A Hardwired approach to the LIBOR Loans mess

Updated: May 10, 2020

With the cessation of LIBOR at the end of 2021 looming, many institutions still have a lot of work to do on the contractual amendments required on their back-book of loans. These contractual amendments, otherwise known as fallbacks, cover the event of when LIBOR ceases to be a rate. With thousands of syndicated loans requiring modifications, will they all be amended in time?

Currently, there are two approaches to contractual amendments. The first is the “Amendment Approach” which takes advantage of the loans amendment flexibility, whereby the agent identifies a replacement rate. The banks/lenders in the syndicate then have five days for a majority of 51% of them to agree to this replacement rate. If they do not agree to a replacement rate, then the rate reverts to Prime. It might not seem like such a big deal until you realise that Prime tends to be 2.5-3.5% higher than LIBOR, which would severely disadvantage borrowers, especially in the current harsh COVID-19 business environment. If borrowers were to be disadvantaged so severely, we would think that the lenders open themselves up to severe conduct risks with lawsuits highly likely.

A second approach is a “Hardwired Approach” which is being taken up by most market participants. It does require re-papering but then the loan will fall back in the case of a USD loan to SOFR plus a certain spread to compensate for credit risk and term rate. If there is no version of SOFR + Spread available in the market, then the loan would follow the Amendment Approach outlined above. Institutions will need to review their population of loans and classify them into three generations of deals:

  • Pre-2018 deals with no fallback language – These currently fall back to the prime base rate

  • 2018 until now – As of 2018 lenders started to incorporate new fallback language that allowed for the possibility of a permanent cessation of LIBOR into their contracts. These deals will currently follow the Amendment Approach

  • New deals going forward – These should all follow the Hardwired Approach to avoid a lender vote and the prospect of falling back to prime.

Operationally loans are also a real challenge, and the switch from LIBOR, with the rate set ‘in advance’ to an Alternative Reference Rate calculated ‘in arrears’ causes all sorts of complexities. Loans can be repaid at any point during an interest period, which leads to several issues when calculating compounded interest. Also, how do you deal with lender groups changing during the life of the loan, leading to complications about how to distribute the interest payments.

There is still a lot of work to be done in the back book loan space and not much time to renegotiate all contracts which require a lender vote if banks/lenders are to avoid lumping borrowers with hefty Prime rates on their loans. There needs to be client outreach but also an intense process to extract and review all contract where LIBOR terms appear. All new loans going forward should certainly use the Hardwired approach to keep contractual re-negotiations to a minimum. Banks need to act now on loans which will require the amendment approach to avoid the prospect of disadvantaging borrowers with their loans falling back to prime.

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