As 2021 quickly approaches, market participants are well on their way toward addressing the IBOR transition issues specific to their product portfolios. Structured finance products present additional levels of complexity that must be tackled.
The London InterBank Offered Rate (“LIBOR”) is scheduled to be phased out by December 31, 2021. In anticipation, global regulatory authorities have established working groups to choose alternative reference rates and recommend contractual fallback language to address cessation of LIBOR. In the United States, the Alternative Reference Rates Committee (“ARRC”) was commissioned to recommend a replacement for USD LIBOR. The ARRC selected the Secured Overnight Financing Rate (“SOFR”), which is based on Treasury repurchase rates, and published fallback language for agreements referencing LIBOR to facilitate the transition to SOFR. Recommended fallback language addressed both loan products and securitizations, and the two approaches are similar but do not track perfectly.
Application to Commercial Mortgage Loans
There are a number of considerations and hurdles related to the adoption of a replacement benchmark rate with respect to commercial mortgage loans. Originators of commercial mortgage loans need to be mindful of potential mismatches between the benchmark interest rates on the underlying commercial mortgage loans, on the one hand, and the benchmark interest rate applicable to warehouse financings and securitizations on the other hand. Many older transaction documents do not contain appropriate fallback language provisions that contemplate the permanent cessation of LIBOR. It can be difficult to amend the underlying loan documents in cases that require consent (usually unanimous) from numerous, often difficult to identify, securitization bondholders. Additionally, in many cases, the underlying loan documents provide for conversion to the U.S. prime rate or fallback to the last quoted LIBOR rate, while more recent warehouse financings and securitizations contemplate a transition to SOFR. The impact of mismatches in the benchmark rate after LIBOR transition needs to be carefully considered by market participants.
Managing spread adjustments is another consideration market participants will need to monitor as the market transitions away from LIBOR. The ARRC’s recommended spread adjustment methodology is intended to be used to determine the spread that can be added to SOFR, such that the spread-adjusted version SOFR would be comparable to USD LIBOR.
Another potential risk is inconsistent approaches across the market. Participants could adopt different measures to address the LIBOR phase out or adopt varying language in transaction documents that could lead to litigation. Draft legislation is circulating in Congress that would establish SOFR as a commercially reasonable substitute for LIBOR, which industry experts hope will reduce the risk of litigation.
There is still work to be done in ensuring a smooth transition away from LIBOR. Given the current uncertainty, monitoring market developments, updating transaction documents to include ARRC’s recommended fallback language, and preparing for contingencies and unexpected challenges will help ease the transition to an alternative reference rate.