOR users.  

The European Union, some of the canniest can-kickers in human history, have kicked this can down the road with their re-commitment to a new and improved Euribor, which became fully effective at the end of 2019.  The new, improved Euribor is old Euribor with very limited changes.  Some less-utilized tenors were eliminated.  If there isn’t enough transactional data on a given day for a particular tenor, the rate for that tenor is interpolated.  If that doesn’t work, panel banks make submissions using modelling techniques approved by the ECB or using expert judgment.  While I am rarely a fan of EU politics or policy, this indeed proves that the blind cat sometimes does find the dead mouse.

The ICE Benchmark Association proposed adopting similar reforms for LIBOR and they were told to talk to the hand.  LIBOR’s death march continues without so much as a look back.  Maybe that was indeed a rational response from the ARRC.  Clutching SOFR to the regulatory breast out of a concern that any delay in selecting an alternate index would lead to failure.  On the other hand, you might say, but I couldn’t possibly comment, that it was just stubbornness on the part of officialdom to not look at more and other fixes to LIBOR.  (You really need to go see the original English version of The House of Cards…way better).  By God, we found our alternate rate and I don’t care what we hear, we’re sticking with it.  It’s the financial equivalent of sticking one’s fingers in one’s ear and saying, “lalalalala” while someone tells you an uncomfortable truth.

Just for a for instance, how about we require major banks to continue to provide quotes and ask those bankers to develop protocols and principals to insure that the quotes provided are developed and shared based on a system that is transparent, verifiable and replicable.  That’s essentially what the Europeans did.  Wow, what a shocking idea!  So what if the FCA promised panel banks it wouldn’t use its compulsory powers to keep LIBOR afloat; that was then and this is now.

A little more outré, require a set of major money center banks to participate in an active  interbank lending market on a regular basis, and base the quotes on actual transaction pricing.  A tad artificial, at least in recent days, since banks don’t need interbank lending, but it would return macroeconomic risk to the index which would be a good thing.  The absence of the macroeconomic dynamic adjustment mechanics in the SOFR index is the intractable, unsolvable and largely unacceptable problem with using a risk free index.  All you need to do is look up from your desk as we sit here right now and see what happens during a period of stress where a flight to quality drives Treasury pricing up and yields down; exactly the opposite way in which the interbank lending market would respond.  That’s nearly insane.

I wish I could come up with an actionable strategy to turn a Hail Mary into a plan and I really do think as an industry we ought to press the powers that be to reconsider where we are right now.  But at the moment, it’s still a hope and not a strategy.

So in the meantime while we think about Plan B, we need to stick on Plan A and get back on the bandwagon and recommit to a process of transitioning from LIBOR.  We need to understand our legacy book and the impact on the legacy book when the transition date occurs.  We need to insert a functional transition mechanism into our loan documents ASAP.   We need to act to minimize mismatches between securitization instruments, underlying loan documents and the swap structure.  We need to communicate all this to the borrower community who are still largely clueless about this impending and significant change.  We need to look at our relationships and determine which ones will be problematic and address those before the chaos of late December 2020.

If you want to get a sense of what January 2021 is going to be like in financial markets, think helicopters on the embassy roof in Saigon in 1974 as a useful and instructive metaphor.