Yes, most of us are aware the LIBOR is about to go the way of the dinosaur. But what does this mean to our institution? Well, it depends on what types of loans were made and what financial assets remain on your balance sheet.
As background, LIBOR or the London Inter-Bank Offered Rate is a forward — looking interest rate index for various maturities. The LIBOR administrator has announced it intends to cease publishing the one week and the two (2) month USD LIBOR on December 31, 2021 and the remaining USD LIBORs on June 30, 2023. LIBOR as an organization has existed since 1986 and was designed to provide independent market driven indices for various maturities. LIBOR worked well until the nadir of the 2008 mortgage crisis when the interbank lending among the largest banks ceased due to the uncertainty of pricing balance sheets laced with mortgaged backed securities, credit default swaps and other derivatives. The “nail in the coffin” occurred a few years later when certain investment bank employees schemed to manipulate the submitting of each banks’ interest rates used to calculate the various LIBOR. With that advance information, illegal profits were made leading to civil fines and criminal convictions. My white-collar crime students’ study this as an example of the ability of bright and well-placed individuals “to game” any complex economic calculation for fun and profit unless you get caught.
The three (3) Federal Regulators issued a statement on November 30, 2020 identifying this as a safety and soundness issue that must be actively managed. The Federal Reserve published further guidance (SR21-7) detailing that an inventory of legacy loans or derivatives tied to LIBOR needed to be identified and reviewed by legal counsel. The Federal Reserve bifurcated its examiner guidance for those institutions over and under $100 billion dollars. Many LIBOR agreement when made did not provide for an alternative index except in the event of temporary disruptions of publication of LIBOR. Each major country has an Alternative Rate Reference Committee (ARRC) providing suggested indexes with each country proposing alternative indices. The U.S. ARRC developed the Secured Overnight Finance Rate (SOFR). Some in the U.S. have pushed for a legislative solution to adopt SOFR as a statutory fallback rate. New York has already passed such legislation. It is unclear whether the U.S. Congress will take action. The International Swaps and Derivatives Association has adopted a fallback protocol to be used while parties negotiate a substitute contractual provision. The Consumer Financial Protection Bureau has published guidance on June 24, 2020 reminding lenders of U.S. Consumer law requirements for amending consumer loan agreements and whether such amendments may be considered a “refinancing.” This will affect adjustable (or variable) rate loans and lines of credit, such as adjustable-rate mortgages (ARMs), reverse mortgage, home equity lines of credit (HELOCs), credit cards, student loans, and any other consumer loans that use LIBOR as the index. Each product will need to be reviewed as to any new disclosure requirements.
Each type of loan or derivative may require a different solution to overcome its own special set of issues. To put this in context, the essence of this exercise is to amend a contract which is either authorized by the existing contract or by the consent of the parties. The decision of the “right” replacement index is ultimately an economic decision based on your institution’s cost of funds and the duration of those financial assets. Once that decision is made, “dot your I’s and cross your T’s” to effectively amend your agreements.