Libor expiry warning
By: Michael Woods
10 October, 2019
After 30-years of benchmark dominance, LIBOR will no longer be published by the end of 2021. What will happen to your loan? What can you do about it?
The London Interbank Offer Rate (LIBOR) stands as the basis of pricing for thousands of project finance loans across the world. The rate won’t be published after 2021, so floating rate loan borrowers may be in for a rude awakening – the cost of borrowing may become a lot more expensive.
Let’s take a look at the risks to borrowers and some suggested next steps. But first, it is important to understand LIBOR itself.
LIBOR was invented by a bunch of London banks
LIBOR originated from a syndicated loan (a loan from a collective of London banks all sharing a portion of the loan) to the Shah of Iran in 1969. Prior to this, each bank would declare their own interest rate, but with syndicated (shared) loans they needed a common interest rate they could quote to the borrower.
But the question was; which interest rate should they use? Each bank had different internal costs and return requirements, and they all had to manage the spread between their own cost of borrowing and the interest they received from lending the money out.
The idea was to use a representative cost for the entire syndicate. Participating banks averaged the expected cost of borrowing of a group of large banks in London, on an unsecured basis, and used this rate, called LIBOR.
LIBOR isn’t the actual borrowing cost of any individual bank, but rather an approximation for all banks to use as a base rate for simplicity. Due to the financial strength of the London banks who managed it, LIBOR was adopted as a global benchmark rate for loans.
Many floating rate project finance loans use this benchmark convention
For floating rate loans, banks charge an interest rate, which includes:
- The approximate cost of their own borrowing (i.e. LIBOR)
- Banks don’t always have the cash they need
- So they borrow money from each other at ~LIBOR to fund their obligations
- Plus a margin
- to cover costs
- to compensate for perceived risks of the borrower
- for liquidity (how easy is for them to sell the loan, if they need to)
- and to make a profit
There are now ~$200 trillion in financial contracts tied to USD LIBOR, including thousands of project finance loans. LIBOR is one of the most commonly used benchmarks in the financial system.
Because borrowers and lenders trusted it……
Until the banks manipulated it to make excess profits
In 2012, it was revealed that banks deliberately reported higher or lower LIBOR values – sometimes in conjunction with other banks – to improve their profits on financial instruments! Ok, we knew LIBOR didn’t exactly reflect their borrowing costs, but lying to improve profits directly affected loan interest rates for unsuspecting borrowers around the world.
This loss of trust in LIBOR resulted in efforts to find an alternative and to increase scrutiny on the banks. Given the complexity and politics involved, changes have been slow.
LIBOR hasn’t been entirely replaced so far (with SOFR)
LIBOR will be discontinued. Countries around the world have made moves to create their own new benchmark rates, such as SONIA, TONAR, and SARON.
In the US, the Secured Overnight Financing Rate (SOFR), published by the U.S. Federal Reserve Bank of New York, is already being used as the benchmark rate for some loans.
SOFR doesn’t rely on self-reporting by the banks, so is harder to manipulate. It is based on market-reported data from the overnight buying and selling of US Treasuries, which have long been called the ‘risk-free rate’. SOFR reflects overnight trades in US dollars.
LIBOR on the other hand, isn’t a risk-free rate. It includes the risk-free rate plus the credit risk of the bank defaulting on its obligations (as it represents the cost for banks to borrow). It is calculated in five different currencies and seven maturity tenors. For example, a 3-month LIBOR is the average cost of borrowing of a 3-month loan, but a 6-month LIBOR rate is the average cost of borrowing of a 6-month loan.
Is the US Treasury (SOFR) is riskier than the banks (LIBOR)?
Most project finance loans use a 3- or 6-month LIBOR rate, meaning the interest rate is fixed for a 3- to 6-month period. However, SOFR is based on a single overnight rate and doesn’t yet have reliable futures or forwards contracts to fix forward looking interest rates for these durations. Instead, the interest rate can swing substantially in one day.
Take this 3-day period in 2019 for example:
Imagine if your project finance loan reset date was September 17 and your interest was calculated on a 5.25% rate, nearly 3% higher than the day before – bad luck! Sure, an average rate will likely be used, but this only if such a mechanism is clearly specified in the loan documents.
Since LIBOR appears to be > SOFR, won’t interest for the borrower go down?
First, let’s explore how LIBOR and SOFR vary from each other.
As expected, SOFR is likely (but as we have seen, not guaranteed) to be lower than LIBOR, given it is a ‘risk-free rate’.
So, interest is going down for borrowers, right?
Unfortunately not… Remember SOFR is a risk-free rate for obligations of the US Treasury, and isn’t a good representation of the credit standing of the banks. Bank cannot borrow at SOFR – they pay more. Banks will reasonably look to recover this spread difference, adding a ‘replacement benchmark spread’ to SOFR.
The risk lies in your current loan documents
Most loan documents aren’t well prepared for the demise of LIBOR:
- Many loan documents don’t address what happens when LIBOR no longer exists, they may only state what happens if LIBOR is unavailable (i.e. for a short-term issue)
- Some loan documents state that an ‘Alternative Base Rate’ will be used if LIBOR isn’t available:
- Sometimes the ‘Prime Rate’
- As of September 19, 2019, Prime was 5% p.a.
- This is the rate at which good consumers can borrow money, which is much higher than LIBOR (1.96% on this date)!
- Or it is based on a ‘reasonable alternative available from banks’
- Wasn’t LIBOR considered a reasonable alternative?…
- Sometimes the ‘Prime Rate’
- Even if loan documents include a provision for the replacement of LIBOR, they don’t often specify a replacement benchmark spread, instead leaving this up to negotiation
- SOFR is more volatile, so the actual day of a rate reset may result in a vastly different interest rate!
- Project finance loan documents commonly use a 3- or 6-month LIBOR. This doesn’t exist in SOFR, so it is unclear what corresponding spread should be added over SOFR.
There are likely many variations globally, however the point is that many project finance loan documents won’t have specified the details required for a replacement of LIBOR.
Timing is everything – will the banks profit from this at the Borrower’s expense?
LIBOR is one of the most important numbers in the finance world. Even though there is little focus in the news on LIBOR’s end, this is a major change, particularly from a borrower’s perspective.
If you will pay more interest or not depends on your loan agreements. Each project finance loan is unique. However, there are a few things to be considered:
(1) Given the long tenor of project finance loans, many loans will be affected by this change
(2) If SOFR is lower than LIBOR, banks may not be in a rush to refinance at a lower benchmark interest rate than they currently have
(3) Someone will do the first few deals, and may ‘make the market’ for loan renegotiations
(4) Perhaps the US Fed will standardize market wording as part of regulation
(5) Leaving negotiations until last minute will only give the lenders more power
- Especially if the loan converts to Prime by default…banks wouldn’t complain
Start planning now. Even if you have fixed rate loans, you may not be immune due to an interest rate swap position or due to an upcoming refinance.
Evaluate your possible exposure and begin discussions with your bankers. Contact us if you would like to know more.
Michael Woods is a jack-of-all-trades renewable energy specialist with Pivotal180, providing financial modeling insights to those new to the industry. He is also a Master of Public Administration in Energy Policy and Finance candidate at Columbia University, and works with GDS Associates, Inc., an energy engineering consulting firm.