November 30, 2020 - Updated on December 3, 2020. Monday, November 30th saw a flurry of announcements from the Federal Reserve, the OCC, the Fed, the Ice Benchmark Association (IBA), the UK Financial Conduct Authority (FCA) and the ARRC about LIBOR cessation. Below, we review the statements and analyze the likely impact on LIBOR transition efforts. But first, the bottom line: New USD LIBOR loan and CLO origination should end no later than December 31, 2021. However, the announcements may give breathing room by extending the orderly remediation and transition of legacy USD LIBOR portfolios through June 30, 2023.
What happened: On November 30th, the IBA announced that it would consult on ending one-week and two-month USD LIBOR on 12/31/21 and ending the remaining USD LIBOR tenors on 6/30/23. The FCA “welcome[d] and support[ed] the extension by panel banks and IBA, together with the proposal to consult on a clear end date to the US$ LIBOR panel, following discussions with the US$ LIBOR panel banks”. The ARRC lauded this announcement, noting that it “would support a smooth transition for legacy contracts by allowing time for most to mature before USD LIBOR is proposed to cease.” The Federal Reserve likewise welcomed the release of “proposal and supervisory statements that would enable [a] clear end date for U.S. Dollar (USD) LIBOR and would promote the safety and soundness of the financial system.”
Critically, while the extension may provide more time to remediate legacy portfolios, this is not a license to print endless LIBOR transactions or ignore fallbacks. The Fed, OCC and FDIC simultaneously released a statement encouraging banks “to transition away from U.S. dollar (USD) LIBOR as soon as practicable.” First, the banking agencies believe that “entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly.” Specifically, they suggested that banks cease entering into USD LIBOR contracts as soon as practicable and, in any event, no later than end-2021. Moreover, new contracts entered into before December 2021 should either reference a rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR ends (e.g., a hardwired fallback).
What does this mean for loans? In effect, LIBOR cessation planning should not really change: No new loans should be written on LIBOR after the end of 2021 (and, according to the banking agencies, ideally it should end earlier), and lenders should continue to remediate their LIBOR portfolios and use hardwired fallback language.
The good remediation news, analytically speaking: Having potentially more breathing room for remediating legacy loans improves the odds of an orderly, safe and sound LIBOR transition. Based on an initial analysis, an extension of LIBOR for legacy loans means more loans should organically refinance into SOFR between January 2022 and June 2023. The nearby COW is an initial attempt to game out how loans may be remediated. We took the B- and better loans in the S&P/LSTA Leveraged Loan Index and used their origination and maturity dates to build potential refinancing/transition scenarios. In our first scenario, we assumed that loans would refinance or transition to SOFR at maturity. (While this is not a realistic scenario because only very troubled loans go to maturity, it does create a hard end date.) As the green bars demonstrate, in this scenario nearly all loans fall back from LIBOR to SOFR after June 30, 2021. In other words, the transition logjam is just pushed out.
Our second scenario is somewhat more realistic, assuming loans refinance one year prior to stated maturity. This cohort (in gold) still sees the majority of loans fall back from LIBOR to SOFR after June 30, 2023. However, 20% would likely refinance into SOFR before mid-2023, thus relieving some of the fallback pressure.
The more realistic (and more complex) scenario assumes loans refinance three years after origination. (This is an assumption often used to calculate “yield to expected maturity” for loans.) In this scenario (in grey), 53% of loans would refinance before December 31, 2021. It is possible that loans that refinance in late 2021 may flip directly into SOFR, thus reducing the logjam of loans falling back after LIBOR cessation. However, loans that refinance in early 2021 might stay in LIBOR and add a hardwired fallback (and thus would be added to the pile that need to fall back after June 30, 2023). The “refi three years after origination” group also sees nearly 40% refinancing between the end of 2021 and mid-2023, and they presumably would refinance directly into SOFR. Finally, there is just a small tail here (9%) that would have to “fall back” from LIBOR to SOFR with no interim refinancing. Ultimately, if the loan market does see most loans refinance within three years of origination, the extension of LIBOR for legacy loans may materially relieve the “fallback logjam” that we feared with a December 31, 2021 LIBOR cessation.
Bottom line: Keep the Workstreams. Lose the Panic.
