Is Libor really on the way out? Is SOFR the most likely index to replace it? And how will these changes affect the loans already on your commercial books and the ones you're going to price in the future. Those answers and more are in this week's episode of The Purposeful Banker.
Helpful Links
Fed Warn That the End of Libor Really Is Coming, So Be Prepared (Bloomberg)
Alternative Reference Rates Committee
Secured Overnight Financing Rate (SOFR) Data
The Purposeful Banker Podcast (home page)
Podcast Transcription
Jim Young: Hi, and welcome to The Purposeful Banker, the podcast brought to by PrecisionLender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Content for PrecisionLender, and I'm joined again today by Joel Rosenberg. He's one of our Managing Directors. He's one of our quant guys, so the ones we kind of affectionately know as, and I put quotes around this, our "bank nerds". It means Joel is one of the guys we usually turn to when it comes to topics like the ones we're going to tackle today. The future of Libor and the rise of SOFR.
Joel wrote a very informative blog post on this that we'll link to in our podcast notes, and both of those, Joel's blog post and the podcast notes, can be found if you go to precisionlender.com and click on the Resources, our Resource page, there's the blog tab and there's a podcast tab where you can find both this podcast and, again, Joel's blog post about, basically, life after Libor. That piece is going to be the basis of today's conversation.
Joel, thanks for coming on the show.
Joel Rosenberg: It's a pleasure being here.
Jim Young: Joel, I think we can assume our listeners know the basics about Libor and SOFR, and if they don't then they should start studying up on it. Let's start with this question. In your daily discussions with banks, how often do these two indices come up in conversations? What sort of questions are banks asking you?
Joel Rosenberg: Usually I talk to what I'll call two different categories of clients at banks. I talk to the RMs or the lenders, and then I talk to the bank administrators and the bank executives and the people that administer PrecisionLender. In terms of the RMs, so the relationship managers, we definitely talk about Libor periodically, and I think most of them know what Libor or are familiar with Libor. Certainly at many of the larger banks, Libor is by far the main index used in floating rate and some adjustable rate loans.
Joel Rosenberg: I'm not sure that SOFR is on the mindset of this group. I'm not sure how many of them know about SOFR or really understand SOFR. In terms of the second group, I think that they definitely understand Libor, and we often have discussions about it, and many have heard the term SOFR, and certainly some of them are fairly familiar, but for many of them, it's not one of their main concerns. I'll often ask this second group, do they have a committee at the bank that's studying SOFR and the transition out of Libor? The general answer I get is yes, but that's not always the case, especially at smaller community banks.
Jim Young: Let me back up a little bit then, and say for anyone who's listening who doesn't get secured overnight financing rate, and according to The New York Federal Reserve, it's a broad measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and that comes straight from Joel's post, Life in a Post-Libor World. I've seen, and what you've just said sort of touches on this, I've seen several articles in the press in which regulators have come out recently and sort of expressed concerns that banks aren't being proactive enough to be ready for the day when Libor isn't there, or isn't used anymore. Why is that, do you think, that regulators are having to publicly chastise banks about this?
Joel Rosenberg: We're definitely seeing a bunch of statements, and in fact they've said when they do regulatory exam of larger banks, they are going to be asking these questions, now and going forward. But I think the main reason for some banks not being proactive, or a number of banks not being proactive, is there's still a question about what's going to replace Libor. It appears that it's going to be SOFR, but there are a couple of other indices that are out there that are fighting and it's not absolutely certain it's going to be SOFR. Many people believe that it's actually overblown, that given the importance of Libor, there's something like $10 trillion worth of bank loans that are using Libor, and the really outstanding number is there's an excess of $350 trillion of derivative contracts that use Libor. It's unlikely that it will go away by the end of 2021, which is the date that's often quoted. In fact, there was an article recently by some people at Basil that basically argued this.
The third reason is some feel that this is somewhat like Y2K, for those of you that remember Y2K. A lot of scare stories, but for those of us that were around then, we know that early in the morning of January 1st, 2000, the lights worked, the plumbing worked, everything was fine. Now, some companies had to spend a bunch of money to reprogram software, but everything worked fine.
And then bankers themselves are generally busy, and certainly at the senior level, they have many priorities, and so this is not that big of a priority, at least today. And finally, the initial date that Libor might end, is at the end of 2021. Well, we're doing this podcast in early July of 2019, that's still two and a half years away. You still have a long time to go. However, and there's a quote from Randal Quarles, who's the vice chairman of the Federal Reserve who recently said last month, "Clarity on the exact timing and the nature of the Libor stop is still to come," but the regulators of Libor, and that's the British banking authority, said that it's a matter of how Libor will end, rather than if it will end.
Jim Young: Right.
Joel Rosenberg: And it is hard to see how one could be clearer than that. They're basically saying it's going to end anyway.
Jim Young: But I think you touched on something though, which is the, "Okay, maybe if," and I'm not arguing with you whether it's going to end, or even when it's going to end, but how much effort do I want to spend getting ready for a particular rate when it might not be the one that's going to be used? And so I guess that brings us back to SOFR, it's the one I hear most mentioned as the likely Libor replacement. Do you believe that's the case, and if so, then how does it differ from Libor?
Joel Rosenberg: I think that is the case, but it's like the political polls for who's going to be the Democratic nominee for president. There are a bunch of front runners, but whether they'll actually end up as the nominee, who knows? At this point, SOFR certainly is the most likely replacement. It's definitely the leading candidate. But there's two, maybe even three possible replacements, ICE in particular, the International Continental Exchange, which runs Libor, is trying to develop an alternative.
Joel Rosenberg: But this is really being pushed hard by a committee called the Alternative Reference Rate Committee, or ARRC, and we'll use the term ARRC throughout this podcast, and that's sponsored by the Federal Reserve, particularly the Federal Reserve Bank of New York, and its committee members are representatives of major banks, the investment banks, a number of the major insurance companies and other large financial institution, federal agencies such as the federal home loan bank system. And then, also it includes the Bank of Canada and a couple of Canadian entities. It's really a 'who's who' of finance and banking in North America, in the United States and Canada, of North America. They're definitely pushing it.
You mentioned that SOFR is the secured overnight finance rate. Well, the first two words are really the important ones in terms of how it's different, 'secured' and 'overnight.' Secured is that this is backed by treasury collateral, so it's basically risk-free type collateral. This is an overnight rate, it's a one day type rate. The other important thing is there's actual transactions with the reported rates. Looking at the month of June, on a typical day in June, about $1.1 trillion of transactions occurred. SOFR is based on the 50th percentile of the rates used. These rates are publicly available.
But the one problem is that the SOFR rates, in terms of published availability, have really only been in extent since early April of 2018, so there's only really a year's worth of data. If we talk about Libor, which stands for London Inter-Bank Offering Rate, its origins have been from about 50 years ago, although, as we know it today, it's really been around for over 30 years. So there's a lot of history on it. On the other hand, it's based on unsecured lending between triple A banks. So, very strong banks, but still not risk-free.
Jim Young: Right.
Joel Rosenberg: In terms of the actual lending between banks, there are very few actual transactions. If we look at the most popular term, the one month and the three month term, on a typical day, there might be anywhere from five to seven actual transactions. As a result, this is set by a committee of major banks that meet in London, and this rate is set about 11:00 London time every business day, but it's really called an expert rate. It's based on these 14 to 20 banks that meet, and what they feel the rate should be, and as a result, in the past it's been subject to some manipulation.
Jim Young: I see.
Joel Rosenberg: The other thing is, there's the big concern, is the variety of maturities. Libor, you can get a maturity anywhere from overnight to one year, with obviously one and three months being the most popular. As we said, with SOFR, there's just one maturity category, overnight.
Jim Young: Okay. Let's assume though, for the sake of this podcast, that it does end up being SOFR is the indices of the future. First is, if we're moving from Libor to this, how does this affect the deals I already have on the books? First, the affect on the deals that may be fixed to the borrower as a result of an interest rate swap?
Joel Rosenberg: In terms of an existing deals, banks really have two main types of deals they need to be concerned about. There are a couple of others, but the two main ones are loans to customers, especially commercial customers, but then these derivative transactions, the swaps that you've talked about. One of the issues is if you go from Libor to SOFR, historically, the average rate for SOFR is less than what it is for one month and three month Libor, which are the main indices used on these derivatives.
Joel Rosenberg: In fact, in a study that we did from data from April 2018 to May of 2019, SOFR on average was about 12 basis points below one month Libor, and about 36 basis points below three month Libor, and this mainly relates to the generally upward sloping yield curve that existed during that time, particularly the short end of the curve, and the fact that SOFR is a near-riskless rate.
Interestingly, as of the end of June and the beginning of July, SOFR is actually pretty much on top of one month Libor and about seven basis points higher than three month Libor, but that just reflects where the curve is today. But in general, people would expect that to go from a Libor type deal to a SOFR type deal, you're going to have to add some spread to make up for this difference. There's a lot of debate what that spread should be, how you should account for that spread when the time comes, when you have to switch, this ARRC committee continues to discuss how to come up with that spread.
On the derivative side, there's what's called ISDA documents that are signed. The interesting thing about ISDA documents, and they're signed on about 99.99% of all derivatives, is this ISDA group can change the terminology or change the wording within that contract without going back to the customers to get permission on a certain category. And there's some interesting discussions going on there where they may use some sort of [inaudible 00:11:51] compounded methodology. I'm not going to go into the technical details of it with this podcast, we don't have enough time.
Jim Young: Right.
Joel Rosenberg: But you could have a situation where your derivative has a slightly different basis than your commercial loan that the derivative is supporting, even though they're both, in theory, using SOFR. That's how it can be affected.
Jim Young: All right, so then the first thing really, that popped into my head on this is, all right, let's say I've got a floating rate or adjustable rate deal that was originally pegged to Libor. How does a bank handle that situation?
Joel Rosenberg: That is a much tougher situation, because what's in your loan documents? Now, some loan documents say that if the indece that you're using, and typically you're going to be using some sort of indece in a floating rate loan, and clearly some sort of indece in an adjustable rate loan, after the initial fixed rate period. But what happens if that indece no longer exists? What do your loan documents say? As a banker, you need to review your loan documents and see what's there, and particularly also you need to review documents relating to participations and syndications that you might have done where you're not the main bank. What do those documents say? Because they could have surprises, also.
And then, you're going to need to, if possible, make changes to them. This ARRC group has suggested some model language, and is that going to work for you going forward? What happens when we replace the index and how do we make these changes?
So, if you have a loan now that's floating rate or possibly adjustable rate that uses Libor, and it goes past 2021, you really need to start looking at what you have in those documents. The other thing, and the other important thing, is if you're making new loans, you definitely need to get some wording in your documents about replacing Libor. In a way, I'm glad I'm with PrecisionLender, and I used to work at banks, that I don't have to deal with this.
Jim Young: That actually leads into my next question, now, let's put you back in this. Let's see you were at a bank here. How much would you say that your front line bankers and your RMs, how much do they need to know about the 'why' of this, or do they just need to know, "Hey, this is the new index, use this?"
Joel Rosenberg: Well, I'm all for education and I think we need to educate our front line bankers about this. Clearly, at some point, I think SOFR is going to replace Libor, and we're seeing actually at some banks today that they are starting to make SOFR loans, offer SOFR loans. It's not that big, but they are, and there's clearly securities out there that are SOFR index. But I think we need to make sure that our RMs have something there already. And many banks today, they provide a internal list of rates to their RMs and their front line personnel, and that will typically list prime, it might list current Libor index, it might list federal home loan bank rates or treasure rates. I would, at a very minimum, add SOFR to that list. And by the way, SOFR's around 2.4% today.
Banks might also want to think about preparing a two or three paragraph typed document, nothing big, with an explanation of what is SOFR that it can provide to this personnel, because you never know when a borrower will come in and ask them a question about SOFR, and you certainly don't want a blank look on your RMs or your front line people's face. They don't need to be experts, although a bank probably should have an expert on SOFR, but give them a one page document with a couple paragraphs explaining it.
You brought up my next question which is, obviously, if a customer asks you about it, you need to have an answer for it, but if they're not asking, do you even need to bring that up to them, or is that too much behind the scenes, too much information?
Joel Rosenberg: Unless you're ready to go, or about ready to go with SOFR loans and start offering them, I wouldn't worry at this point about doing too much in the way of customer education. I think it's important, but not necessarily today, and that might be the one thing you can put off until 2021, or thereabouts.
Unless, like I said, the caveat there is if you're going to start offering SOFR loans and you need to at least prepare those type of clients that you're likely to offer the SOFR loans to. Again, you might want to have a two or three paragraph type document written up eventually to explain about SOFR, but I would probably wait until you get closer to offering those loans.
Jim Young: Finally, I'm just going to throw this one open to you, we're going to make you the hypothetical head of commercial pricing at a bank. Aside from what we've already discussed, what would be, I was going to say top three, but I'm going to take it easy on you and just say, aside from what we've discussed, tell me what would be your top priorities in making sure that the transition from Libor to a new index, in this case most likely SOFR, in making sure that transition goes smoothly?
Joel Rosenberg: One of the things, and I know you said not that we've mentioned, but clearly, I would be concerned about my current loan documents, does it have language about replacing Libor? But I think, in terms of being the head of commercial pricing, would I would be concerned about is in my present pricing tool, my loan pricing tool, does it capture the SOFR index today? Not so much that I'm going to offer a SOFR loan today, but at least I can compare it with what I'm offering today. And so, am I getting some sort of daily download of the SOFR index, and does that tool provide me the ability to maybe capture, maybe not on a daily download basis, but some of these other possible alternative indexes that are out there?
The other thing is, I want to be able to understand what's going to happen with my derivative contracts, particularly swap contracts, if I'm doing back to back type swaps, and how that's going to be affected. And so, that's another area that I would be very concerned about. Those are the main things that I would be concerned about.
Jim Young: Great. Again, I want to remind our listeners, the written version of this expertise is a blog post called Life After Libor, that is again, at explore.precisionlender.com, which is where you will also be able to find the show notes for this podcast as well. Joel, thanks so much for coming on the show.
Joel Rosenberg: Hey, it's a pleasure, and if anybody does have a question, they should feel free to call me, whether they're a client of PrecisionLender or not, I'm happy to talk to them about it.
Jim Young: All righty. That'll do it for this week's show, and now for a few friendly reminders. If you want to listen to more podcasts or check out more of our content, again, you can visit our resource page at precisionlender.com, or you can just head over to our homepage to learn more about the company behind this content. Finally, if you like what you've been hearing, make sure to subscribe to the feed in iTunes, Google Play, or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this has been Jim Young for Joel Rosenberg, and you've been listening to the Purposeful Banker.
