[UPDATE: January 10, 2020]
The impending cessation of LIBOR is drawing nearer and calls for banks to begin preparing for the transition are getting louder.
As recently reported by The Wall Street Journal, financial regulators, including the New York State Department of Financial Services and the Federal Reserve, are asking banks to submit evidence of their preparations for managing the risks associated with LIBOR’s demise. The Office of the Comptroller of the Currency has also planned to increase oversight of the issue for national banks. Global banks, however, face the challenge of needing to consider possible alternative rates that could be applicable to currencies across the world.
Atalaya will continue to monitor the transition and its impact on equipment leasing transactions.
In July 2017, the U.K. Financial Conduct Authority announced that LIBOR will be replaced by the end of 2021. The impact of this change on the equipment leasing market is uncertain at this point, but may be manifested in a myriad of ways including, but not limited to, funding costs for lessors, leases that are priced or repriced using a benchmark rate and securitization markets. We wanted to provide a brief background on the impending rate transition as well as the possible industry impact and response. While not as prevalent in equipment leasing transactions (which often feature fixed pricing so that borrowers can better predict cash flow obligations), LIBOR remains the prevailing benchmark rate and its impending cessation will certainly have an impact throughout the finance industry.
Since its origination in 1969, LIBOR has been the floating, market-determined interest rate for syndicated loans. Over time, it became the benchmark interest rate for at least 350 trillion dollars’ worth of global financial arrangement. It is calculated using the trimmed average interest rate at which major global banks borrow from one another.
Unfortunately, growing concerns and scandals over this flawed determination of LIBOR have forced the global financial realm to turn towards replacement rates. In the U.S., SOFR stands out as a prime candidate to replace LIBOR, though as discussed below, the process for replacement is complex.
The primary difference between the rates is that LIBOR has a term structure and SOFR is an overnight rate. This is crucial because contracts currently using term LIBOR will seek to transition to an equally attractive term rate. As such, the market is aiming to generate a term SOFR. For SOFR to be used as a term rate, a term curve would have to be developed from consistent SOFR futures trading. Currently, the federally-convened Alternative Reference Rates Committee (ARRC) is developing this term curve; however, as Ropes & Gray LLP counsel Jill Kalish Levy said, there is “no guarantee that we will have a term SOFR benchmark before 2021 (or at all)”.
Process for Transition
In the meantime, the ARRC has outlined two primary methods to deal with the transition within credit documents. While individual equipment leases are often structured with fixed-rate pricing, there are potential impacts to the securitization market, leases that are priced or repriced using a benchmark rate as well as asset financing facilities. This Ropes & Gray podcast identified a few approaches to implement a new rate.
The first method is that lessors and borrowers may incorporate an “amendment approach” in their leasing documents. That is, if LIBOR becomes an unreliable or an unavailable rate, creditors and borrowers will select a new rate together based, again, on market-based factors. However, these negotiations between lessors and borrowers may present a challenge due to SOFR’s volatility and uncertainty around the effective date.
In lieu of the amendment approach, lessors and borrowers could also turn to a “hardwired approach”. This approach provides a clear outcome for selecting a replacement benchmark and spread adjustment that would apply if LIBOR is no longer usable; the downside to this approach is that parties would be committing to specific rates and spread adjustments before those rates and spread adjustments have even been determined.