Floating rate debt for commercial real estate loans and many other forms of financing have been based on an interest rate index called the London Interbank Offered Rate for decades. If LIBOR went up or down, the interest rate a borrower was paying would also go up. And LIBOR rates were quoted each business day for a range of repayment terms ranging from one day to one year. In the real estate sector, the usual loan period is traditionally 30 days, so real estate LIBOR loans are revalued every 30 days.
About a decade ago it became clear that LIBOR reflected in part the creative writing of money dealers from large banks. It did not reliably or accurately reflect actual borrowing and lending market conditions. So the regulators and industry organizations decided that LIBOR was broken and the market should switch to something better.
This began a surprisingly complex exercise lasting several years. So far, his main conclusion has been to replace LIBOR at least in the United States with a so-called Secured Overnight Financing Rate. The SOFR fluctuates daily and is determined after the fact (retrospectively) and not at the beginning of each loan period, which is always only one day. In contrast, the LIBOR price is set at the beginning of each credit period. And it offers a range of possible loan periods of up to one year. SOFR also assumes an absolutely risk-free borrowing rate at all times, i.e. it does not react to changes in money prices caused by changes in the overall credit risk in the financial markets as a whole. Based on these differences alone, the suitability of SOFR as a substitute for LIBOR hardly seems obvious.
International banking regulators have been drummed louder in recent months to announce the impending end of LIBOR, but the SOFR replacement has had limited impact. More promising, private actors have come up with possible replacements for LIBOR: the Ameribor rate published by the American Financial Exchange; Bloomberg’s Short Term Bank Yield Index (BSBY); and IBA’s Bank Yield Index.
Unlike the SOFR index, these three new potential substitutes for LIBOR contain an element of credit risk, are priced, and offer a range of repayment terms. They look a lot more like LIBOR. Regulators are generally open to these substitute sentences, subject to some persistent concerns about their behavior over time, and particularly during periods of stress.
Market participants should be smart enough to find out all of this, with or without the help of regulators. In the course of time, the market should make friends with one or more of these substitutes for LIBOR or with another privately generated substitute index.
That creates a new problem. Some long-term financial structures with LIBOR-based rates involve two different sets of documents and relationships. Each sentence has its own language in order to deal with the possibility, once purely hypothetically, that LIBOR could disappear. For example, adjustable rate residential mortgage loans have a mechanism to replace LIBOR when it goes away. Many of these home loans generate mortgage payments, which in turn fund payments to bondholders. But these bonds often have a different mechanism to replace LIBOR when it goes away.
These differences will create some gap between the incoming cash flow and the outgoing payments that the same cash flow must fund. One LIBOR replacement rate may develop differently than another. The result: a risk, or perhaps a pleasant surprise, for the institutions that make the payments to the bondholders. This separation can also create an opportunity for those who can decide on any replacement for LIBOR. The outcome could be litigation, unexpected gains or losses, and possibly a new product for the derivatives industry.
Identifying the problems with LIBOR may have been relatively straightforward. Finding the ideal replacement for LIBOR is not that easy.