LIBOR to SOFR: What Lenders Need to Know

By Cindy Barreda 

Libor’s phase-out is nearly complete. By the end of June 2023, the market will transition from the controversial London Interbank Offering Rate (LIBOR) benchmark to a completely new way to calculate interest. So, what’s the replacement?

As officially recommended by the Federal Reserve-backed Alternative Reference Rates Committee (ARRC) in July 2021, the Secured Overnight Financing Rate (SOFR) is likely to be the new replacement for LIBOR.

Why LIBOR is Being Phased-Out

The need to switch to a new interest rate benchmark arose in 2012, after the discovery of rate collusion between several major financial institutions—going back as far as 2003.

After reports of manipulation, regulators sought an alternative benchmark that would add credibility and stability to reference rates. A few options were recommended which worked well for their respective markets.

In the UK, authorities favoured Sterling Overnight Index Average (SONIA), and in Europe the Euro Short Term Rate (€STR) was adopted, and SOFR became the aforementioned recommendation of the ARRC in 2017.

How SOFR Differs from LIBOR

It’s important to understand the differences between LIBOR and SOFR. The biggest change is that SOFR looks at existing transactions in the US Treasury Repo market as the basis of the rate. Now, the rate will be formulated from around USD 1 trillion in daily transactions.

This presents a downside for lenders. SOFR is based on Treasury Repo—a credit risk free market—meaning that in its simplest form, SOFR does not have credit risk “baked in.”

This lack of baked-in credit risk means there are still a few rivals that may challenge SOFR as the benchmark for the USD lending market. These credit sensitive rates include Ameribor, BSBY and even the US Prime Rate used by the credit card industry. Despite their merits, these rates haven’t received official backing from the Federal Reserve, and, more importantly, don’t have supporting transactions behind it, like SOFR.

Within SOFR there are different calculation methods which alleviate some of the credit risk issues, and the Federal Reserve is making proposals using some of these. Derivatives transactions, for example, use SOFR compounded in arrears, non-government-sponsored enterprise (GSE) cash deals apply the CME Group’s Term SOFR. Other contracts, including multifamily CMBS, could be covered by a 30-day average SOFR, all of which add to tenor spread. A good step—but not a complete solution.

With this is mind, there are several challenges in the transition to SOFR which shouldn’t be underestimated. During the switch to SONIA in 2021, Trimont’s global teams guided clients through the funding and cash-flow model changes that affect business-critical outcomes.

Furthermore, there are few important distinctions to note about the transition. This will be a seismic change to how markets price and mark their trades. Also, it will affect approximately USD 300trn in existing deals across loans, derivatives, and cash transactions. Although many market participants have expressed concerns over the transitions, the threat to market stability is minimal.

How Lenders Can Prepare for SOFR

How should lenders and investors prepare? Start by evaluating your existing agreements and loan documentation. Look at the benchmark-dependent wording in your contracts and adjust accordingly. Accounting for the new benchmark might reveal additional costs you might be responsible for, such as brokerage costs for changing swap rates or legal fees to change contracts.

The changes will likely take time to resolve and could result in adjustments being made to numerous loan agreements. With this in mind, lenders should plan to have these client conversations early.

The next major step in making the switch is to think differently about your benchmark implementation. SOFR has four methodologies, and can be determined either at the start or end of the accrual period. This makes calculating end-of-term income more unpredictable and challenging for your clients. This makes calculating end-of-term income more unpredictable and challenging for your clients.

The most straightforward solution to the complication of transferring to SOFR and managing assets under the new rate is to work with a loan servicer who specializes in complex credit and understands how the change will affect your business.

Work With the Right Partner

At Trimont, one of our chief aims is to be a trusted partner to our clients. Our global team of experts has the knowledge and expertise in loan servicing, and we are keenly aware of the effect that SOFR will have on CMBS, MBS, and many other loan products.

Learn more about Trimont’s services, or contact our complex credit experts.

Cindy Barreda is Senior Managing Director of Credit Administration (Americas) at Trimont.