LIBOR Sunset Update - What to Do Now

LIBOR Sunset Update – What to Do Now

By the end of 2021, banks will no longer be required to publish rates that are used to calculate the London
Interbank Offered Rate (LIBOR). LIBOR serves as a reference rate for derivative transactions, as well as bond
investments, bank loans and variable-rate mortgages. Market participants need a replacement rate that is
supported by a liquid market and behaves in a predictable manner. LIBOR is deeply entrenched in financial
markets and weaning off that rate is moving slower than expected. While progress is being made, there is still a lot
of work to be done. A September 2019 Accenture survey found that fewer than half of the 177 companies
surveyed are confident they will be prepared for LIBOR’s demise. Although 84 percent have begun preparations,
only 47 percent expect those efforts would be completed in time. This article provides an update on reference rate
reform activities and guidance on what companies should do now.

SOFR Update
In 2017, the Secured Overnight Financing Rate (SOFR) was selected by the Alternative Reference Rates Committee
(ARRC), an industry panel, as the preferred alternative rate for U.S. dollar LIBOR. SOFR is a measure of the cost of
borrowing cash overnight—collateralized by U.S. Treasury securities—and is based on directly observable U.S.
Treasury-backed repurchase (repo) transactions. Some significant progress has occurred since 2017:
        April 2018 – The Federal Reserve Bank of New York began publishing the SOFR rate
        May 2019 – The Chicago Mercantile Exchange (CME) launched SOFR-based futures contracts
        June 2019 – A U.S. Treasury official announced the department is considering issuing SOFR-linked debt
         (the Treasury is currently converting its auction system, delaying SOFR note issuance until late 2020 at
         best)
        July 2019 – Freddie Mac and Fannie Mae announced a plan to use SOFR for new adjustable-rate mortgage
         (ARM) originations
        September 2019 – The Federal Housing Finance Agency (FHFA) announced that by the end of the first
         quarter of 2020, all member banks should stop selling LIBOR-linked debt maturing after December 2021
        January 2020 – CME launched options on the three-month SOFR
        January 2020 – SOFR-denominated debt issuances reach a record monthly high of $10 billion. Total
         outstanding SOFR debt now stands at $328 billion
        February 2020 – FHFA, Fannie Mae and Freddie Mac announced they will no longer acquire LIBOR ARMs
         and will retire all LIBOR ARM plans later this year

LIBOR Sunset – What to Do Now

Volumes

Volatility
As noted above, SOFR is calculated from repo transactions. Volatility in repo markets can cause disruption in the
SOFR rate, as evidenced by a sudden spike in September 2019. A cash shortage caused repo rates to spike until the
Federal Reserve intervened to inject billions of dollars of overnight loans. SOFR supporters point out that short-
term averages should be used for LIBOR transition, noting that the one-day spike caused only a 0.04-percent
increase in the three-month LIBOR average and a 0.02-percent increase in the 90-day average.

Source: https://www.pensford.com/resources/libor-vs-sofr/
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LIBOR Sunset – What to Do Now

                                                 LIBOR vs. SOFR
                         LIBOR                                                      SOFR
 Unsecured rate                                            Secured rate
 Various maturities                                        Overnight
 Built-in credit component                                 Minimal credit risk
 Partially transaction-based                               Wholly transaction-based
 $500 million of underlying transactions                   $750 billion of underlying transactions
 Forward-looking                                           Backward-looking currently (term structure planned
                                                           for late 2021)

SOFR Alternatives
ARRC’s selection of SOFR as a LIBOR replacement is a recommendation and is not mandatory. The Bank for
International Settlements has noted that a one-size-fits-all alternative may be neither feasible nor desirable.
Empirically, SOFR has been more volatile than federal funds, overnight indexed swap (OIS) or LIBOR and subject to
seasonality (intra-month jumps due to Treasury settlements). In September 2019, executives from 10 regional
banks wrote a letter to the Fed, the FDIC and the Office of the Comptroller of the Currency stating they did not
think SOFR is a suitable LIBOR replacement for lending products. Because SOFR is tied to Treasuries, the rate would
likely experience disproportionate swings during times of economic stress because investors tend to rush to
Treasuries for security. Banks may face heightened risk from SOFR rate moves as a result. The banks asked for the
creation of a private market participant industry working group on this topic.

Ameribor
A potential SOFR alternative gaining some traction is Ameribor. Created in 2015, Ameribor is a benchmark
overnight rate for unsecured loans based on transactions of members of the American Financial Exchange (AFX).
The AFX is an electronic marketplace where small and midsize banks trade loans daily. Annual volume in 2019 was
$428 billion, which more than doubled 2018 volume of $192 billion. Record daily volume peaked on September 19,
2019, at $3 billion. Ameribor contains a credit spread component based on unsecured loans in contrast to SOFR,
which is based on collateralized loans. Ameribor tends to be roughly 15 basis points higher than both LIBOR and
SOFR.
In September 2019, ServisFirst Bank—a Birmingham, Alabama-based commercial lending bank with $7 billion in
assets—made the first-ever Ameribor referenced loan. As of January 1, 2020, ServisFirst will transition to Ameribor
ahead of the LIBOR sunset.

Accounting Relief
FASB
FASB approved SOFR OIS as a benchmark interest rate for hedge accounting purposes in October 2018 (see BKD
article SOFR Approved as a Hedging Benchmark Rate).
In September 2019, FASB released an exposure draft that would temporarily update hedge accounting rules so
when companies adjust contracts to scrap references to LIBOR or any other discontinued reference rate, they will
not lose the favorable accounting method for common risk management strategies. For other contracts, the

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LIBOR Sunset – What to Do Now

proposal would simplify accounting analyses under current generally accepted accounting principles for contract
modifications. The proposal includes a general principle that would temporarily permit entities to:
         Consider contract modifications due to reference rate reform to be a continuation of those contracts
         Not reassess previous determinations
See BKD article FASB Proposes Accounting Relief for LIBOR Transition.

GASB
Derivatives are widely used by states and other larger governments, certain business-type entities and pension
plans. GASB, the governing body for governmental accounting guidance, issued an exposure draft to address
reference rate reform in October 2019 and a final standard is planned for June 2020. For governments, LIBOR’s
sunset will affect the hedge accounting provisions of Statement No. 53, Accounting and Financial Reporting for
Derivative Instruments. For derivatives that are effective hedges, changes in their fair value are recognized as
deferred outflows or deferred inflows of resources. Should a hedging derivative cease to be effective or terminate,
the accumulated deferrals are recognized in investment income and subsequent changes in the derivative’s fair
value also would be recognized in investment income. Tentative decisions for the exposure draft, subject to
change, include:
         An exception to the lease modification guidance for contracts amended only to change the index rate for
          variable payments. The scope of the exception will be limited to circumstances in which the original
          contract references an interbank offered rate (IBOR) or a rate based on an IBOR.
         For purposes of determining whether an expected transaction is probable of occurring, a government
          should assume the reference rate on which the hedged cash flows are based is not altered as a result of
          reference rate reform.
         An exception to the hedge accounting termination provisions for certain hedging derivative instruments.
          This exception would be limited to hedging derivative instruments that continue to be effective and in
          which the original hedging derivative instrument references an IBOR or a rate based on an IBOR. GASB will
          not propose specific guidance on which reference rates may be selected as a replacement. If the
          replacement is effectuated by ending the original hedging derivative instrument and entering into a new
          hedging derivative instrument, those transactions must be ended and entered into on the same date. In
          addition, critical term changes that are either essential to or related to the replacement of a reference
          rate would be permitted.

IRS
In October 2019, the Treasury Department and the IRS released proposed legislation offering LIBOR transition
relief. The IRS recognized that the alternation of a debt instrument or a modification of a hedging agreement to
accommodate the LIBOR sunset could result in a realized gain or loss and income or deductions for federal taxes.
Highlights include:
Section 1001
Changes as a result of LIBOR transition would not result in the realization of income, deduction, gain or loss for the
purposes of Section 1001.
Integrated Transactions & Hedges
A taxpayer would be permitted to alter a debt instrument’s terms or modify one or more of the other components
of an integrated or hedged transaction to replace LIBOR with a qualified rate without affecting the tax treatment of
either the underlying transaction or the hedge, provided that the integrated or hedged transaction as modified
continues to qualify for integration.

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LIBOR Sunset – What to Do Now

Source & Character of a One-Time Payment
Because there is no exact substitute for LIBOR, counterparties will need to agree on how appropriate a rate
spreads and/or a one-time payment to balance future cash flows. The proposal seeks feedback from market
participants on appropriate tax relief.
REMICs
An interest in a real estate mortgage investment conduit (REMIC) would be able to retain its status as a regular
interest for modification to transition from LIBOR.
Tax-Exempt Bonds
Issuers of tax-exempt bonds are required to file IRS Form 8038 if there is a material modification to a bond.
Noncompliance could adversely affect an offering’s tax-exempt status. The IRS proposal would exempt changes to
a LIBOR alternative from the notification requirements. The new rate change must result in a “substantially
equivalent fair market value (FMV).” The IRS included two safe harbors in determining the FMV equivalence.
The proposed regulations apply to changes to affected contracts made upon the finalization of the proposed
regulations. Taxpayers and their related parties optionally may apply the proposed regulations to changes that
occur before then, provided proposed regulations are applied consistently.
The comment deadline was November 25, 2019.

SEC
The SEC is actively monitoring the extent to which market participants are identifying and addressing the risks
associated with LIBOR discontinuation and transition to a new rate(s). In July 2019, the SEC released Staff
Statement on LIBOR Transition. A number of existing rules or regulations may require disclosure related to the
expected discontinuation of LIBOR, including disclosure of risk factors, management’s discussion and analysis,
board risk oversight and financial statements. The SEC’s Division of Corporation Finance encourages companies to
consider the following guidance:
        The evaluation and mitigation of risks related to the expected discontinuation of LIBOR may span several
         reporting periods. Consider disclosing the status of company efforts to date and the significant matters
         yet to be addressed.
        When a company has identified a material exposure to LIBOR but does not yet know or cannot yet
         reasonably estimate the expected impact, consider disclosing that fact.
        Disclosures that allow investors to see this issue through management’s eyes are likely to be the most
         useful for investors. This may entail sharing information used by management and the board in assessing
         and monitoring how transitioning from LIBOR to an alternative reference rate (ARR) may affect the
         company. This could include qualitative disclosures and—when material—quantitative disclosures, such
         as the notional value of contracts referencing LIBOR and extending past 2021.
In recent speeches, SEC representatives have commented that current disclosures are too generic; many said only
that the end of LIBOR exposed the company to risk. SEC Division of Corporation Finance Director William Hinman
noted, “We are really pushing for more tailored disclosure that reflects the company’s actual situation.” The value,
type and number of contracts tied to LIBOR would be useful information.

ARRC
The ARRC’s recommendations are voluntary, and the Federal Reserve is not mandating what fallbacks to use, but
there is a lot of value in a common approach. If LIBOR ceases and different instruments that use it fall back to
different rates or at different times, basis risk will be higher and hedging more difficult. The ARRC started its
fallback work by adopting a set of guiding principles to apply across all product types. Among other things, those
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LIBOR Sunset – What to Do Now

guidelines suggested that—to the extent practicable and appropriate—market participants should (1) maintain
consistency of fallbacks across asset classes and minimize basis risk between products; (2) use SOFR or a
benchmark based on SOFR as the replacement rate; (3) minimize value transfer over the life of the contract if the
fallback is triggered; and (4) include specific triggers that activate the fallback.
Following these overall principles, the ARRC commenced consultations on specific fallbacks for four types of cash
products: floating-rate notes, syndicated business loans, bilateral business loans and securitizations. In general, the
consultations proposed that following a trigger event—such as LIBOR being discontinued—the instrument would
instead pay interest at SOFR or a rate based on SOFR, adjusted so the new rate is comparable to the old one.
ARRC’s consultations recognized that different solutions may be necessary or preferable for different markets and
products but promoted common approaches as much as possible.

What to Do Now
Companies should begin the process of identifying existing contracts that extend past 2021 to determine their
LIBOR exposure. Many legacy contracts have interest rate provisions referencing LIBOR that, when drafted, did not
contemplate the permanent discontinuation of LIBOR and, as a result, there may be uncertainty or disagreement
over how the contracts should be interpreted.

Existing Contracts
Companies should consider the following questions for existing LIBOR contracts:
        Do you have or are you or your customers exposed to any contracts extending past 2021 that reference
         LIBOR? Are these contracts, individually or in the aggregate, material?
        For identified contracts, what effect will the LIBOR discontinuation have on the contract’s operation? Do
         loan documents address the calculation of interest rates in the absence of LIBOR?
        For contracts with no LIBOR fallback language—or with fallback language that does not contemplate
         LIBOR’s permanent discontinuation—do you need to take actions to mitigate risk, such as proactive
         renegotiations with counterparties to address the contractual uncertainty? What are each of the party’s
         rights in the event LIBOR is no longer available?
        What ARR might replace LIBOR in existing contracts? What are the differences between LIBOR and the
         ARR that would need to be adjusted?
        For LIBOR-based derivative contracts that are used to hedge floating-rate investments or obligations,
         what is the impact on the effectiveness of the company’s hedging strategy?
Other items to consider that may have an accounting and financial reporting effect include:
        Inputs used in valuation models—property, cost of capital, pension liabilities and capital asset pricing
         models
        Benchmarks for asset managers
        Project finance calculations
        Late-payment clauses in commercial contracts, price escalation or adjustment clauses
Many business loans in existence today will mature or be renegotiated before the end of 2021 in the ordinary
course and, therefore, the loans can be converted entirely to SOFR loans before the clock runs out on LIBOR, or at
least fallback provisions can be added.
A large percentage of derivative contracts also are shorter-term. Over-the-counter derivatives that do extend past
2021 can be amended to incorporate new rates and fallback provisions through a protocol procedure that the
International Swaps and Derivatives Association (ISDA) will put in place. That is still a lot of work for everyone who

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LIBOR Sunset – What to Do Now

has LIBOR derivatives, but it is a relatively clear way forward. Also, for exchange-traded derivatives, the exchanges
themselves can specify fallbacks through rulebook amendments. The exchanges have indicated they will adopt the
same basic fallback methodologies as ISDA. This is all good news.
Consumer loans present different issues. The documentation generally gives the lender discretion to unilaterally
choose a comparable rate if LIBOR goes away. That sounds simple. However, in practice, the knot of reputational,
operational and legal considerations involved in changing the interest rate basis on consumer loans will require
attention and resources to unravel. Also, more than 40 percent of LIBOR-based residential mortgage loans
currently outstanding extend past 2021.
One of the more difficult challenges is the one posed by floating-rate notes, securitizations and preferred stock
whose payments are tied to LIBOR. These securities either have no fallbacks at all to handle a LIBOR cessation, or
they effectively become fixed-rate instruments. Also, in practice, it is very difficult—if not impossible—to add the
kind of provisions that will be standard for new issuances going forward.

New Contracts
Market participants should stop writing new LIBOR contracts and start using SOFR or another appropriate
alternative. Also, especially if you need to keep using LIBOR, make sure your new contracts have strong and
workable fallback language. Companies should consider whether contracts entered into in the future should
reference an alternative rate to LIBOR (such as SOFR) or—if such contracts reference LIBOR—include effective
fallback language.
The transition away from LIBOR will be complicated and likely will require significant hours to implement correctly
for companies with a large volume of contracts. If you would like assistance, contact your BKD Trusted Advisor™.

Contributor
Anne Coughlan
Director
317.383.4000
acoughlan@bkd.com

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