The world's most important number to retire by 2021
The London Interbank Offered Rate, known as LIBOR, will be phased out by 2021.
What began in 1986 as a benchmark interest rate for large international corporate loans is now widely utilized in middle market and smaller business loans, interest rate swaps and other derivatives, and even adjustable rate residential mortgage loans, credit cards and auto loans.
We have seen estimates that somewhere in the range of $150 to $400 trillion of financial transactions around the world may now be based on the LIBOR index. The odds are fair that most readers of this article are affected by LIBOR in their business or personal finances. So, the British Bankers' Association may not have been exaggerating when it called LIBOR the world's most important number.
Why? It is no small matter that the UK regulatory body, the Financial Conduct Authority, announced in July that its panel banks will not sustain LIBOR after the end of 2021. It cited a number of reasons for the change including: 1) The scandals relating to the manipulation of the LIBOR index, which led to the imprisonment of some individual participants, and 2) the fact that the index is often calculated on the basis of theoretical bank borrowing costs instead of actual transactions. This has impaired its reputation as a reliable and accurate benchmark.
In addition, the underlying basis of LIBOR is the rate at which banks in the London market will loan funds to each other, which has little rational connection to the measurement of risk in small business and mortgage loans.
What's next? The Alternative Reference Rates Committee convened by the U.S. Federal Reserve, has been meeting to consider this question since 2014, and has recommended using a reference rate based on U.S. government debt. The Bank of England, EU banks and Asian banks will also likely play a role in developing a replacement benchmark rate.
We are confident that the parties will adopt a workable new standard, but it may not come soon.
What happens to a loan based on LIBOR when that rate is no longer available? Of course, there are many transactions already in existence that will continue after 2021, and loans and swaps are being closed every day with LIBOR as the reference rate.
The first place to look for the answer is in the transaction documents. Our experience is that most business loan documents contain provisions that address the issue in some way. Some of those agreements call for a comparable interest rate to be determined by the lender.
Others revert to prime rate or some other designated rate or formula. Some may be silent.
Both Fannie Mae and Freddie Mac include wording in their ARM documents that a comparable alternative index may be selected if LIBOR is no longer available.
Borrowers should be informed on the terms of the applicable documents in advance of the change.
Borrowers and lenders currently negotiating loan documents have the opportunity to pay attention to words that might previously have been overlooked as boilerplate.
In addition to considering the provisions regarding replacement interest rate, both parties can think about the reasonable allocation of the costs of a rate change they know is coming. Another thing to consider is that lenders and loan servicers will be challenged to update their technology to accommodate the calculation and application of the replacement rate.
A requirement to share the calculation might make sense for an initial period after the replacement rate takes effect.
Hopefully, LIBOR will ride off into the sunset to join Y2K and the Curse of the Billy Goat as forgotten relics. Being prepared by reviewing your documents and by working with your advisors is the best way to make sure this happens.
• Dave Hight is the office managing partner of Ice Miller's DuPage office and can be reached at (630) 955-5821 or at david.hight@icemiller.com.