SOFR being a different rate than LIBOR, with a number of distinguishing features, a “Spread Adjustment” is necessary to minimize the difference of value between the two rates.
The New York Fed, as the administrator of SOFR and in cooperation with the Treasury Department’s Office of Financial Research, publishes the 30-, 90-, and 180-day SOFR Averages as well as an overnight SOFR index.
The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities and is based on actual transactions in the U.S. Treasury repurchase market, one of the largest markets in the world. SOFR is the alternative index recommended by the ARRC and the U.S. Federal Reserve to replace LIBOR.
Fallback language in a legal document provides direction on the selection of the replacement index if certain events occur with respect to the currently utilized index. The fallback language can vary greatly from lender to lender, and many older legacy documents do not address a replacement index at all.
Maybe. Depending on the fallback language in the documents, current market conditions at the time of transition, and the lender’s methodology, the fallback index may be higher or lower than the comparable LIBOR Index. Additionally, the spread adjustment applied to SOFR may differ from lender to lender and from your loan and your hedge.
The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate. The ARRC’s recommended alternative is the Secured Overnight Financing Rate (SOFR). It is important to note that the ARRC makes recommendations that will likely be followed by most lenders; however, the ARRC’s chosen fallback rate is entirely elective for lenders. Some lenders may choose fallback rates other than SOFR.
Generally speaking, most loan documents give the selection of a fallback index to the lender or loan servicer.
Yes. The fallback language in the borrower’s loan documents will likely not match to the corresponding fallback language in the hedge, leaving the borrower exposed to a mismatch in indices, or “basis risk.” In order to avoid this basis risk, the borrower will have to revisit the loan and swap documents to amend the fallback terms on a bilateral basis. Use our calculator here to quantify your potential risk.
Yes. Borrowers should be taking an inventory of their LIBOR exposure and developing a plan to mitigate contracts. While the ISDA IBOR Fallback Protocol is designed to provide a fallback should LIBOR cease to exist, borrowers should not rely on the protocol to amend their hedging agreements. Borrowers should be having conversations today with their advisors, lenders, and other stakeholders to ensure they are adequately prepared for the end of LIBOR.
Many lenders will discontinue offering LIBOR based products at the end of Q4 2020. It is currently anticipated that LIBOR will no longer be useable as an index beyond 2021.
Most existing or “legacy” loan documents do not contain workable fallback provisions should LIBOR no longer be available.
Depending on the fallback language in your loan documents, if the loan documents contain any, the cessation of LIBOR could create significant P&L losses or lead to expensive litigation.
For hedging clients, their ISDA documents may be amended either through a bilateral negotiation or through an ISDA Fallback Protocol. If the ISDA fallback provisions do not match the terms of the hedged items, the borrower could be exposed to unanticipated “basis risk” in addition to other less obvious risks such as spread risk and accounting or tax risk.
Thirty Capital Financial, a division of Thirty Capital.
