The final laps for LIBOR transition
Housing associations, along with other market participants, are approaching the LIBOR home straight.
The Bank of England (the BoE) and the Financial Conduct Authority (the FCA) intend to phase out LIBOR as the key interest rate benchmark for sterling by the end of 2021. Borrowers now have around nine months to remove their reliance on LIBOR, both for new financing arrangements and in legacy LIBOR contracts.
Many of our clients are actively discussing the transition from LIBOR. Naturally, some are further ahead than others. It's also the case that different banks are in different states of readiness.
To help housing associations assess where they are, or ought to be, in the transition landscape, this article looks at some of the game-changing developments and provides a summary of the vast commentary on LIBOR.
At the start of the year, the BoE, FCA and the Working Group on Sterling Risk-Free Reference Rates (the Working Group) released a joint statement on completing the LIBOR transition by end-2021 and a priorities roadmap for 2021 (the 2021 Roadmap). The clear message is that the primary way for participants, including housing associations, to have certainty over the economic terms of their existing LIBOR contracts is to take active steps to transition them.
The 2021 Roadmap sets out the Working Group's top level priorities for 2021 and the sequential steps – financial product-by product – required to meet key milestones. By the end of Q1 2021, all participants must cease using sterling LIBOR in any new lending or other finance products that mature after the end of 2021. Further, it recommends that throughout Q2 and Q3 2021 all participants progress and complete the conversion of existing legacy LIBOR contracts expiring after end-2021 to an alternative rate. By the end of Q4 2021 participants should be fully prepared for the cessation of sterling LIBOR.
Bear in mind that banks will want you to transition on an interest rollover date - so you may well have even less time than you think!
The working assumption is that sterling LIBOR will be replaced by SONIA (the sterling overnight index average). SONIA is an overnight rate derived from actual rates paid on overnight deposits, and is published on a daily basis by the BoE. SONIA is known as a near risk free rate (RFR) because, unlike LIBOR, it does not incorporate any mark up in respect of counterparty credit risk.
As SONIA is a daily rate published in arrears, the rate charged in respect of an interest period will be a compounded rate calculated from the daily rates published during the interest period. The actual rate and the amount of interest will therefore not be known until close to the end of the interest period. To allow for this calculation to be made before the interest actually becomes payable, most lenders are adopting the practice of using SONIA published for each day during an "observation period" that begins before the start of the interest period and finishes before the end of it (with, for example, a five day lag for ease of calculation).
In addition, the BoE publishes a daily compound index for its overnight SONIA interest rate. The SONIA compound index for a given London business day is published at 9am on the BoE's interactive statistical database. Each day it represents the total compounded SONIA from a specified base date and is seen as a route to reach the same result as the compounded SONA methodology above.
The Loan Market Association's (the LMA) "RFR exposure draft" documents use compounded SONIA calculation methodology. These drafts are intended to raise awareness of the issues involved in structuring loans referencing compounded SONIA and have been a useful precedent for day one SONIA loans. Last July, we advised Coastline Housing on its first SONIA based loan facility from Lloyds, which is believed to be the first day one SONIA facility in the social housing sector. The facility agreement was aided by RFR exposure drafts.
In November 2020, the LMA further published "rate switch exposure draft" documents, to facilitate the switch of loans referencing LIBOR to compounded RFRs. Pursuant to the drafts, the switch to a compounded RFR will happen either on an agreed date or when LIBOR ceases to be published or it is officially decided that LIBOR is no longer representative of the underlying market or economic reality.
Whilst we have seen facility agreements integrating large parts of the LMA suite of exposure drafts, we are yet to see standardised drafting emerge, as lenders take slightly different approaches.
There is also not as yet a standard form document or template which can be used to transfer legacy LIBOR loans to SONIA.
In the joint statement, the Working Group also acknowledged that some parts of the sterling markets may need to model a forward-looking rate, such as term SONIA, and that some providers are beginning to make these available. Term SONIA is a forward-looking term reference rate based on overnight SONIA but looks and feels far more similar to LIBOR.
However, we have not as yet seen any housing association loans being documented on the basis of term SONIA and we do not expect there to be any significant use of this alternative in the social housing finance market.
The use of SONIA is not mandatory and it is always open to the parties to agree to move to a different floating rate basis.
In particular, we understand that a number of banks are looking at a Bank of England base rate alternative which they may offer to their smaller housing association customers.
The LMA regularly publishes a list of syndicated and bilateral loans referencing RFRs (such as SONIA).
The purpose of the list is to raise market awareness of the fact that lenders are offering RFR- based lending products and some of the conventions being adopted in those transactions. The latest version was published on 19 February 2021 and included references to a number of housing association transactions.
ISDA Fallbacks – free standing swaps
For those associations with free-standing swaps, their existing ISDA master agreements are unlikely to envisage the permanent cessation of LIBOR. Consequently, new fallback wording will need to be incorporated into these contracts.
To address this issue, ISDA in October 2020 published the IBOR Fallbacks Supplement (the Supplement) and IBOR Fallbacks Protocol (the Protocol), linking-up LIBOR derivatives contracts stretching beyond 2021 with the wider work on the cessation of LIBOR. The Supplement amends the 2006 ISDA Definitions for interest rate derivatives to incorporate new fallback wording. The Protocol, on the other hand, will allow parties to incorporate the new fallbacks into existing swap contracts. The Supplement and Protocol both took effect on 25 January 2021 for those participants who sign up to them.
Clients should take care that any interest rate swap transitions at the same point as the underlying loan. There are also slight differences in the ISDA methodology compared to the loan market, which means that simply adopting the Protocol may not work without further adjustment.
Enhanced FCA powers – "tough legacy"
In June 2020 the Government announced that it intended to bring forward legislation under the Financial Services Bill 2019-21 (the Bill) to amend the existing regulatory framework for benchmarks such as LIBOR. The Bill will give the FCA enhanced powers to help manage and direct an orderly wind-down of LIBOR and help deal with so-called "tough legacy" contracts where reaching agreement with all relevant parties may be difficult.
However, the FCA has made clear that these provisions will apply only to a limited number of contracts. Housing associations are clearly not in scope and should not place reliance on any such mechanism.
All roads lead to the full transition from LIBOR sooner rather than later this year. In the sterling markets SONIA compounded in arrears will likely become the norm for most variable rate loans.
Housing association treasury teams should be actively considering their LIBOR exposure and tracking their location on the 2021 Roadmap. They should also consider whether it may be possible to transition with all their lenders at the same time. This is likely to be tricky as lenders are approaching LIBOR transition in different ways and each facility is likely to have different rollover dates.