The following is based upon the Fixed Income Market Structure Advisory Committee Panel meeting held on Monday, November 5 entitled ‘LIBOR Transition Update and SOFR Volatility,’ and related statements from the Federal Reserve Bank of New York.
Recent Fed Liquidity Infusions
Since the spike in the Secured Overnight Financing Rate (SOFR) in mid-September, SOFR has remained stable. A prime factor in maintaining stability was steps taken by the New York Fed, as directed by the Federal Reserve, to actively increase the supply of reserves in the banking system from, among other things, the sale of Treasuries to banks through repurchase agreements (repos).
As reported at the meeting, the New York Fed recently infused approximately $220 billion into the banking system – $70 billion of overnight repos and $150 in term repos. The New York Fed has recently authorized, at least through January 2020, the sale of (i) at least $120 billion of overnight repos and (ii) at least $45 billion of general bi-weekly sales of term repos. It is contemplated that Treasury bill purchases of $60 billion per month will replace, over time, the newly-instituted repo operations. These recent repo operations have boosted the supply of reserves and helped mitigate the risk of money market pressures adversely impacting monetary policy implementation.
We note that the foregoing operations and Treasury bill purchases have not occurred to this extent since the end of the recent financial crisis.
The New York Fed, in cooperation with the Treasury Department’s Office of Financial Research (OFR), are proposing to publish three compounded average indices of SOFR (30-day, 90-day and 180-day indices). It is expected that these longer term average SOFR indices will smooth out any temporary aberrations in SOFR due to, for example, month-end/quarter-end/year-end liquidity needs.
Limited Credit Component
As SOFR is based upon the credit of the Federal Government, it should be at a significantly lower rate than LIBOR, which is generally based upon the credit risk of the LIBOR Panel Banks. It was noted that the differential between Treasuries and LIBOR significantly increased to 150 to 300 basis points upon the onset of the Great Recession.
Ideally, the rate paid on SOFR plus a spread based upon historical differences, factoring in the different tenors, should result in rates substantially similar to LIBOR. However, the correlation between SOFR and LIBOR may become weaker if (i) these historical differences are based upon recent aberrations and/or (ii) market abnormalities occur for the LIBOR Panel Banks. This will have significant financial implications to issuers and borrowers.
The lower all-in SOFR rate, if it were substituted for LIBOR without the appropriate mark-up, would benefit issuers/borrowers with variable rate notes/bonds.
Conversely, this lower all-in SOFR rate will likely have negative consequences for a typical interest rate swap issuer/borrower counterparty where the issuer/borrower pays a fixed rate to the bank counterparty and, in turn, the bank counterparty pays a lower variable rate to the issuer/borrower. This lower rate would then translate to an increase in (i) mark-to-market valuations of the swap as reflected on the issuer’s/borrower’s financial statements and (ii) termination payments should the borrower/issuer terminate the swap.
The foregoing is exactly what occurred during the financial crisis, exacerbating liquidity problems for borrowers/issuers.
Even a 1 basis point (0.01%) differential between the LIBOR rate and the new SOFR rate plus the spread could have a significant financial impact on issuers and borrowers. Extrapolating from prior estimates, such a differential could lead to a swing in benefits or losses in the aggregate of tens of billions of dollars for standard 10-year LIBOR-based bonds and swaps for the overall U.S. dollar LIBOR market.
Inadequacy of Corporate Issuer/Borrower Representation
As previously mentioned, the rate conversion process is being spearheaded by the Alternative Reference Rates Committee (ARRC).
Membership to this committee, either directly or indirectly, is primarily comprised of LIBOR Panel Banks, other banking institutions and associations, diversified financial firms, insurance companies, energy and commodities firms, and Federal Government regulators. ARRC members also include accounting firms, exchanges/clearinghouses, investors, IT vendors, mortgage insurers, private equity firms, rating agencies, servicers, a state/local government association and trustees.
Interestingly, there appears to be no involvement of companies outside of the financial, insurance, energy, commodities and securitization areas including not-for-profit corporations, such as hospitals, many of which were detrimentally impacted by ‘underwater’ swaps during, and subsequent to, the recent financial crisis.
A Panel member observed that legacy LIBOR-based instruments typically only contemplated a short-term unavailability of LIBOR and not a wholesale termination of the LIBOR rate. As a result, fallback language has been instituted for most new floating rate notes but has not been implemented to any great extent for other types of instruments or for older LIBOR-based instruments.
A Panel member highlighted a concern about possible litigation resulting in legacy LIBOR-based instruments. One suggested method to reduce this risk is to continue publishing LIBOR after the end of 2021 (referred to as ‘Zombie LIBOR’). There was general agreement among the Panel that this might not be the best path forward.
Special New York Legislation
Another avenue discussed by the Panel member was obtaining special legislation in New York State (as most US Dollar derivatives use New York as the governing law).
- Potential Delay
The concern with this approach is that legislation may not be enacted until 2021.
- Non-New York Loan/Bond Documents
Such legislation, however, would not address (i) loan transactions governed by other state laws or (ii) the situation where a loan is governed by non-New York law but the related derivative is governed by New York law.
- Relevant Federal Law
There are also implications on how to deal with indentures, even if governed by New York law, utilizing LIBOR-based rates under the Trust Indenture Act of 1939 - a Federal law.
 Based upon our calculations using information from the New York Fed (i) there could be current availability of up to $340 billion in T-bill/repo purchases to support reserves in the banking system and (ii) there has been an increase by $644.4 billion (35.6%) from April 10, 2018 through October 9, 2019 in the total tri-party repos market.
 See (I) Statement Regarding Repurchase Operation, dated September 17, 2019, for the sale of overnight repos up to $75 billion on September 18th, (II) Statement Regarding Repurchase Operation, dated September 18, 2019, for the sale of overnight repos up to $75 billion on September 19th, (III) Statement Regarding Repurchase Operation, dated September 19, 2019, for the sale of overnight repos up to $75 billion on September 20, 2019, (IV) Statement Regarding Repurchase Operations, dated September 20, 2019, for the sale of (a) overnight repos of at least $75 billion on each business day from September 23rd through October 10th and (b) 14-day term repos of at least $30 billion on September 24th, 26th and 27th, (V) Statement Regarding Repurchase Operations, dated October 4, 2019, for the sale of (a) overnight repos of at least $75 billion on each business day, extending from October 11th through November 4th, (b) 14-day term repos of at least $45 billion on October 8th and 10th, (c) 6-day term repos of at least $45 billion on October 11th, (d) 14/15-day term repos of at least $35 billion on October 15th, 17th, 22nd, 24th and 29th, (VI) Statement Regarding Treasury Bill Purchases and Repurchase Operations, dated October 11, 2019, for (a) the purchase of Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November and (b) extended the sale of overnight repos and term repos pursuant to clause (V) above at least through January 2020, (VII) Statement Regarding Repurchase Operations, dated October 23, 2019, relating to (a) the increase of overnight repos to at least $120 billion on each business day starting on October 24th, (b) the increase of 14-day term repos to at least $45 billion on October 24th and 29th, and (c) the sale of 13/14-day term repos of at least $35 billion on November 1st, 5th, 7th, 12th and 14th, and (VIII) Statement Regarding Repurchase and Reverse Repurchase Agreements Small Value Exercise, dated November 4, 2019, for the sale of 2-day reverse repos up to $175 million from reverse repo counterparties.
 Also see Remarks of Lorie K. Logan, Senior Vice President of the New York Fed at the Annual Primary Dealer Meeting of the New York Fed, as prepared for delivery on November 4, 2019.
 Also see Statement Requesting Public Comment on a Proposed Publication of SOFR Averages and a SOFR Index, dated November 4, 2019.
 See the section ‘Unaddressable/Unaddressed Issues’ in the Client Alert entitled ‘The End of LIBOR’ by Richard A. Newman and Les Jacobowitz, dated November 1, 2019 (“The End of LIBOR Alert”).
 See the section entitled ‘Proposed Treasury Regulations - Details’ in The End of LIBOR Alert.