New Libor bill fails to clear up potential Libor versus SOFR mismatch

The signing of the Adjustable Rate Libor Bill (H.R.4616) into law eight days ago introduces important clarity into the Libor transition process, but the structured finance market is very far from out of the woods yet.

The bill creates a safe harbour for contracts lacking a specfied replacement rate for Libor and directs the Federal Reserve, when necessary, to determine a new benchmark rate. The Fed and its Alternative Reference Rates Committee (ARRC) favour the use of SOFR, but there are still many unanswered questions about how the substantial difference between SOFR and Libor will be reconciled satisfactorily.

“This statute is great thing, and it has solved many issues but it is not the end of the story,” says Amy Williams, a partner and structured finance specialist at Hunton Andrews Kurth.

Libor has many term periods, and while the CME has introduced a term SOFR contract, SOFR is an overnight index. There is also a growing disparity, between SOFR and Libor. Overnight Libor is currently 3.27bp and at the beginning of the month ago was close to 8bp. One month Libor is around 44bp. In comparison, overnight SOFR is at 5bp and hasn’t budged for weeks.

The Libor bill says that the fall back rate is to be used plus a spread from June 2023 when all contracts currently referencing Libor must be remarked to the new rate. All old GSE securities, all private label MBS deals and all CLOs which were sold as instruments priced against Libor are then forced to move to the new rate.

In its October 2021 paper, AARC used values calculated by Bloomberg in March 2021 to produce five year historical mean spreads between Libor and SOFR. One month Libor was determined to be SOFR plus 11.44bp, while three month Libor was plus 26.16bp and six month Libor was plus 42.86bp.

These rates look as if they will be imposed on all Libor fall back contracts when the venerable index finally expires next year, but there is significant potential for disappointment from either investors or issuers.

“Will it be closer to 11.44bp in June 2023? If so, the spread adjustment will feel fair. If not, it will not feel fair to investors or issuers depending on which way it goes,” says Williams.

It is also undecided which form of SOFR will be used in each type of contract. As SOFR is an overnight rate, there are various ways in which it is possible to arrive at a monthly rate to match Libor. It could be calculated using a compounded formula or by simply adding the overnight rate over 30-day period.

This is to be determined by the Fed in forthcoming regulation, but the latter could, for example, impose a different format in consumer loans to that of ABS products that reference those loans, leading to an asset/liability mismatch.

Consumer loans linked to Libor will be also be adjusted over a transitional period to avoid giving an unexpected and unpleasant jolt to borrowers, but this will contribute to the potential mismatch between assets and structured products.

“The interesting thing for structured products rather than loans is that I’m not sure anyone has done the work to find out what happens to these securities in the case of a basis disconnect. Is it clear in the indenture or trust agreement what is supposed to happen?” asks Williams.

The Libor bill was that rarest of animals in today’s DC: a law that achieved wide bipartisan support. It was passed 415-9 in the House, for example.

The bill’s sponsor was Representative Brad Sherman, a California Democrat, who also chairs the House Financial Services Committee’s Subcommittee on Investor Protection, Entrepreneurship and Capital Markets.

Introducing the bill on the floor of the House, he said it was the “the most important, genuinely boring bill that will come before this House this year.”

Few would perhaps argue. But for the investors, lenders and borrowers whose assets and liabilities are tied to Libor, the consequences of a shift to SOFR could be anything but boring.

Simon Boughey