The End of LIBOR Is in Sight
Complications Expected When the Switch to SOFR Takes Place
When it comes to multifamily finance, few terms are as widely known or used as LIBOR. The London Inter-bank Offered Rate, or LIBOR ― as it’s more commonly called ― has been utilized globally as an index rate for financial transactions as well as for financial institutions to gauge funding costs for many extensions of credit and other such investments. Interestingly, while LIBOR has been so widely used within the financial services industry, its time has finally come to be phased out of use.
There have been quite a few announcements and updates to the state of multifamily finance as we prepare for the new year and the new presidential administration. Still, in terms of widespread implications, the end of LIBOR has to be one of the biggest and most staggering updates thus far. After all, since its inception, LIBOR has been utilized as a representative benchmark for trillions of dollars in securities worldwide.
LIBOR is supposed to have started as far back as 1969 when a banker used the reported funding costs of banks as a means to arrange a syndicated loan. Benchmarking the rates that banks charge for short-term loans to each other, LIBOR grew to become a standard in financial markets around the world. On a global scale, LIBOR administers 35 different rates between five different currencies through the intercontinental exchange.
Even while playing such a critical role in global markets, LIBOR has been the subject of near countless scandals, marring an otherwise impressive reputation. Since LIBOR utilizes the borrowing costs submitted by banks to set rates, it is quite easy for banks to manipulate these figures. After countless incidents on record, the credibility of the LIBOR index has waned greatly, particularly in the eyes of the Financial Conduct Authority (FCA).
The manipulation of LIBOR by banks came in various forms throughout the years. In the era known as the Great Recession, liquidity issues led many banks to claim low LIBOR numbers falsely to appear strong financially. A few more cunning players in the finance world realized they could fare better in LIBOR-linked transactions if they manipulated the rates themselves.
All of this came to a head in 2017 when the FCA announced that LIBOR would no longer be used beginning in 2021. Even with the vast, possibly chaotic effects on the market after LIBOR is discontinued, many regulators are actually happy to see the change take place. The hope is that LIBOR will be replaced with reference rates that reflect real transactions accurately, rather than ones that can be manipulated by banks on a whim.
To meet the hopes of regulators, the Alternative Reference Rates Committee (ARRC) ― a group comprised of regulators and private market participants ― proposed legislation this past March that would pave the way for adopting a new benchmark. If all goes according to their plan, LIBOR will be replaced with the Secured Overnight Financing Rate (SOFR). SOFR is based on the United States Treasury repurchase (repo) market, where U.S. Treasuries are borrowed or loaned overnight. These transactions are on record in great detail, making them much more difficult to manipulate.
Still, complications are expected from the switch from LIBOR to SOFR since the two are not mirrors of one another. Although both reflect borrowing costs over the short-term, there are key differences that make SOFR appear to be a step back rather than an upgrade. For starters, SOFR is based on the risk-free rates of overnight Treasury transactions, whereas LIBOR was based on transactions that included credit risk, which made the rates naturally higher than those of SOFR. Even more problematic, however, is that while LIBOR could be utilized for borrowing periods up to 12 months, SOFR is linked to overnight transactions that occur on a daily basis, which makes it much harder to predict and calculate future payments.
The differences won’t be enough to stop the ball rolling, though. Regulators have already begun reaching out to financial institutions to prepare for the phasing out of LIBOR by drafting new provisions that detail how any disparities between the two reference rates are to be handled. There is still much work to be done regarding how older transactions based on the soon to be extinct reference rate will be handled.
Change is coming, but we have yet to see how this change will affect the multifamily finance market. We may see more borrower action based on the lower rates that SOFR is expected to reflect, but even that isn’t set in stone. Perhaps the silver lining here is a switch to a reliable benchmark rate that is based on real, tangible transactions and not subjective, falsified submissions from banks.