LIBOR transition confronts a skeptical market

| January 24, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Alternative Reference Rate Committee, or ARRC, is moving ahead resolutely with plans to transition US markets from LIBOR to SOFR by the end of 2021, but it faces healthy skepticism. ARRC aspires to a fallback from LIBOR to SOFR that flows through robust data and risk systems and offers combinations of term structure and spread adjustment that barely cause a ripple in asset values. The market sees potential for an inconsistent fallback, LIBOR securities that go from floating to fixed, litigation and a zombie market in LIBOR. If the expected outcome is either triumph or train wreck, then train wreck so far is winning.

A recent conference of Amherst Pierpont clients showed clear skepticism about LIBOR transition.  Several dozen banks and insurers, money managers and hedge funds and other investors listened to a brief presentation on the potential outcomes from LIBOR transition and debated and discussed the possibilities. The listeners voted before and after the session on whether transition will be a triumph or train wreck.

The case for triumph

ARRC has put key elements in place for a triumph, starting with development of the Secured Overnight Financing Rate, or SOFR. The rate relies on a deep market in Treasury repo transactions and solves the problem of thin bank-to-bank lending volume that allowed LIBOR to get manipulated in the early 2010s if not before. ARRC has encouraged a growing market in SOFR futures and cumulative issuance of SOFR debt of more than $314 billion. Both futures volume and issuance, however, weakened in the last quarter of 2019.

ARRC has also done extensive work on model contract language for transitioning from LIBOR to SOFR or another index. The language usually defines a trigger that marks the end of LIBOR and outlines a waterfall of alternative rates and spreads to replace LIBOR. Issuers have slowly worked versions of the model language into new loan and securities contracts.

The evolving SOFR futures market has planted the seeds for an eventual term structure of expected rates, necessary if SOFR will smoothly replace the current market in expected 1-, 3-, 6- and 12-month LIBOR. And ARRC in the last week made its first proposal for a spread adjustment that might fairly square up LIBOR and SOFR. For context, however, open interest in SOFR futures is a fraction of open interest in fed fund and eurodollar futures.

The industry and its vendors have also started developing systems that can handle SOFR and estimate market, credit, capital and liquidity risk.

 The case for train wreck

With all the good momentum toward LIBOR transition, the challenges start with hesitation by a surprising number of investors to actively prepare—to measure their LIBOR exposure, evaluate pricing or other transition risks and consider SOFR systems. At the Amherst Pierpont conference, almost the entire room raised a hand to acknowledge some LIBOR exposure, but a minority raised a hand to indicate any active transition program. Heavily regulated portfolios, including the largest banks’, are in the lead. Most others have done little.

The LIBOR fallback language in legacy securitizations poses possibly the most intractable obstacle to smooth transition. The language typically requires the trustee to survey a series of banks if LIBOR vanishes and then, absent banks willing to quote LIBOR, to set the index at the last LIBOR value. That would convert floating securities into fixed, a potential shock for holders of the asset. Amending the language can require agreement by investors that can be hard to find, and where the trustee needs 100% agreement and some investors hold small stakes, hard to get focus.  Even if investors in a legacy deal want to change the language, working through DTCC is slow and cumbersome.

There’s also risk of litigation both in legacy and new fallback language. Legacy language can allow the trustee to exercise some judgement in replacing LIBOR, and new language can differ from market to market and deal to deal from the ARRC model. If inconsistency erodes consumer or investor trust, litigation risk rises. And litigation could reduce the liquidity of contested securities.

There’s also the possibility that ICE, the LIBOR administrator, continues publishing LIBOR estimated from rates on bank commercial paper and other indicators of bank funding rates. That could seed a market in securities still indexed to zombie LIBOR, complicating transition.

The vote

An optimistic 35% of the audience started the discussion thinking the LIBOR transition could be a triumph, but that dropped to 21% by the end (Exhibit 1). The pessimists started at 65% and finished at 79%.

Exhibit 1: The votes on LIBOR transition before and after debate

Note: Vote count before is Triumph=25, Train Wreck=46; after is Triumph=11, Train Wreck=41. Source: Amherst Pierpont Securities.

This year should prove critical to addressing market concerns about transition. ARRC needs investors to get onboard. The process has started with regulated institutions—the Federal Home Loan Banks, Fannie Mae and Freddie Mac, larger banks—where regulators have the most leverage. The campaign now moves toward private investors. And in the private markets, for now, the skeptics rule.

* * *

The view in rates

The rates market looks likely to continue swimming along in the same lane it has taken for the last quarter. The Fed path of steady rates has crystalized. The continuing risk of trade surprises keeps growth expectations low. Inflation expectations remain below the Fed target as well. Other than potential for realized inflation to slowly move higher, it is hard to see viable surprises that might dramatically lift or reshape the curve. Last year, a drop in interest rates generated a health share of fixed income total return. This year, a drop in rates looks very unlikely. The risk is slightly to higher rates, but still below 2% for the 10-year note.

The view in spreads

The appetite for spread and compounding income only looks likely to stay strong in a market with likely steady rates and a flat yield curve. The US economy looks healthy enough to keep credit concerns at bay for investment grade companies and even most high yield companies, so spreads have room to compress further. MBS has some room to run tighter even though low rates stand to keep prepayments elevated through the spring, especially in Ginnie Mae MBS. If the economy moves above current expectations of less than 2% real GDP growth, spreads should tighten further.

The view in credit

A variety of measures of corporate leverage remain high, but leverage spells trouble only if growth falls below current expectations and financing for leveraged borrowers tightens. That does not look likely. It looks more likely growth might slightly exceed expectations, lifting corporate fundamentals. As for the consumer, that is a story of generally continued strength with low unemployment, strong income, rising net worth and low debt service as a share of income.

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