The London Interbank Offer Rate (LIBOR), an interest rate which major global banks used to lend to one another, was one of the most widely recognized interest rate benchmarks to value various financial products. For many years, LIBOR has established interest rates for common financial products, including credit cards, loans, bonds and adjustable-rate mortgages. LIBOR is a floating rate asset class, which means that loans reset monthly or quarterly to a spread over a base rate. However, LIBOR has been riddled with controversy and has been gradually phased out by the Federal Reserve since 2018.
The Federal Reserve has been advising banks to stop writing LIBOR contracts since 2020 and ended the issuance of new loans valued using LIBOR on December 31, 2021. While it is not currently being used to price new loans, LIBOR will formally stick around until June 2023, at which point the Secured Overnight Financing Rate (SOFR) will take over.
Controversy surrounding LIBOR
LIBOR came into widespread use in the mid-1980s as a standardized benchmark for pricing floating rate loans and is currently based on five currencies, the U.S. dollar, the euro, the British pound, the Japanese yen and the Swiss franc. It served seven different maturities, overnight/spot next, one week, and one, two, three, six, and 12 months. This created 35 different LIBOR rates that were calculated and reported every day using waterfall methodology.
After the beginning of the global financial crisis of 2007–2008, the major international lender, Barclays, manipulated LIBOR downward by instructing calculators that it could borrow money at inexpensive rates to make the bank appear less risky. The falsely low rates submitted by Barclays came during a period of severe financial disruption. Artificially lowering the rates provided the bank with some stability in an unstable economic environment. In 2012, as part of a settlement with U.S. and U.K. authorities, Barclays confessed to the mass manipulation of rates.
In 2012, an international investigation into LIBOR uncovered a scheme by 15 banks to manipulate these rates for profit starting as far back as 2003. Regulators in the U.S., the U.K., and the European Union have fined banks more than $9 billion for rigging LIBOR, which underpins over $300 trillion worth of loans worldwide. Since 2015, authorities in both the U.K. and the U.S. have brought criminal charges against individual traders and brokers for their role in manipulating rates.
To demonstrate, let’s say a company relied on its revolving credit facility with a particular bank. Under the terms of that facility, this company would be charged interest at the LIBOR rate plus 1.5 points on all outstanding borrowings. If the outstanding principal was $5 million, an over inflated LIBOR rate could cost the company thousands of dollars in interest payments. If LIBOR was accurately assessed at 3.25%, the company would be paying approximately $237,500 over the life of the facility. A slight increase in LIBOR to 3.75% would cost the company an additional $25,000 in interest payments over the term of the facility.
What is SOFR?
The Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) in 2017 to gradually begin replacing LIBOR in future financial contracts. The ARRC believes SOFR represents best practice for use in several new USD derivatives and other financial contracts. SOFR is an overnight secured rate and is based on transactions in the Treasury repurchase market and better reflects the way financial institutions currently fund themselves. SOFR is a more transparent rate than LIBOR that is reflective of the market across a broader range of participants. Ultimately, SOFR is seen as preferable to LIBOR as it is based on data from observable transactions as opposed to estimated borrowing rates.
Navigating the transition
The effect of the transition from LIBOR to SOFR will be a case-by-case situation. Whether an entity is positively or negatively affected will depend on various factors that are unique to each company. The phase out of LIBOR will require companies to thoroughly review and amend all of their financial contracts. Such amendments could significantly impact companies and certain relationships including hedge contracts.
Citrin Cooperman’s team can help review contracts and financial implications of this transition for clients and how the change may impact cash flows moving beyond 2022. For more information on how the transition from LIBOR to SOFR may affect you, please contact our Financial Services Practice specialists or Nicolas de la Vega at firstname.lastname@example.org.
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