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FAREWELL TO LIBOR: Preparing for the Effects of a Disappearing Lending Benchmark

For decades LIBOR (short for London Inter-bank Offered Rate) was one of the most commonly used benchmark interest rates for financial transactions. Derived from a daily survey of about 20 large banks, it was intended to reflect the interest rate at which banks lent to one another. However, confidence in LIBOR as an accurate reflection of market interest rates was shattered when investigations concluding in 2012 uncovered criminal manipulation of LIBOR markets by certain reporting banks. Despite attempts at reforming the system, in 2017, it was announced that LIBOR will be effectively phased out at the end of 2021.

While efforts to develop a replacement for LIBOR have been ongoing for years, financial markets have yet to settle on the replacement benchmark rate with different countries coming up with various alternatives, but no one proposal is gaining clear traction as the universal benchmark rate. In the United States, the Federal Reserve and United States Treasury have introduced the Secured Overnight Finance Rate (SOFR) as the proposed LIBOR replacement and began publication of that rate in April 2018. The SOFR is a rate derived from market data on overnight loans collateralized by Treasury securities. Some of the primary differences between SOFR and LIBOR are that SOFR is based on real transactions from a range of firms versus the reported expectations of a small set of bankers on which LIBOR was based (making SOFR more transparent and less susceptible to manipulation), and SOFR reflects the interest rate for collateralized loans which are now more common, whereas LIBOR reflected an unsecured interest rate. One concern with SOFR is that it has been susceptible to price swings tied to Treasury Bill issuance and month/quarter end supply variations, which has made it more volatile than LIBOR. Also, for SOFR to truly replace LIBOR, larger volumes of trades are needed in order to develop longer term SOFR based reference rates.

With US banks currently holding an estimated $10 trillion in LIBOR benchmarked loans, there are major potential implications for the elimination of LIBOR and transition to a new interest rate benchmark. At the end of 2021, LIBOR benchmarked loans will fall into two general categories: (1) non-problematic loans containing an adequate replacement benchmark rate provision that either identify a specific, and viable, alternative benchmark rate, or allowing the lender to choose the alternative benchmark rate; or (2) those that do not. Lenders with LIBOR benchmarked loans that do not have adequate benchmark rate replacement language could face significant loan administration issues including possible loss of interest income and increased risk of litigation. In order to mitigate this potential risk, lenders should consider consulting with counsel to evaluate existing loan portfolios for inadequate language and incorporating new replacement benchmark rate provisions in connection with any borrower requests for modifications, waivers or any other concession.

Michael P. Carolan, Esquire