We are all going to be heartedly sick of discussing LIBOR and LIBOR transition long before it becomes a thing at the end of 2021, but we really need to get this done. I can’t make this at all funny. We have a problem…but not a solution. Fixing it is going to be a heavy lift. Like a colonoscopy, demonstrably necessary, but in no way fun. (Actually, I really should say, that my doctor is a lovely person, but one simply can’t make wonderful really matter when discussing all things proctologic.)

Okay, we are indeed doing stuff. I appreciate and certainly don’t want to diminish the efforts of our trade organizations, major banking institutions or the Alternate Reference Rate Committee of the Fed (ARRC), but I fear we are not doing enough and not doing it quickly enough. Even as one who got a merit badge during an undistinguished boy scout career for procrastination (I never got around to picking it up), I know that to elide this from the immediate to do list, hoping someone rides in on a white horse to make all this better, is really a bad idea.

Notwithstanding much work by a hardy band of very committed bankers, regulators and trade groups who are paying attention to this meaningful but, let’s face it, pretty obscure issue of financial plumbing, the broader market is snoozing. Is this our Brexit? Is this something we know we have to fix, but we know it’s hard so we kick the can down the road?

The LIBOR transition got some energy and attention at CREFC and a tiny bit at the MBA CREF Convention this past winter. But outside the Olympian heights of a small circle of initiates at major banks, in the regulatory apparatus and in our key trade organizations, it all just doesn’t seem very real, does it? Those of us in the wonky trenches talk among ourselves, express concern and bloviate, but in the real world where borrowers and lenders meet, not much is happening. Very slowly and in a scattershot sort of way a variety of alternate rate text is finding its way into some lending programs, but it’s not creating a coherent jumping off place for conversion.   The clock keeps ticking.

We need A SOLUTION. See, the problem is that A SOLUTION is not simply agreeing on something and saying with some fanfare, “here’s what you should do,” but actually having thousands of lenders and transaction parties embedding that solution into tens of thousands of transactions worth trillions of dollars. We can’t do a Charlton Heston in The Ten Commandments here and write down the rules and declare victory. What did he get for his hard work? Lots of inappropriate smoting, tons of blaspheming, general venality, sly shagging and, to date, about 4,000 years of generally bad behavior. Saying it is step one; doing it is the important thing. How’s that going to work? Think Augean Stables.

The ARRC is beavering away, which is something. It is hell bent on producing an “answer” real soon, but it’s not clear whether it’ll be the right answer. Give ARRC its due. It published a series of consultations over the past year or so, the most recent on contract language to trigger the switch away from LIBOR to SOFR, and asked for comment. However, for most of the country, that was the equivalent of shouting down a well. The bulk of our industry has been paying zero attention. It’s like an election where only 30% of the public votes, we get what we deserve, right? (I don’t necessarily think so, but it’s possible to construe that comment as commentary on the perilous state of our politics. Just saying.)  I worry that we think a good process is a pretty good substitute for a good outcome. Consultations done. Oh well… Check. No one is paying attention. Check, what a relief! Time to declare victory and publish our roadmap and stand back and tut-tut over the ensuing chaos? Sounds like a plan! It’s not a plan.

A couple things are, at this point, clear. The Secured Overnight Financing Rate (SOFR) is a lock for the new and improved LIBOR. We are going to have a wide range of complex, often subjective triggers prompting the switch out of LIBOR, and regrettably, we are going to have a waterfall of prospective alternate SOFR rates to choose from when we switch. It’s pretty clear that when 2022 rolls around, we’re not going to have a single trigger or a single, easily understood, alternative rate. What we need is broadly agreed, clear, bright lined rules as to the date on which we switch rate and clear bright lined rules on what the index will be. We’re not getting it.

To refresh, the ARRC’s most recent consultation included the following triggers:

“Benchmark Discontinuance Event” means the occurrence of one or more of the following events with respect to LIBOR:

1. a public statement or publication of information by or on behalf of the administrator of LIBOR announcing that such administrator has ceased or will cease to provide LIBOR, permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator that will continue to provide LIBOR;
2. a public statement or publication of information by the regulatory supervisor for the administrator of LIBOR, the U.S. Federal Reserve System, an insolvency official with jurisdiction over the administrator for LIBOR, a resolution authority with jurisdiction over the administrator for LIBOR or a court or an entity with similar insolvency or resolution authority over the administrator for LIBOR, which states that the administrator of LIBOR has ceased or will cease to provide LIBOR permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator that will continue to provide LIBOR;
3. [a LIBOR rate is not published by the administrator of LIBOR for five consecutive Business Days and such failure is not the result of a temporary moratorium, embargo or disruption declared by the administrator of LIBOR or by the regulatory supervisor for the administrator of LIBOR;]
4. [a public statement or publication of information by the administrator of LIBOR that it has invoked or will invoke, permanently or indefinitely, its insufficient submissions policy; or]
5. [a public statement by the regulatory supervisor for the administrator of LIBOR or any Governmental Authority having jurisdiction over the Lender announcing that LIBOR is no longer representative or may no longer be used.][1]

And here is the waterfall:

       “Replacement Benchmark” means

1. Term SOFR for the applicable Interest Period (or, if an Impacted SOFR Interest Period, the Interpolated SOFR Rate) as of the applicable Reference Time, plus the Replacement Benchmark Spread for the applicable Interest Period; provided that:
2. if the Lender determines on the applicable Benchmark Reset Date (which determination shall be conclusive and binding absent manifest error) that the Unadjusted Replacement Benchmark cannot be determined in accordance with clause (1) above, then Compounded SOFR for the applicable Interest Period as of the applicable Reference Time, plus the Replacement Benchmark Spread for the applicable Interest Period[; provided, further, that:
3. if the Lender determines on the applicable Benchmark Reset Date (which determination shall be conclusive and binding absent manifest error) that the Replacement Benchmark cannot be determined in accordance with clause (1) or (2) above, then an alternate rate of interest to replace the Benchmark that shall be selected by the Lender, in its sole discretion, [giving due consideration to any unadjusted rate reflecting any evolving or then existing convention for similar U.S. dollar denominated credit facilities, which may include any unadjusted rate that is selected, endorsed or recommended as the replacement for such Benchmark by the Relevant Governmental Body,] plus the applicable Replacement Benchmark Spread].

If the Replacement Benchmark as determined pursuant to clause (1), (2) or (3) above would be less than zero, such Replacement Benchmark shall be deemed to be zero for the purposes of this Agreement.

Clear as day, right?

The ARRC has been encouraging folks to voluntarily move from LIBOR to SOFR in advance of the trigger date, but that hasn’t happened and seems unlikely to happen until the conversion is compelled by circumstances. Replay my procrastination comments. But really, who’s going to be the first to go to their borrowers and say, “Hey, my friend. I’ve got this nifty new index rate for you that you’ve never heard of. Oh, and we really don’t have any certainty as to how it will perform over time, but don’t you worry! And you may not be able to hedge without basis mismatch.” I love this idea!

This is all pretty discouraging.

We’ve had some speechifying on point recently from the great and good. A while back, Andrew Bailey, the CEO of the UK’s Financial Conduit Authority made sure that everyone understood that the LIBOR transition wasn’t something that might happen, it’s a will happen thing and that everyone needs to get ready. More in the same vein from Mr. Bailey very recently where, writing on behalf of the Financial Stability Board, he reminded us that it’s entirely possible that the FCA could even make a pre-2021 finding of non-representativeness bringing some of these problems forward. Recently, Michael Held, the EVP and General Counsel of the Federal Reserve Bank of New York, made a speech which is worth reading. In his remarks, he said a bunch of interesting things. Mr. Held referred to the need to get the transition done as a “call to arms.”

You rarely see a call to arms to a garden party.

Mr. Held went on to admit that the folks behind the curtain have yet to grapple effectively with the absence of a risk premium in the SOFR rate. SOFR is essentially a risk-free overnight rate. LIBOR has a risk premium built into it, and that risk premium is therefore built into every coupon charged on every floating rate loan on the planet. This matters. The easy answer is to say, well on whatever date we convert, we’ll compare LIBOR (presumably still being published) and SOFR and that spread will be the risk premium. We’ll add it to SOFR and we’re done. We have a risk premia SOFR, right? Not really. Some have said we can improve on this by simply looking at data sets of LIBOR and SOFR for some significant period of time prior to 2021 and build an average spread. That’s better, but still insufficient. What’s not been said enough is that while we know how SOFR has performed for the past several years, no one has a clue what happens to the spread between SOFR and LIBOR (or what would be LIBOR, if LIBOR was still available) during a period of credit constriction or material credit risk associated with a significant downturn of the economy. The fact that the two rates have been close to on top of each other during period of interest stability does not tell us a great deal about what will happen to SOFR in a period of interest stress. (There is also serious questions about how SOFR will perform at month end and quarter end and we will certainly have to deal with that complexity as well.) If there is significant difference between these two rates in periods of interest rate stress, that will create winners and losers between borrowers and lenders, and lenders might be the losers in that trade. Mr. Held helpfully pointed out in his comments: “the goal is to create a value-neutral adjustment mechanism that doesn’t create winners and losers as LIBOR contracts reset. Ideally, the adjustment would also be easily understood, transparent and based on objective factors, not on discretion. That’s a very tall order. This is another area where the ongoing consultations are very important.” YIKES! Let me translate what the Honorable Mr. Held just said in government speak: That’s hard! Hope someone has a clue. (He also said some unflattering things about lawyers. Shame! I’ll return to this later.)

While ARRC is beavering away toward a proposed structure, ISDA and the swaps market are sashaying to a different beat and seem intent on creating their own SOFR, calculated in a different way. The triggers under the ISDA consultative documents are different and the fallback rates are calculated in different ways. If this isn’t fixed, then we’ll have basis mismatch between cash and swap products. Will the two sides stop pouting and chest thumping and start reconciling alternate views between now and 2021? One could only hope so, but there’s certainly no indication of that sort of adult behavior breaking out right now.

As we get close to a final ARRC proposal, many market participants are finally beginning to focus on the fact that the ARRC product is likely to settle on a “compounded, daily in arrears” method of calculating SOFR. If that’s what we get, we will no longer be able to tell a borrower at the beginning of each interest accrual period what his or her interest charges will be for the month or quarter. While compounding in arears is simple, requires no term product to be conceived or constructed and could be done today, it seems like a very tough lift in commercial real estate markets and middle market lending where borrowers have oddly gotten used to knowing what their interest charges would be in advance. For those fans of forward looking rates, please note that it may become available, it does not now exist and ARRC thinks it unlikely to exist in sufficiently robust form to support pricing until the end of 2022, if at all.

That reinforces my concern that after flipping out of LIBOR, we may be dealing with evolving methodologies for calculating SOFR as markets develop for a considerable period of time. Think of the confusion when you not only have to transition to SOFR from LIBOR, but then explain how SOFR calculations might change over the life of a deal, maybe numerous times. That will lead to convivial and productive conversations between borrowers and other counterparties I am sure!

Adding to this litany of woe, there is talk now that the transition from LIBOR to SOFR might occasion capital charges for prudentially regulated banking institutions. That will do nothing but increase the cost of borrowing and cause capital constraint.

Let’s close by talking about lawyers. I said I would. In Mr. Held’s speech he said, “You can imagine the litigation risk when the reference rate for a twenty year contract disappears and there’s no clear path to replace it.” Now imagine a $1.90 trillion worth of these contracts. Mr Held went on to describe “this is a DEFCON 1 litigation event if I ever saw one. …it all invites litigation…on a massive scale.”  How comforting, coming from one of the masters of the universe who is actually engineering this change. Now, for the macro inclined, you might notice that 2021 is in the center of the range of most economist’s predictions of when the next recession will occur. How perfect is that? Might one observe that the problems of conversion are unlikely to be ameliorated by lenders and borrowers at loggerheads because of a recession. Let’s paint a picture here. Loans maturing and unable to be refinanced, defaults and risk of default in the air. Borrowers and lenders both in need of modifications of existing loan documentation. When things go awry, isn’t it likely that Count Four of every aggrieved borrower’s complaint will be that its business was disrupted and its expectations frustrated by the indeterminacy of its interest rate and that the change in the interest rate imposed by the lender based on alternate rate language (that few paid any attention to when the loan was closed) is somehow a breach of the contract entitling the borrower to damages and remedies, etc.? Will its claims prevail? Well, I think largely not. Will these sort of claims survive summary judgment and create leverage in disrupted borrower/lender relationships at the time of the conversion? You betcha!

Is there anything to do about this?

Clarity provided by some authoritative source on when to convert and what to convert to would be so terribly helpful. If this was published by the Fed or by one of the other prudential regulators in the United States and similar governmental institutions around the globe, it would materially reduce these problems. If we had a clean date and a clean conversion, these problems would be materially reduced.

Apparently, the ARRC thinks so, too. David Bowman, special advisor to the Federal Reserve Board of Governors and manager of the ARRC process in a speech at the Finance Industry Group Conference in Las Vegas suggested that the ARRC could go to the New York Legislature for a fix here. Suggested? Maybe they ought to be begging! But I actually don’t think they should. I don’t think they will, and if they do, I don’t think our elected representatives will oblige. If it did get taken up what might be initially presented as a technical LIBOR alternate rate conversation matter is likely to rapidly devolve into an ISSUE, grist for the sausage making of the political process. In this age of populism and hostility to bankers and Wall Street, do you have any doubt how will this play out? Dimes to dollars the proposal to deliver legislative clarity would be positioned as an “us vs. them” issue; “us” being the people (e.g., easily riled up voters) and them being the nefarious denizens of Wall Street. Forget what the experts may say about this, it’s clearly a scheme to hurt the little guy (or the voters), right? And that wouldn’t be at all helpful, would it?

Alternatives? More, much more, industry self-help. We need to start now spending meaningful time and energy (and regrettably, money) as an industry educating ourselves, educating the borrower community, educating the regulators and our gloriously elected officials that this is a change which is needful, will make lending and banking safer and better for everyone and that it’s not a nefarious effort by card-carrying members of the trilateralist commission or the Illuminati to abuse the downtrodden borrowers for the benefit of banks and the Street. We need to find the very best alternate rate language we can find. We need to get clarity around triggers and rates. It’s hard, but we need to declare victory and get moving now on coherent, systemic and consistent implementation. We need to start baking these clear mechanics into legacy documentation now. If we don’t, then this is going to be a disaster.

All those pesky lawyers are just waiting in the wings. Mr. Held, perhaps talking his own book, said “I blame the lawyers…” for where we are today. Ha! Just wait to where we will be when! I guess someone should have a chance to look forward to the death of LIBOR with a genial glow of satisfaction and maybe it’s the lawyers.

In any event, we have an opportunity to diminish the amount of fun they have, to decrease the amount of noise and disruption when we get close to the transition, but we need to act now. Have at it everybody.

[1] Note that CREFC has proposed a sixth trigger based on a 50% OPB conversation of the loans in a securitization TBD.