My, my, my! Another governmental red line looks to be breached; at least this time no one gets hurt. We, at CrunchedCredit, have in some sense been carrying the government’s water about LIBOR transitions. We have been talking about how to prepare for transition, how to move current loan production onto a sound non-LIBOR basis and how to address legacy assets. In other words, we had taken seriously the warnings of the FCA and the Fed, as well as others upon the regulatory heights who assured us that the LIBOR transition would arrive in early 2022. While we had heard stray musings from the regulatory establishment throughout, we all took on board the assurances from the regulatory doyens and rebroadcast their message, that everyone’s “central assumption” should be that they “cannot rely on LIBOR being published after the end of 2021.”
I gotta tell you, I feel a little bit like Charlie Brown with the government playing Lucy.
Oh well. Now it’s June 2023 (promise). We think it’s instructive just to review what’s happened these past few weeks and how we got where we are now. First, last month Mr. Quarles testified in Congress that the Fed was working on a plan to “facilitate” a better transition. It was all a bit opaque, but for those of us who have nothing better to do than to follow this sort of thing, it seemed meaningful. We doubted that Mr. Quarles would have said that in the place he did, unless something was really about to happen. Then, two weeks ago, we heard from the ICE Benchmark Administration (IBA) that it will enter into a “consultation” in which it would consider delaying the end of US dollar LIBOR until June 30, 2023. The Federal Reserve Board almost simultaneously published a statement welcoming the development from IBA and we got similar joyful-noise-unto-the-Lord type comments from the FCA, which is the place that really matters as it controls the process by which panel banks are obliged to provide quotes to support LIBOR.
So, now it’s pretty damn certain—perhaps not totally certain, but pretty damn certain—that the heretofore immutable cessation of LIBOR in 2022 will not happen (except for two stray tenors which aren’t really important to the commercial real estate markets). Given the obdurate refusal of anyone from the regulatory heights to publicly entertain that possibility until about a month ago, well, it’s very frustrating.
Are we now done? I am reminded of the story of Bob, who agreed to take care of his brother’s cat, which was dear to him, while he went on vacation. Of course, the cat promptly expires and when Bob’s brother calls to check on his precious cat, Bob simply said, “It’s dead,” sending his cat-loving brother into a spiraling depression. Weeks later, the brothers talked again and the grieving brother said, “Bob, if you have to give someone really bad news, you should let them down gently. For instance, in this case you should have first told me that my cat had jumped into a tree and the fire department was on site. Only after all that, should you tell me that notwithstanding the heroic efforts of our local fire department, the cat had fallen out of the tree and died. I could have gotten used to the notion that my dear cat might be in danger and been reconciled to the ultimate receipt of bad news.” Bob, being a sensitive sort, assured his brother that he would certainly do better in the future. As they were finishing this call of reconciliation and were exchanging pleasantries, Bob’s brother said , “By the way, how’s Mom?”……. “Well, Mom’s on the roof.”
Is that what they just did to us? Is it over? Is June 30, 2023 now really it? Is Mom dead, or still on the roof? Is there more to come?
Before we start celebrating that we’ve got an additional 18 months to deal with the LIBOR transition (which, to be clear, we urgently need), let’s pause to note that this consultation process has to be completed. We need the FSA to make clear that they will either require a sufficient number of reporting banks to continue to report LIBOR quotes through June of 2023 or have some other arrangement in mid to deliver LIBOR quotes. We need FSA, pinky promise, to assure us that they will not, prior to June 2023, declare LIBOR unrepresentative. Although a highly placed FCA representative had said the FCA was “confident” that representativeness thresholds could be maintained, my trust is a bit shaken at this point and words like “confident” give me pause. After all, we were told to confidently plan for LIBOR’s end in 2022.
And then we really ought to hear from our prudential regulators about all of this in a definitive way. We’ve heard some mutterings from the Fed, the OCC and the FDIC that a LIBOR loan with “robust fallback language that includes a clearly defined alternative reference rate” would be considered prudentially acceptable (suggesting, without saying that something else might not be), but we don’t really have clarity about how the prudential regulators will treat LIBOR loans without a hardwired SOFR transition. Is that imprudent banking? Will the bank regulators take a view that banks must either convert to SOFR or have a hardwired SOFR alternative? The Fed also recently said that their expectation was that prudential banking required loans to have some form of effective fallback for LIBOR. That’s pretty open-ended and hardly a ringing endorsement of SOFR, is it? Why aren’t the banking regulators naming SOFR? Is it just because the ARRC’s recommendations are supposed to be voluntary or are they still leaving open the possibility that other rates could develop? The bottom line is that we still have a fair bit of opacity here and there will be significant pressure from the market to stick to LIBOR until we are again quite close to the next red line.
Do we really think that notwithstanding the delay, private cash markets will move aggressively to SOFR during the next year without absolutely clear guidance? Do we really think there will not be significant pressure from the borrower side to stick to LIBOR until we are quite close to the next red line?
Hardwired SOFR is a hard formulation to love. What happens if the parties simply agree to negotiate a LIBOR replacement when LIBOR goes away? It could happen with strong borrowers. What happens if the parties want Ameribor or Prime or agree to some significant variation of the SOFR preferred language? Would that be prudentially deficient? Also, until LIBOR is gone entirely and SOFR is it, every loan will be a legacy loan and may need transition. My suspicion is that we won’t see a broad movement to SOFR priced loans (notwithstanding the leadership of the GSEs) until the red line begins to hover into view once again.
But as we here at CrunchedCredit are of a sunny disposition, let’s focus on the good news.
This delay may give the market time to come up with a better alternative to SOFR. Remember, SOFR is deeply flawed by the absence of a credit component and the likelihood that SOFR will risk significant value transfer value from borrowers to lenders or vice versa. Maybe we’ll come up with something better.
So, net/net, this is an unalloyed good. It recognizes the reality that we were, until this point, heading towards a chaotic LIBOR transition in the first quarter of 2022 and there were increasingly few paths to avoid it. And at some level, as a card-carrying member of the Procrastinators Club of America, I’m just as happy to deal with this in 2023 as opposed to a mere 12 months from now.
But there’s been real damage to the credibility of the regulatory establishment from this. The fact that we were essentially staring down a chaotic exit from LIBOR should have been apparent to the regulators long before this past month and the process should have been put on pause. And now, what happens when 2023 comes around? Shame on them the first time, shame on me the second time. Like poor Bob, are they telling us that Mom’s on the roof? If this new, absolutely, unbendable, immutable and unmovable commitment to LIBOR transition gets kicked down the road again, that would be embarrassing. We’ll have to watch carefully whether we think the behavior of the FCA, the Fed and of the prudential regulators matches their words and whether we’ll have confidence that June 2023 is a hard date. I’m not betting the ranch that we’re done with this. If they want us all to be SOFR lemmings, they better get their act together.