Senate passes Libor act, but worries about adequacy of SOFR remain

The US Senate yesterday passed the Adjustable Interest Rate (LIBOR) Act into law, but market sources say the replacement of Libor by SOFR in legacy contracts will precipitate legal action.

Problems are predicted as there is currently a wide and growing disparity between Libor and SOFR settings.

“There’s going to be a lot of law suits. People that were expecting to get a bump in interest aren’t going to get any,” says an experienced structured finance market source.

One month Libor is today just below 40bp. This is 10bp wider than a week ago and 30bp wider than a month ago. The Russian invasion of the Ukraine has raised risk in all markets, and Libor reflects these concerns.

During the same period, 30-day average SOFR has been rooted to 5bp, according to the Federal Reserve Bank of New York.

Clearly, for investors would have enjoyed better returns if the reset date on their Libor-based bonds had occurred in the last few days. 

The Libor Act requires SOFR, plus a set spread depending on the Libor term, to be used instead of Libor for all contracts from the middle of 2023. Yet there are few clues about how this spread will be calculated.

The legislation applies to those contracts which have no fall-back provisions or provide an alternative rate. This has been a sticking point for the change to SOFR as many contracts in the structured finance world have no fall-back language.

Yet there continues to be dissension about whether SOFR is an adequate replacement index. “SOFR is the dumbest index I’ve ever seen. It’s just a stupid index, badly put together,” says another source.

The act does, however, provide safe harbour provisions to protect parties from liability as a result of lawsuits occasioned by the move away from Libor.

Libor is used extensively in the structured credit market, and what happens when Libor disappears into the sunset has been a source of anxiety for some months. While the legislation creates certainty and has been welcomed by many, questions remain.

Issuers of CLOs face particularly pressing problems, as the great majority of loans which provide the collateral are indexed against Libor. Nonetheless, there has been an increasing number of CLOs referencing SOFR priced this year, and more are expected.

The Federal Reserve must now issue regulations to administer the law within the next 180 days. More details on the setting and calculation of the spread might be forthcoming on this occasion.

Simon Boughey