LIBOR: changing times
There is no escaping the topic of LIBOR since the Financial Conduct Authority (FCA) first announced its intention to phase out LIBOR as the key interest-rate benchmark for sterling in 2017.
Housing association treasury teams (in fact, all corporates) must start to consider their funding portfolios in light of the proposals. To assist, we have tried to summarise the vast amount of commentary out there and make some recommendations as to the next steps.
The FCA intends to cease using its powers to compel banks to submit contributions to support the publication of LIBOR at the end of 2021. Its intended replacement, SONIA, is an overnight interest rate benchmark which is an average of interest rates banks pay to borrow sterling overnight from each other. The Bank of England publishes the rate daily based on actual transactions.
To use SONIA to calculate interest, current practice is to use the overnight rate compounded in arrears (Compounded SONIA) over an "observation period" that starts before the interest period (of say, three months) and finishes before the end of the interest period (with, for example, a five day lag for ease of calculation).
Many lenders would prefer that a "Term SONIA" rate be developed. This would be a forward-looking term reference rate based on overnight SONIA but far more similar to LIBOR than Compounded SONIA (LIBOR also being a forward-looking term reference rate). Fundamentally, a Term SONIA seems a more straightforward replacement. There are no Term SONIA rates available at present, nor has the market been able to develop plans to do so. FCA guidance cautions that the market should not depend on this.
Borrowers, including housing associations, need to be assessing the exposure to their organisation of LIBOR withdrawal and, where possible, seeking to mitigate risk.
Anecdotally, we hear most borrowers seeing this as a lender side issue – as well they might given the control that banks have over interest rates and loan pricing. However, the FCA's stated view is that borrowers should be engaging with their lenders on the issue. Its position is that market participants should be able to run their business without LIBOR from the end of 2021.
In late 2019, the FCA announced that no new LIBOR cash-based financial products could be offered beyond 30 September 2020. On 29 April 2020, this deadline was extended to the end of the first quarter of 2021 as a result of Covid-19.
When entering into new loans at the very least borrowers should understand their funder's view on LIBOR transition, and ideally the document should incorporate fallback drafting allowing for a transition to a SONIA-based rate in the future. The majority of new loan agreements still only reference LIBOR, though Riverside announced the closing of the sector's first SONIA loan in April. Other borrowers are looking to follow suit, but many lenders are not yet ready to offer SONIA-based lending products. The FCA's expectation is that by the end of Q3 2020, lenders should be in a position to offer non-LIBOR linked products to their customers so we would expect more SONIA-based borrowing through the second half of the year.
The FCA has been very clear that there will be no centrally-set solution via legislation or "grandfathering" exemptions which will allow for LIBOR's continuation.
The Loan Market Association's "exposure draft" documents use existing Compounded SONIA calculation methodology. Existing loan documents will require very significant amendments if a switch to this backwards-looking formula is mandated.
We are aware that many lenders have provided notes setting out their current policy in relation to LIBOR transition. In almost all cases, these notes have no legal status and the terms of the loan contract will bind the parties. Many newer facility agreements have clauses dealing with "replacement of the screen rate" relating to the unavailability of LIBOR and in most cases, these are drafted as an "agreement to agree". In such a case as a matter of contract law, these are not enforceable (for either side).
Ultimately, this could mean that there are unpalatable consequences (including ultimately the frustration of a loan contract for uncertainty) in the event that the parties cannot reach agreement on how interest is to be calculated in the event LIBOR is not available. In a worse case scenario, this could result in the effective loss of funding available under any affected agreement. Older agreements may even be silent on the subject.
Even where interest rate fallback provisions exist, these may not be a solution, if for example the fallback drafting was only ever intended for use in a situation where LIBOR was temporarily (rather than permanently) unavailable. Another potential risk is if LIBOR continued to exist, but in a radically different form. If only a few panel banks provide submissions (the FCA fully expects numbers to dwindle from the end of 2021), loan pricing could be adversely affected.
The FCA are recommending that from Q4 2020, onwards lenders should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion to SONIA ahead of end-2021. We recommend that associations engage their lenders on this subject as soon as possible to achieve a smooth transition. In addition, borrowers and lenders will need to work together to agree a process to amend legacy agreements, which should be standardised as far as possible for speed and cost reasons.
Associations should also be reviewing their loan portfolio now to confirm any existing interest rate fallbacks or clauses governing replacement methodology so that their position on their current book is clear and readily available in the event that advice is required.