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August 18, 2017  

Libor Sunset Has CMBS Pros Scrambling

While the phase-out of Libor as a benchmark for spreads on floating-rate loans and securities is four-plus years away, commercial-mortgage pros are recognizing they need to move quickly to adapt.

Discussions between lenders and their attorneys are just getting under way, following the U.K. Financial Conduct Authority’s July 27 decision to phase out the widely used benchmark by the end of 2021. But it’s already clear they must scrutinize and revise some of the standard language used in floating-rate loan agreements and prospectuses for commercial MBS offerings.

Revisions are expected to start showing up in transaction documents over the next few months. Lenders and CMBS issuers will be looking to give themselves flexibility to switch to whatever replacement benchmark ultimately gains widespread acceptance.

“Right now, we’re still in the early stages, “ said an attorney who represents CMBS loan originators. “We’re trying to get a group of folks together to talk it through and figure out what’s needed,” he said, referring to borrowers, lenders and attorneys. “Even though Libor isn’t going away for a while, some things need to be addressed now.”

That’s because loans written this year may outlive Libor. While the change will also affect portfolio lenders, CMBS issuers are under greater pressure to take immediate action because it’s difficult, if not virtually impossible, to amend loan agreements and bond-offering provisions after issuance.

“It’s a big mechanical issue that will require baking something into the docs sooner rather than later,” while providing enough leeway to switch to a Libor alternative that may not be established for several years, said Rick Jones, the partner in charge of Dechert’s global finance and real estate practice.

Virtually all floating-rate securitizations already include mechanisms that kick in if Libor is unavailable. The loan agreements and prospectuses tied to many outstanding CMBS loans call for switching to a spread pegged to the prime rate or to some other short-term lending rate supported by a certain set of banks. But those provisions were designed as temporary stopgaps and could end up conflicting with a market consensus on a successor to Libor. For example, the Alternative Reference Rates Committee — a group assembled by the Federal Reserve to explore alternatives to Libor — has endorsed a new overnight repurchase rate tied to Treasurys.

Another potential complication involves interest-rate swaps purchased by borrowers to cap their coupons. If the swap contract and the loan agreement don’t agree on how to replace Libor, the interest payments on a mortgage could fall out of sync with the returns promised to bondholders, the CMBS originations attorney said.

“We’ve always had language to cover what would happen if Libor goes away,” he added. “Now that it’s actually happening, we have to make sure these provisions and the financial products we buy actually work. Any real estate attorney worth his salt has to get his derivatives person involved in the discussion.”

Lenders and their attorneys are also identifying language that may need to be amended to ensure that a switch from Libor “does not create operational issues under the loan documents,” said Janet Barbiere, a partner at Orrick Herrington who advises CMBS issuers and underwriters.

“The current conversion language sometimes doesn’t cover all of the minutiae,” she said. “There are certain mechanics that may not be fully developed or woven through the loan agreements.” Something as simple as a reference to the interest-rate determination date, for example, may need adjustment if the benchmark switches from London-based Libor to a rate set in another jurisdiction where the business days are different, Barbiere added.

The looming discontinuation of Libor has yet to affect CMBS liquidity, according to industry pros. But they said that could change down the line for bonds that are outstanding now, since they won’t benefit from current efforts to update the language in supporting loan and transaction documents. However, since CMBS floaters typically mature within 5-7 years, it’s likely that many of the underlying mortgages will be paid off or refinanced before there’s much disruption.

Libor, or the London Interbank Offered Rate, is a measure of what some of the world’s leading banks charge each other for short-term loans. Following a wave of scandals tied to manipulation by participating banks, oversight of the rate was turned over to the Financial Conduct Authority in 2013. That agency cited a lack of eligible borrowing activity among participating banks as the reason behind its recent decision to find a more reliable benchmark.

Intercontinental Exchange, which has served as Libor’s administrator since 2014, said in its second-quarter earnings call on Aug. 2 that it expects a smooth changeover and that it likely would take over reporting for any replacement benchmarks.