The Transition From LIBOR Alternative Reference Rates and What They Mean for Valuations

The Transition From LIBOR Alternative Reference Rates and What They Mean for Valuations

April 25, 2022

Update: On March 15, 2022, President Biden signed the Adjustable Interest Rate (LIBOR) Act into law. The Act is designed to increase legal clarity surrounding existing contracts that lack the fallback language necessary to address the discontinuation of LIBOR.

During a panel discussion at the Stout Valuation Summit, Jamie Spaman, Managing Director in Stout’s Valuation Advisory Group, led a conversation on the end of the London Interbank Offered Rate (LIBOR), its potential replacements, and the transition’s effect on accounting and valuation needs.

The following panelists contributed their insights on this timely topic:

  • Ritesh Bansal, Sr. Director, Technical Accounting, RSM — Ritesh has over 15 years of financial advisory and auditing experience, including RSM, a major Canadian Bank and Big Four accounting firm.
  • Will Pierce, Managing Director, White Oak Global Advisors — Will works on new investment strategies, fundraising, and building relationships with LPs (limited partnerships), helping to ensure White Oak’s goals are aligned and its challenges addressed.

The discussion has been edited for length and clarity.

Why Is the Market Moving Away From LIBOR?

Around $225 trillion in derivatives, mortgages, consumer loans, corporate debt, and other instruments all reference LIBOR. However, concerns regarding the validity and transparency of LIBOR have led banking regulators to begin the transition to an alternate reference rate for those instruments.

LIBOR is calculated from a limited number of panel banks submitting the rates at which they could borrow funds from other banks in the London Interbank Market. Regulators seek a new reference rate due to shrinkage in the interbank lending market and LIBOR-fixing scandals between 2014 and 2017. Non-USD LIBOR rates, as well as the one-week and two-month USD LIBOR rates, ceased publishing in December 2021. The longer USD LIBOR rates (such as the one-month and three-month rates), which are used more frequently, will be kept until June 2023.

“The Alternative Reference Rates Committee (ARRC) started searching for an alternate reference rate that is more liquid and uses more observable transactions,” said Ritesh Bansal. “The Secured Overnight Financing Rate (SOFR) is one that a lot of regulators have been inclined toward using. It is a risk-free reference rate that is much more transparent than LIBOR.”

SOFR as a Potential Alternative to LIBOR: Strengths and Weaknesses

Because SOFR is calculated on observed and clear transactions in the marketplace, it offers a more transparent method for determining a common benchmark. SOFR is calculated from the rates that large financial institutions pay each other for borrowing overnight loans, drawing on the actual rates being used in the borrowing of short-term, unsecured loans between various banks. As a result of this method, SOFR is based off a significant amount of trading value, and the rate is risk-free in nature; both are key factors in establishing a benchmark rate. SOFR is also expected to be less subject to manipulation since it is calculated from observed transactions that are imposed on various banks rather than a handful of financial institutions.

But SOFR has its limitations. The rate dropped from 0.05% to 0.03% given a large repo trade that was known in the market, but then it spiked back to 0.05% because the change was predicated upon a roll as opposed to a true indication of value.

“LIBOR had its shortcoming — that it was being handled by primary dealers — where SOFR seems to almost have the opposite problem, where it is driven by flows,” said Ritesh. “SOFR keeps having these hiccups that are leading the leverage loan market to wonder whether it is going to be a true indication of value. SOFR’s lack of any sort of duration —one-month, three-month, and six-month rate that we had with LIBOR — is also a serious limiting factor.”

As a risk-free rate, SOFR requires the use of spread adjustments, meaning some companies will require a significant number of upgrades to their systems and processes to adopt SOFR. By replacing LIBOR with SOFR, not only will they have to add a spread — which they used to do when they used LIBOR — but also will need to add the difference between what the rate is when SOFR is used versus LIBOR.

Alternative Reference Rates Being Considered

SOFR is typically the first reference rate discussed as an alternative to LIBOR, but it is not the only potential replacement.

One alternative is the Ameribor Unsecured Overnight Rate (“Ameribor”), created by the American Financial Exchange (AFX). Ameribor is an index that is based on the unsecured borrow cost of small- and medium-sized banks across the U.S. Many smaller financial institutions prefer Ameribor to SOFR, since utilizing SOFR will require them to use a spread adjustment. A credit-sensitive rate such as Ameribor will be easier to implement and will not require a significant amount of change to their systems and processes.

Bloomberg’s Short-Term Bank Yield Index (BSBY) is another reference rate that financial institutions could use. BSBY is based on commercial paper, certificates of deposit, U.S. dollar bank deposits, and short-term bank bond transactions. The index is reported each day at 8:00 A.M. EST to Bloomberg terminal subscribers, and it includes one-month, three-month, six-month, and 12-month standards. Unlike SOFR, BSBY does not require the use of an added spread adjustment.

The U.S. Prime Rate is another potential alternative to LIBOR. The U.S. Prime Rate has been used for years as a benchmark for credit card rates and home equity line of credit or other variable rate products, such as loans and unsecured products.

Another alternative is the Effective Federal Funds Rate (EFFR), which is calculated from what U.S. banks pay each other for unsecured loans from reserves held at the Federal Reserve.

The LIBOR Transition’s Effect on Accounting

Products or contracts based on LIBOR may need to be modified due to the LIBOR transition.

“Most of the contracts we see that are based on LIBOR are debt agreements, the loans receivable by financial institutions, and derivative products or agreements,” said Ritesh. “A handful of leases are variable rate leases that are based upon LIBOR. All these agreements may have to be modified if they don’t have fallback language that identifies what alternate rate should be used if LIBOR is not available.”

For a company or institution that has only a few contracts, reviewing them for fallback language (and modifying contracts as needed) may not be a significant undertaking. But for a bank or small financial institution with hundreds or thousands of loans, reviewing those contracts for necessary language would be a significant undertaking. Plus, changes will need to be made across various departments — loan processing and accounting, for example — and department systems and processes will need to be updated.

The Financial Accounting Standards Board (FASB) provided a simple evaluation for contract modification that will ease some of the requirements when it comes to accounting for these agreements. The FASB is also providing relief for any modification that is required for phasing out or transitioning from LIBOR to another reference rate.

How Will LIBOR Affect Valuations?

“The price of risk is the price of risk, whatever the reference rate is, and our borrowers are going to understand what their cost of capital should be,” said Will Pierce. “If you see any meaningful divergence when this switch happens, you'll either have refinancing or repricing.”

Will expects to see some shakiness but does not view the move from LIBOR as significantly impacting valuation. At the end of the day, he said, loans are priced considering prevailing rates, spreads, and the overall cost of capital, and he expects the market to continuing viewing them that way.

“Wherever we end up, we'll likely triangulate to a very similar sort of all-in rate,” he said.