Last week, UK regulators announced the plan to abandon the controversial Libor benchmark by 2021, and a group within the Bank of England started working on potential replacements. Given how entrenched Libor is in the bank markets and in interest rate swaps, the transition is sure to cause hospitals some headaches.
The demise of Libor is of particular relevance to the municipal markets, where Libor (London interbank offered rate) has been baked into many different types of financial contracts for years, including bank loans, bank placements and interest rate swaps, and in spite of being more than 4 years away from Libor’s end, some hospitals are wondering what they can do now to stay ahead of the coming changes.
Bank loans may be relatively easy to amend based on a new short-term benchmark rate. Even if the lender is unwilling or unable to switch to a new benchmark, the hospital can simply pay off the facility without penalty (other than Libor breakage) and simultaneously refinance with another lender.
Bank placements on the other hand typically carry pre-payment penalties so they may be more expensive to renegotiate, although lenders can be surprisingly flexible on penalties if they get to keep the hospital’s business in return. At this point, it remains unclear as to whether a change in a tax-exempt facility’s index would trigger a reissuance for tax purposes.
The biggest concern is Libor-based swaps, which make up the majority of municipal swaps. Many of these swaps convert bank loans and placements from a Libor-based rate (Libor or a percentage of Libor) to a fixed rate.
Interest rate swaps define Libor based on 2000 and 2006 ISDA (International Swap Dealers Association) definitions. For U.S. dollar-denominated swaps, the definition mentions a specific Bloomberg or Reuters screen. If no rate appears (which is the scenario in 2021 with Libor dead), the definition switches to an average of rates paid by “reference banks” on deposits for the same period, as gathered by the calculation agent. This fall back will probably not be acceptable to most counterparties, and swap agreements will need to be either terminated or renegotiated.
Swaps can be terminated any time at their mark-to-market value. In today’s interest rate environment, most pay-fixed swaps have a negative mark-to-market so hospitals wanting to terminate must make a payment (often in the millions of dollars) to their counterparty, which is not something they like to do. As rates rise, the payment will shrink and eventually swing into positive territory where the hospital receives a payment, a more favorable option but not one that can be counted on for the time being.
Aside from termination, hospitals will also have the option to renegotiate swaps based on a new benchmark rate. This will require the cooperation of the counterparty or call for novation (finding a new counterparty). If the hospital owes a significant amount, the process may require a payment. If the hospital’s credit picture has deteriorated, a new swap agreement may also require additional collateral posting conditions, or may not be available at all. However, just like banks, swap counterparties should have an incentive to renew on reasonable new terms once a new benchmark emerges.
Given the uncertainty surrounding the healthcare sector, four years may seem like an eternity, and many hospitals probably won’t do much until they get closer to 2021, although they will want to make sure any new debt or swaps provide for alternative benchmarks, which ought to keep lawyers (and financial advisors such as ourselves) quite busy.
Others who don’t like surprises and prefer to plan ahead can start with a review of their debt and swap portfolio, looking for “at-risk” instruments that mature on or after 2021. Existing terms, expected access to the markets and renewal options (driven by projections about financial position and bond ratings) can be used to develop a basic timeline for transition, which can be fine-tuned as central banks provide more clarity on new benchmarks.