ncreif · –scott omalia, isda ceo 16 temporary libor unavailability ... futures from 7 to 13...

NCREIFLIBOR update: a Greek tragedy

July 2020

Proprietary and confidential chathamfinancial.com

The origins of LIBOR

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Minos Zombanakis

“I felt a sense of achievement to set up the whole thing, but I didn’t think we were breaking ground for a new period in the financial world.”

“We just needed a rate for the syndicated-loan market that everyone would be happy with. When you start these things, you never know how they are going to end up, how they are going to be used” - Zombanakis


• Best definition was by Aristotle in Poetics• Downfall of a character who is neither

completely good nor completely bad• Fall brought about by a tragic flaw• Witnessing the downfall of basically good

people evoked emotions of pity and fear in the audience

• Audience then experiences a catharsis or some sort of emotional cleansing

A Greek tragedy

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LIBOR

Manipulation

Banks?

SOFR transition


“If you ain’t cheating, you ain’t trying!” – Barclay’s trader

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The bandits’ club

The mafia

One team, one dream


The solution to everything: form a committee

‘The cases of attempted market manipulation and false reporting of global reference rates, together with the

post-crisis decline in liquidity in interbank unsecured deposit markets, have undermined confidence in the

reliability and robustness of existing interbank benchmark interest rates’

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The Federal Reserve convened the Alternative Reference Rates Committee (ARRC) in November 2014

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June 22, 2017: the Alternative Reference Rates Committee (ARRC) identified a broad Treasuries repo financing rate, which the Federal Reserve Bank of New York has proposed publishing in cooperation with the Office of Financial Research, as the rate that, in its consensus view, represents best practice for use in certain new U.S. dollar derivatives and other financial contracts


SOFR it is

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Andrew Bailey – July 2017 – the first time anyone cared

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“The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets.”

“I and my colleagues have therefore spoken to all the current panel banks about agreeing voluntarily to sustain LIBOR for a four to five year period, i.e. until end-2021”

Proprietary and confidential chathamfinancial.com9


Spot SOFR vs. SOFR compounded-in-arrears

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About that SOFR rate


It’s a good thing we don’t have a lot of LIBOR exposure

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Cash instruments

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New issuance dominated by government agencies


Cash instruments – the legacy problem

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Temporary LIBOR unavailability

Many legacy loans include one or more of the following:1. Polling (consistent with ISDA)2. Prime3. Fed Funds + spread

Triggers

ISDA Triggers plus pre-cessation triggers:1. Index not published for five consecutive business days2. An insufficient number of dealers provide quotes3. Public statement from regulators indicating benchmark is no longer

representative

Replacement rate

Term SOFR↓

“Daily Simple SOFR” or Compounded SOFR↓

Replacement Benchmark / Endorsed Replacement Rate

Spread adjustment

Spread Adjustment methodology as selected or endorsed by relevant Government body

↓Spread Adjustment methodology as selected by ISDA

On June 30Following its consideration of feedback received on its initial public consultation, the ARRC recommended a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR. The five-year median spread adjustment methodology matches the methodology recommended by the International Swaps and Derivatives Association (ISDA) for derivatives.


Cash instruments – “Tackling Tough Legacy”

What is a “Tough Legacy” contract?

• Contracts where it may be all but impossible to amend or renegotiate the contract to include a fallback

o Ex. Some floating-rate Notes or Securitization may require consent from ALL noteholders to amend the agreement

What can be done about “Tough Legacy” contracts?

• UK FCA is being given powers via legislation to change LIBOR’s methodology in the event LIBOR is no longer

representative and thereby create a “synthetic LIBOR” to be used only for a small number of contracts

• NY State “Legislative Fix” which would: remedy these anticipated and severe market disruptions by

nullifying the polling mechanism included in the existing fallback language in most derivatives contracts.

Instead of the fallback polling process that did not anticipate these issues, the proposed legislation would

implement the recommended benchmark replacement, which is consistent with the adjusted rate

proposed in the ISDA protocol. Transactions in the affected markets would then be consistent. The

proposed legislation would benefit commercial end users (i.e., those that have operational and other

hurdles to adhering to protocols) by reducing the uncertainty embedded in their derivatives contracts. It

would increase consistency across derivatives markets about the value of derivatives linked to U.S. dollar

LIBOR, align with the floating rate note and securitization markets that use derivatives to hedge cash

exposures, and mitigate economic risks and the potential for disputes that could disrupt the efficient

operation of these vital markets at the time of a LIBOR discontinuance.

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June 26 ISDA Op-Ed / FCA / NY Legislature


Derivatives – major players involved

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Derivatives

“The adjustments are necessary

because IBORs are available in multiple

tenors, but the RFRs are overnight. The

IBORs also incorporate a bank credit

risk premium and a variety of other

factors, while RFRs do not. The

adjustments are intended to ensure

the contracts function as closely as

possible to what the counterparties

originally intended after a fallback kicks

in. That doesn’t mean the adjusted RFR

will exactly match the relevant IBOR –

it won’t, so there will be winners and

losers. That’s another reason to act

early and reduce or eliminate exposure

to LIBOR.” – Scott O’Malia, ISDA CEO

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Temporary LIBOR unavailability

Agent polls third-party banks and calculate an average LIBOR

Triggers

1. Public statement from Benchmark administrator indicating permanent cessation

2. Public statement from public authority indicating permanent cessation

3. A “pre-cessation” trigger around a determination that LIBOR is “non-representative”

Replacement rateSOFR

(Compounded Setting in Arrears Rate)

Spread adjustment 5Y Historical Median


Building liquidityNext steps: build out SOFR products

Increase the number of months covered by their 1-

month SOFR Futures from 7 to

13 months

Increase the number of quarters covered by their 3-

month SOFR Futures from 20 to

39 consecutive quarters

Launched SOFR Options on January

6, 2020

CME’s plan to build out their SOFR product suite

• Trading in CME’s 1-month and 3-month futures contract exploded the week of September 16 in response to the volatility in the underlying repo markets.

• CME’s combined open interest exceeded $1 trillion

SOFR futures Year 1 Year 2

Global participants 140 425

Avg. Daily Volume 14K 43K

Avg. Daily OI 56K 365K

Peak OI 151K 612K

Large OI Holders 69 161

% of SOFR traded via ICS vs. ED or FF 4% 32%


Building liquidity

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First steps: clearing houses switch to SOFR discounting

CME and LCH announce discounting switch for October 16, 2020

Proposals: Discounting Risk Switch + Cash Compensation + Basis Swap

Discounting Risk Exchange: By changing the discounting curve, CCP would effectively move the discounting risk of all participants from EFFR to SOFR at closing curve levels.

Cash Compensation: To neutralize the value transfer attributed to the change in the discounting rate, CCP would make a cash adjustment that is equal and opposite to the change in each cleared swap’s NPV.

Basis Swap: To mitigate hedging costs associated with this transition and sensitivity to closing curve, CCP would book a series of EFFR/SOFR basis swaps to participants’ accounts. These swaps would restore participants back to their original risk profiles and be booked at $0 NPV.

Impact to Liquidity

CCPs believe that by switching Discounting to SOFR, firms that manage

their PAI and Discounting risk would eventually voluntarily

switch to trading in SOFR derivative products


Classic chicken and egg problemWhat develops first: cash markets or derivatives markets?

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LIBOR transition

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Words to transition by

Source: Bloomberg, “Fed Warns That the End of Libor Really Is Coming, So Be Prepared”

“Clarity on the exact timing and nature of the Libor stop is still to come, but the regulator of Libor has said that

it is a matter of how Libor will end rather than if it will end, and it is hard to see how one could be clearer

than that.

… After Libor stops, it may be fairly difficult to explain to those who may ask exactly why it made sense to

continue using a rate that you had been clearly informed had such significant risks attached to it.”

- Randal Quarles, Federal Reserve Bank Vice Chairman of Banking Supervision

https://www.bloomberg.com/news/articles/2019-06-03/fed-warns-that-the-end-of-libor-really-is-coming-so-be-prepared


Surely COVID-19 has delayed all of this?

“The ARRC continues to focus on the established timeline for the transition from LIBOR. The ARRC recognizes

that near-term, interim steps may be delayed given the current economic environment with the global

pandemic, but given the latest announcements from the official sector…it remains clear that the financial

system should continue to move to transition by the end of 2021.”

The FCA already expects some banks to depart from Libor panels at the end of 2021. As others make up their

minds, Libor’s fate could be sealed well before then. “It is therefore entirely plausible that you could see

announcements about discontinuation in the final week of this year to give markets a whole year of notice to

prepare for that,” Schooling Latter said.

The FSB maintains its view that financial and non-financial sector firms across all jurisdictions should continue

their efforts in making wider use of risk-free rates in order to reduce reliance on IBORs where appropriate and

in particular to remove remaining dependencies on LIBOR by the end of 2021. COVID-19 has highlighted that

the underlying markets LIBOR seeks to measure are no longer sufficiently active. Moreover, these markets are

not the main markets that banks rely upon for funding. The increase in the most widely used LIBOR rates in

March put upward pressure on the financing cost of those paying LIBOR-based rates. For those borrowers, this

offset in large part the reductions in interest rates in those jurisdictions where central banks have lowered

policy rates.

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Recent regulator push - FHFA

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Recent regulator push – NY FED ARRC

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With 19 months left until LIBOR could become unusable, it is important that market participants accelerate their transition efforts. Recognizing this need, the ARRC developed these recommendations for date-based guidance on the near-term transition steps it believes should be taken.


Something for the accountants in the room

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On March 12, 2020, FASB issued an ASU (2020-04) to provide for temporary optional guidance to ease the potential burden in the transition to alternative reference rates.

The ASU provides temporary exceptions for applying GAAP principles to contract modifications, hedging relationships and othertransactions affected.

Relief would be time-limited through December 31, 2022.

U.S. Treasury guidance to avoid modifications being deemed taxable exchanges.

Allows entities to continue to consider hedged forecasted transactions as “probable”

Contract currently references LIBOR

Change in terms moving from LIBOR to RFR would change the amount and timing of contractual cash flows

Changes to other terms like contractual spread or interest and payments dates would change the contractual cash flows

Eligibility Benefits for Debt and Derivatives

Would allow hedge accounting relationships to continue without re-designation

Would allow for certain changes to debt instruments to avoid being accounted for as an extinguishment of debt; changes in rate would be accounted for as prospective effective yield adjustment. For leases no reassessment of classification.


What comes next?

How will SOFR be adopted?

Will banks continue to voluntarily submit rates after 2021?

What risks do our clients face?


What comes next?




• Operational Hurdles: systems need to be updated for both buy and sell side firms and their vendors to provide the ability to calculate payments, price risk, hedge, etc. based on SOFR

• Many of our clients are not experts or otherwise familiar with Repo markets so they face a significant learning curve in their desire to consider using an overnight Repo rate as a benchmark for their loans and derivative transactions

• Repo markets have experienced significant volatility of late (see 5.25%) which further exacerbates the adoption challenge

• The NY Fed has stepped into provide liquidity to dampen volatility in this rate• Raises question around SOFR effectively

being a Policy Rate• Lack of demand for SOFR indexed loans at

present


What comes next?




• It’s all about litigation risk. Staying in LIBOR panels is a risk, but so is dealing with the cost of switching systems and possible litigation arising from transitioning away from LIBOR.

• Banks are currently dealing with “edicts from on high.”


What comes next?




• Basis Risk• Value Transfer: “if you are not also

the biggest profit center at the bank for the next five years, I kind of think you are doing it wrong?” – Matt Levine (Bloomberg)

Proprietary and confidential chathamfinancial.com29

Questions?


Engage and learn with Chatham

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Contact

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Rob is a Director on Chatham’s Global Real Estate hedging and capital markets team. He advises clients ranging from publicly traded equity and mortgage REITs to specialty finance, debt funds, and private real estate funds. Rob specializes in providing interest rate and foreign currency risk management strategies. Since joining Chatham in 2007, Rob has provided hedging strategies, derivatives regulatory advisory, and hedge accounting guidance for commercial real estate investors. Prior to joining Chatham, Rob worked for Ernst & Young focusing in audits of financial institutions. He is an inactive CPA in the state of Pennsylvania and a CFA charterholder. Rob graduated from the University of Delaware with a BS in Accounting and a minor in Management Information Systems.

Rob Mangrelli

Director

Global Real Estate

+1-484-731-0419

[email protected]

mailto:[email protected]


Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the

United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA);

however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit

chathamfinancial.com/legal/notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and

accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of

the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be

deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the

derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions.

All rights reserved.

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