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T.H.A.T. Thought No. 30 – Phasing out LIBOR

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FCA Chief Executive Andrew Bailey has announced plans to phase out the LIBOR by 2021 as part of its efforts to reform major interest rate benchmarks.

The FCA's key concern is that "the underlying market that LIBOR seeks to measure - the market for unsecured wholesale term lending to banks - is no longer sufficiently active".

Their Working Group has proposed SONIA1 as an alternative, which they believe will be more representative of underlying transactions between lenders, and so provide a better reference rate compared to a quote-based system such as LIBOR.

While this is no doubt a reasonable aim, it may have a significant impact for the sector.

Housing associations are among the largest users of long-dated fixed-rate swaps in the sterling market. The sector's agreed borrowing facilities totalled £83.6bn according to the latest HCA Quarterly Survey, of which £58.1bn were bank loans. Fixed rate debt comprised 71% of total drawn borrowings, and while a portion of this will be accounted for by capital markets transactions, a large amount will be in the form of LIBOR-linked swaps.

Mark to Markets and swap rates

First, there is a danger that LIBOR's replacement will have an adverse effect on mark to market positions over time.

This can feed into valuations through either

  1. Discount curve used for discounting future payments, or
  2. Calculation of floating rate cash flows on the ‘receive’ leg of the swaps.

While SONIA swap rates broadly track their LIBOR equivalents, there is still a difference; and this is not stable. The basis - or difference - between the 10yr SONIA vs 10yr LIBOR swap rate has been seen to vary by as much as 64bps and as little as 21bps. Shown below is the 10yr swap rate as an example – where Sonia is consistently lower that LIBOR.

In both issues mentioned above a fall in the curve will result in a fall (greater negative) MtM valuation. Something both borrowers and lenders are likely to be happy with. Borrowers will have a greater liability, while lenders may also see a larger exposure to HA borrowers and an increase in capital costs.

Libor-vs-Sonia-10-year-swap-rate
 


Libor-OIS-Basis

To put this in context, let us take a £10m 5% 10yr quarterly pay fixed swap. Valuing this using the SONIA curve for our discount factors and the 3M LIBOR curve for our forward rates will yield a negative mark to market of £3,650,000 (negative).

If we switch to using SONIA for our forward curve, this mark to market will increase to £3,810,000 (negative).

This represents a material difference and will have to be provided for to ensure both borrowers and lenders are in a position that is no better or no worse than before when these contracts are renegotiated.

Bank loans

Second, there is a risk that the change amounts to a material amendment to the contract. This is unlikely to affect new bank loans – where there is likely to be wording to allow for the substitution of a new rate setting mechanism – so SONIA in the place of LIBOR.

However it may not be as straightforward for legacy bank facilities.

Several accountants have suggested that references to LIBOR rates in loan documentation will simply be substituted for the new replacement rate once LIBOR ceases to exist.

However, some City lawyers believe that this may not be so simple. While it is true that more recent loans provide for fall-back mechanisms should the interest rate benchmark (LIBOR) be unavailable, it has been argued that these provisions are only temporary – not intended to provide for a permanent replacement of the benchmark.

We have no doubt that the FCA will work towards a suitable transition, however there remains a danger that some facilities will have to be negotiated on an individual basis, which could lead to considerable disruption.

Accounting impact

Under FRS102, this may have implications the treatment of HAs' derivative portfolios as well as hedge accounting.

Following on from our comments on bank loans, the materiality of this change may impact treatment. Taking the case of hedge accounting, the effect would depend on any potential mismatch between the debt and the derivative cash flows, and how each applies the new ‘substitute’ index.

HAs will need to discuss the issue in detail with their accountants to avoid any unwanted volatility in the financial statements, and to ensure that accounting issues are considered as part of any loan renegotiation – not after the fact.

Conclusion

While each of these will no doubt be explored in depth over the weeks, months, and years ahead, we believe this is a topic that HAs need to be cognisant of. It might be useful for HAs to

• Review existing documentation for any wording around the replacement of LIBOR
• Ensure that any new contracts being executed have appropriate provisions for the change

If you want to discuss any of these issues mentioned then please do get in touch with a member of the JCRA social housing team.

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