In just two years we say so long to Libor, the London Interbank Offered Rate. It looks like SOFR—the Secured Overnight Financing Rate—will replace Libor as the index of choice sometime in 2021. For many people this change has the same foreboding as did the panic of Y2K.
You may recall the predicted havoc that Y2K was supposed to have on computers so many predicted couldn’t transition from 1999 to the year 2000. Now, like then, words like apocalypse and panic are being spoken and written about related to the changeover from Libor to SOFR.
Yet, as we prepare to say so long to Libor, the scaremongering is different this time. The problem with Libor, and at least part of the reason for its demise, is that it is only a daily survey of what banks charge to borrow from each other without collateral. In other words, it’s an estimate rather than an actual transaction rate. As such, it was easily manipulated. Regulators discovered the free-for-all banks had in manipulating Libor and gaming the system to their own advantage. Hence the change to a real rate than cannot be fudged.
The Libor scandals and manipulations cost banks billions in penalties and disgorgements. Regulators had enough. So in concert, they decided Libor was to fade into the sunset by 2021.
This change is not nearly as easy as it might seem. Libor is tied to all sorts of financial instruments—derivatives, structured products like certain bonds and preferred stocks, adjustable rate mortgages, student loans, floating rate municipal bonds and interest rate swaps.
One word comes to mind in describing the depth and breadth of Libor’s usage as a benchmark rate—humongous. Bloomberg estimates “about $350 trillion of derivatives, loans, mortgages, commercial paper, and other debt is tied to Libor.”
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This is a full employment act for Wall Street analysts and lawyers. They, along with CFOs, math geeks, and traders will determine what covenant amendments need to be made, fallout clauses revised, or tender offers on all these contracts sometime before the 2021 changeover.
The New York Federal Reserve Bank publishes the Secured Overnight Financing Rate. Unlike Libor, SOFR is an actual transaction rate. It is the cost of borrowing overnight collateralized by Treasury securities. Market participants and the Feds are ahead of the curve and already deploying the new SOFR benchmark to see how it works. So the real-time testing phase has already begun.
Our clients at Envision Capital do have a few Libor-based preferreds and bonds. And as with Y2K when everyone was worried their livelihood was on the line, whatever wrinkles exist will be ironed out before the 2021 changeover. There’s too much at stake.