Earlier this month, the Federal Reserve Bank of New York started publishing daily rates for SOFR, the reference rate favored to replace LIBOR by 2021. For hospitals and thousands of other borrowers and swap counterparties, this is a positive development, but SOFR still has a long way to go before being adopted as the new reference rate.
In the U.S. debt markets, LIBOR is used to set rates for what currently totals $200 trillion in financial contracts, roughly 10 times the U.S. gross domestic product. Over the counter swaps, forward rate agreements and options represent $127 trillion of this total, while business loans and bonds represent $5.2 trillion. Most not for profit hospitals carry some type of exposure to LIBOR in the form of variable rate debt or derivatives, including bank placements and percentage of LIBOR swaps.
LIBOR measures the cost of funds for large global banks and is available for tenors ranging from overnight to one year. Each day, 20 banks are asked at what rate they would lend to each other without collateral. During the last financial crisis, these banks had no observable market prices and had to guess, which resulted in unreliable rates, and for some, in manipulation.
After fines totaling $9 billion and several crimincal convictions, it became clear that there wasn’t enough meaningful data to sustain LIBOR as a reference rate, and in 2014, the Federal Reserve Bank formed the Alternative Reference Rates Committee (ARRC) to find a new rate.
In 2017, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as the best alternative to LIBOR. A month later, the U.K. Financial Conduct Authority announced LIBOR would be phased out by the end of 2021. Although LIBOR may still be published beyond 2021, there are no assurances that there will be enough submissions to make it reliable.
Earlier this month, the Federal Reserve Bank of New York started publishing SOFR, along with two other alternative rates. Unlike LIBOR, SOFR is based on actual transactions –overnight repurchase agreements or “repos” from broker-dealers, money-market funds, asset managers, insurance companies and pension funds. The market-based nature of LIBOR makes it less susceptible to manipulation. According to the ARRC, SOFR daily volume exceeds $750 billion, compared to an estimated $500 million for the 3-month LIBOR, making it the largest rate market in the U.S.
The Federal Reserve Bank had previously made available SOFR data from August 2014 to October 2017, which showed a strong correlation between the 1-month LIBOR and the 1-month volume-adjusted compound average SOFR as evidenced by a regression analysis r-squared of 87%. Simply put, SOFR has tracked LIBOR closely over that 3-year period, as shown in the chart below.
The correlation also holds true between the 3-month LIBOR and 3-month SOFR, with an r-squared of 79%.
SOFR may be closely tracking LIBOR, but it presents two major issues that will need to be resolved before the rate can gain broad market support..
First of all, SOFR is an overnight rate, so unlike LIBOR, SOFR does not have different rates for specified tenors (term structure). Assuming SOFR is selected, the replacement to LIBOR will likely not be SOFR, but a derived rate based on a smoothed out SOFR curve which has yet to be constructed. The CME Group, which owns the Chicago Mercantile Exchange, CBOT, NYMEX and COMEX, announced it will start publishing SOFR futures quotes starting in May, which is expected to be followed by trading.
The second concern is that unlike LIBOR, SOFR does not embed credit risk thus may not reflect changes in overall credit conditions. This could actually be a plus for borrowers in a rising rate environment, but it’s not as good for lenders.
As we reported in a 2017 article, the LIBOR phase-out will affect some hospitals more than others, depending on how much LIBOR-based loans and swaps they hold on their balance sheet and their maturities.
For hospitals with existing LIBOR-based loans, either taxable bank loans, or tax-exempt bank placements and other forms of floating rate debt, the outlook is relatively favorable. The ARRC estimates that 80% of outstanding commercial loans will mature before 2021. For the remaining 20%, borrowers will likely be able to amend documents with more flexible language for selecting an alternate rate. If not, many of these loans can be refinanced with minimal or no prepayment penalty. Nonetheless, hospitals should ask their legal counsel to review documents to determine if they allow selecting a replacement rate.
New LIBOR-based loans should include fallback provisions in the form of a clear alternative to LIBOR if it ceases to be published, or if it continues to be published but becomes unreliable. Ideally, provisions should include a specific fallback rate and method for determining adjustments to credit spreads to prevent a significant change in borrowing costs. Until there is a clear consensus on a successor to LIBOR, the best course of action may be for new loan documents to provide the flexibility to designate an industry-standard replacement rate when such a rate emerges. Alternate rate language will need to address how credit spreads may be adjusted to reflect differences between LIBOR and the replacement rate in order to preserve the original economics.
The LIBOR phase-out is a greater concern with interest rate swaps, which are not as popular with hospitals as they used to be, but can still be found on many balance sheets. While only 34% of LIBOR swaps will continue past 2021, swaps can be much more expensive to break if counterparties cannot agree on how to replace LIBOR. Most pay-fixed swaps are out of the money and termination can involve very large payments, although these payments will be lowered if rates rise.
Under the International Swap Dealers Association (ISDA) standard definitions that govern over the counter swaps, if LIBOR ceases to be published, counterparties must seek quotes from London or New York reference banks. If two or more such quotes are obtained, the contract will pay the average of the rates, but if one or no quotes are received, then the rate is unspecified. Most observers find it unlikely that banks will be willing to provide quotes, which has the potential to leave more than a hundreds trillion dollars of swaps in limbo. ISDA working groups are currently reviewing their options.
Hospitals and other municipal borrowers who rely on LIBOR-denominated instruments for access to capital should take inventory of their debt and swap portfolio and identify positions that extend beyond 2021, so they can decide what needs to be done and when.
We will continue to watch as SOFR develops.