The Federal Reserve Bank of New York (FRBNY) has been holding a number of workshops to build a shared understanding of the challenges that lie ahead for banks and their borrowers as they attempt to transition away from the London Interbank Offered Rate (Libor) before 2022.

These sessions are exploring methodologies to develop a robust lending framework that considers a credit sensitive spread that could be added to the Secured Overnight Financing Rate (SOFR) for revolving lines of credit, commercial and industrial loans, and commercial real estate loans.

While the first three workshops focused on banks, the next one will attempt to gauge corporate borrowers’ concerns about the transition. Ahead of the meeting, the Fed scheduled a call with AFP and a group of treasury professionals to gain their perspective on the potential credit supplement to SOFR.

SOFR SUPPLEMENT

During the discussion with the Fed, it became apparent that treasury and finance professionals are apprehensive about the credit supplement. Practitioners appeared particularly concerned that it could be applied across further SOFR categories.

In a follow-up discussion with representatives from the Loan Syndications and Trading Association (LSTA), the International Swaps and Derivatives Association (ISDA) and a group of treasurers, Tom Hunt, CTP, AFP’s Director of Treasury Services, asked whether the credit sensitivity component is something that corporates should be concerned about if they have regional banks in their syndicate.

Meredith Coffey, Executive Vice President of LSTA, addressed treasurers’ concerns. She doesn’t expect the credit supplement to emerge in Libor fallback language. She began by noting that the Alternative Reference Rates Committee (ARRC) currently recommends using hardwired fallback language for any new agreements beginning after September 30, 2020. The hardwired approach basically says that when LIBOR ceases or is declared unrepresentative, the market participant falls back to SOFR, plus a spread adjustment.

“The spread adjustment that the ARRC is going to recommend in a hardwired approach is the ISDA spread adjustment. Everything is perfectly aligned there—you've got SOFR, and you've got the spread adjustment as recommended by the ARRC, which will be the ISDA spread adjustment,” she said. “ There is little likelihood of going through a risk-sensitive spread adjustment in the hardwired approach. And again, the ARRC has recommended that by the end of September of 2020, all new syndicated loan agreements should go hardwired because that reduces market disruption.”

However, the ARRC has also offered an alternative “amendment approach” for fallback language. This approach recognizes that loan agreements are typically amended and seeks to create a streamlined process to select a replacement rate and spread adjustment.

In this situation, Coffey still believes that the ARRC/ISDA spread adjustment would become the market standard. But it does allow for the possibility that a risk-sensitive spread adjustment could become the norm instead.  “So with a hardwired approach, there’s no chance of getting a risk-sensitive spread adjustment,” she said. “With the amendment approach, I think the risk is low but there is some potential if a risk-sensitive spread adjustment was developed and then became the market standard.”

Treasurers that have existing loan agreements that haven’t been amended or renewed recently and mature past 2021 should work with their administrative agent if Libor hasn’t been addressed or if they plan to use the amendment approach, Hunt advised. In reality, the real deadline is June 1, 2021 for all new loan syndications to be using SOFR as a fallback as recommended by the ARRC.

Even more importantly, treasurers should check whether their bank groups subscribe to the ARRC’s recommendations. The smaller the bank, the more likely the amendment approach would be acceptable, and that could include the credit sensitivity component—thereby treating SOFR differently across SOFR exposures in derivatives, loans, asset-based lending, etc. “Its best to work with your general counsel, understand your position and work with your bank group and administrative agent to address this before the clock runs out, as banks have far more exposures than corporates do,” Hunt said.

RENEGOTIATING REVOLVERS

Coffey noted that banks are dealing with “hundreds of thousands” of credit facility amendments under the amendment fallback approach, and not all of them are going to be resolved immediately after Libor ends. For those that don’t, they could end up with a prime-based rate, which she views as the worst-case scenario. “Our concern from the lender perspective is market disruption. From the borrower perspective, I would be concerned that I'm in the group of people that do not get their amendments through, and end up in prime-based rate for a period of time,” she said.

Amid this turbulent environment, many banks and being more demanding when clients attempt to amend their revolvers. A treasurer for a major utility explained that his bank advised him that upfront fees and renewal fees would be much higher this year if the company elected to make an amendment on its revolver. “We have a five-year and we’re into our third year. So in normal circumstances we would renew that this early because we have an automatic renewal clause and we pay upfront. But banks are advising to just wait to see if things cool down,” he said.

Most of the input in the discussion came from non-investment grade issuers. One treasurer for a major retailer raised questions about “anti-cash drawdown language” in loan documents, in addition to Libor floors. He explained that his company drew down under its revolving credit and parked the money in cash, just to ensure that it had access to capital in case there was a repeat of what happened in 2008-2009. So, he had about $265 million in the bank by June.

The treasurer’s company then signed an amendment to its credit facility in June to expand availability in early June. Two of the biggest changes in that amended facility were the introduction of a Libor floor, and provisions designed to stop cash drawdowns. “So for example, I cannot borrow further on our credit agreement unless I can represent, at the time of the borrowing, that the amount of cash I have in the U.S.—including the amount I'm going to borrow—is going to be less than or equal to $50 million,” he said. So the company would have to spend more than $215 million before it could borrow more.

“I think the banks responded by making it crystal clear that you might have done in it in the past, but you're not going to do it in the future,” he added.

Two other treasurers on the call fared better with their banks. They also signed amendments around the same time, but after fighting “tooth and nail,” they managed to avoid both Libor floors and anti-cash concentration language.

Banks appear to be testing the waters with these provisions right now, seeing whether corporates will agree to them.  A fourth treasurer for a major auto manufacturer said that his company also recently renewed its facility. He said that while he doesn’t believe there is a big push for anti-cash drawdowns  provisions, his bank did bring them up in the negotiation. “But we were able to successfully renew without that,” he said.

NEXT STEPS

Market participants are now awaiting an ISDA IBOR Fallback Protocol, which is set to arrives soon. The protocol will implement new fallbacks for legacy derivatives products. The fallbacks “will be critical to ensure that derivatives contracts continue to reference clear, transparent and consistent rates if the IBOR they currently reference is discontinued or, in the case of Libor, becomes non-representative,” ISDA said in a statement. 

The ARRC recommends adopting the protocol, which it says is critical to ensuring that existing derivatives contracts feature durable fallbacks since Libor cannot be relied upon after the end of 2021.

For more insights on the Libor transition, visit AFP’s Libor Transition Guide. And don’t miss the Libor sessions in the Capital Markets & Investments track at AFP 2020.