Since 1986, the London Interbank Offered Rate (LIBOR) was the standardized interest rate benchmark used to price a vast number of adjustable-rate commercial loans, mortgages, securities, and derivatives. Set daily, the administrative entity overseeing LIBOR would solicit borrowing cost estimates from 18 large banks based on a pre-determined period of time, from which it would define the trimmed mean.
Contributed by Mark Fisher, managing director, JLL, New York City
Over time, however, this mechanism created controversy. The 2008 Financial Crisis highlighted its underlying weakness and resulted in a reluctance for banks to lend to one another and increased LIBORs costs.
The issues associated with LIBOR were further exposed following the prosecution of a myriad of price-fixing scandals that started to emerge in 2012. The episodic scandals targeted the very trading desks that were responsible for setting the rates.
With the clarity of hindsight, regulators in both the U.S. and the U.K. realized the LIBOR index had become outdated. A search commenced for a more market-based replacement based on actual borrowing costs, which are less likely to be manipulated.
In June 2017, after many years of work, the Federal Reserve announced that by June 30, 2023, LIBOR would be phased out and replaced by the Secured Overnight Financing Rate (SOFR), with no additional two-month or one-week LIBOR contracts enacted after December 31, 2021.
Both SOFR and LIBOR reflect short-term borrowing costs. The main difference between LIBOR and SOFR, however, is how the rates are determined. SOFR is a secured, risk-free, daily rate based on the U.S. Treasury’s overnight repurchase, or repo, retail market. It is based on observable transactions rather that estimates, making it a more accurate measure of borrowing costs.
For most borrowers, the move away from LIBOR will result in very negligible efforts and costs.
Lenders have had sufficient time to prepare for termination of LIBOR contracts and are prepared to use the new pricing index. More importantly, recent vintage loan documents were most likely drafted in anticipation of this new index so there should be a relatively seamless process to set borrowing costs.
There also should be no additional borrowing costs for switching to SOFR. The current 30-day LIBOR contract, which is the most popular interest rate index for floating loans, is 10.14 basis points. The current One-Month Term SOFR contract (per the CME) is 5.27 basis points. The miniscule difference in pricing will most likely be covered by lender-imposed floors in the near term which are expected be identical to the LIBOR floors that have been quoted over the past six months.
In fact, the greatest challenge may face is understanding the documentation and getting used to new terminology. For those borrowers with fixed-rate loans, there will be no impact on a day-to-day basis. However, for those borrowers with existing LIBOR-based loans older than 18 months, it would be wise to review the replacement language at the time of closings as some clarifications or modifications may be needed.
Ultimately, however, borrowers should view the transition to SOFR as simply one index being replaced by another.
