Libor’s Last Users Face Challenges as the Deadline for Its Demise Nears

Libor, which has long underpinned financial contracts such as mortgages, corporate loans and interest-rate derivatives, will cease in its current form in July—essentially the death penalty for a manipulation scandal that came to light more than a decade ago. Companies, however, have been slow to shed their Libor ties over the past several years and ready their information-technology systems to handle the switch to a replacement.

More than half of companies haven’t completed their transition, said Amol Dhargalkar, managing partner and global head of corporates at Chatham Financial, a financial-risk adviser.

“At the end it’s just like any term paper anybody wrote in college," he said. “For the most part, it all gets done right at the last minute."

Most U.S. businesses that made the switch have selected a version of the Secured Overnight Financing Rate, U.S. regulators’ preferred alternative to Libor. A handful of companies have switched to the Bloomberg Short-Term Bank Yield Index, known as BSBY, or American Financial Exchange’s Ameribor. Companies’ efforts have been aided, in part, by legislation aimed at easing the switch for certain legacy contracts. Regulators also extended the deadline by 18 months and permitted use of a key safety net called synthetic Libor.

Businesses that have switched from Libor aren’t necessarily immune to hurdles. Term SOFR, a popular longer-term version of SOFR that helps businesses forecast cash, continues to cost more to hedge than the alternatives due to restrictions on banks, but not enough to deter companies from using it.

About 55% of U.S. loans in collateralized loan obligations, or securities made of bundles of low-rated corporate loans, were tied to Libor as of May 30, with the remaining 44% tied to SOFR, according to Barclays. The measure represents a proxy for the broader loan market. The percentage of Libor-linked loans is down from 79% at the end of 2022.

The percentage will likely be in the 40%-to-50% range by July 1, based on the current rate of the transition, said Corry Short, a research analyst for U.S. credit strategy at Barclays.

That amount of lingering Libor on the books is unlikely to cause market disruption because many of those companies have loans that are set up to automatically switch to SOFR after the phaseout, said Short. “We’ll have to monitor closely, particularly the operational risk," he said.

Depending on the contract, loans will have different outcomes after the phaseout. Nearly 36% of U.S. outstanding leveraged loans are set up to automatically switch to SOFR after the phaseout, according to Covenant Review, a unit of research firm Fitch Solutions. These loans contain fallback language from the Alternative Reference Rates Committee, or ARRC, a group of financial firms handling the U.S. phaseout of Libor alongside the Federal Reserve Bank of New York.

Some companies that have arranged an automatic fallback to SOFR have put off upgrading their IT systems in favor of addressing other priorities such as inflation, Chatham Financial’s Dhargalkar said. For example, their systems may not be set up for a rate that represents a daily weighted average of SOFR over a certain period. “Some have said, ‘Let’s do it later once this all dies down,’" he said. “‘We’ll let it fall back and we’ll deal with that later because we have other priorities.’"

Companies also might not have the same fallback language for their debt and derivatives, raising other operational risks. “Those operational considerations are real for both debt and derivatives in that they fall back to something that companies’ processes and systems don’t currently support," Dhargalkar said.

Finance executives need to have protocols and reporting processes in place so they can look at their portfolios and readily determine the value of their financial contracts, said William Wagner, partner at law firm Venable. “This is a lot more than just simply updating programming," he said.

Roughly 56% of U.S. leveraged loans allow for a transition via amendments, most of which require lenders to approve or not object, Covenant Review said. Firms have been clashing with their debtholders over the amount of interest they will be paying as they switch these agreements.

More than 8% of outstanding U.S. leveraged loans tied to Libor have no successor listed as of May 30, down from 10.9% a year earlier. Companies that lack transitional language in their financial contracts or haven’t manually switched to a replacement rate could face operational risk and higher costs as their contracts could revert to the prime lending rate, a pricier benchmark, come July.

The loans that face the most risk are those that fall back to the prime rate if Libor is no longer available or representative, especially if all of the lenders need to agree on Libor’s replacement, said Joyce Frost, co-founder of Riverside Risk Advisors, an advisory firm. The borrowers will encounter prohibitively costly rates under prime, she said.

“The onus is on the bank and the borrower to focus and address and remediate these Libor-based loans," she said.

In lieu of prime, however, corporate borrowers in this situation will benefit from a synthetic version of U.S. Libor for 15 months through Sept. 30, 2024, thanks to a decision by the U.K. Financial Conduct Authority, the regulator in charge of overseeing Libor, in April. Synthetic Libor rates aren’t intended to be representative of the underlying lending markets.

Synthetic Libor has its drawbacks, corporate advisers say. In some cases, companies could trip their debt covenants and face a technical default if their hedging and financing fall back to different benchmarks, for example synthetic Libor for the former and certain versions of SOFR for the latter.

In addition to synthetic Libor, companies can hang on to Libor longer by rolling over existing Libor-linked loans for as long as 12 months just before the phaseout. The option applies not only to companies with no changeover arrangements but also to those whose replacement terms are written into their existing loan documents.

David Ridley, partner in law firm White & Case’s debt-finance practice, said a number of his clients are considering a rollover, particularly if they are unable to reach agreements with their lenders on loan-amendment terms. “Sometimes it’s a backup plan," he said.

The ARRC on Wednesday urged companies and other market participants to complete their transition. Those that aren’t prepared risk “significant ramifications," including uncertain and potentially unfavorable outcomes regarding their existing Libor contracts along with operational disruptions, the ARRC said.

“These are choices that individual market participants can make, but eventually they will have to deal with this," said Tom Wipf, chairman of the ARRC and vice chairman of institutional securities at Morgan Stanley, referring to companies’ potential Libor extensions. “This is maybe the last round of can kicking."