WASHINGTON – A U.K. banking regulator’s plans to eliminate a key benchmark index could wreak havoc with hundreds of millions of dollars of floating rate bonds and interest rate swaps in the $3.8 trillion municipal market.
Andrew Bailey, chief executive officer of the Financial Conduct Authority in London, announced last week that the FCA will abandon LIBOR, the London interbank offered rate, by the end of 2021.
LIBOR is the average rate at which major banks can obtain unsecured funding from each other. It has been used in trillions of dollars of derivatives transactions globally and has been at the center of a series of scandals in which banks and bankers have been charged with manipulating it for financial gain.
LIBOR has been widely used in the tax-exempt bond market.
There is “a very large volume” of bank loans with floating rate notes or bonds that have rate resets based on LIBOR, said Milt Wakschlag, a partner at Katten Muchin Rosenman in Chicago.
Also interest rate swaps tied to muni bonds that have been publicly offered are often LIBOR-based. The most common swap is floating-to-fixed where a state or local government agrees to receive a LIBOR-based floating interest rate from a dealer or other swap counterparty in exchange for paying the counterparty a fixed interest rate when hedging variable rate debt.
Under this “synthetic fixed rate” structure, the floating rate paid on the variable rate debt is expected to be substantially the same as the floating rate received on the swap. Frequently the floating rate on the swap is set as a percentage of LIBOR, reflecting the long-term average ratio of tax-exempt short-term interest rates relative to a specific LIBOR maturity, meaning 67% of one-month LIBOR, the Municipal Securities Rulemaking Board wrote in a 2012 paper.
No one knows how many LIBOR-based bank loans or swap transactions exist. Despite lobbying by credit rating agencies and regulators, bank loans and other private placements are not subject to disclosure requirements and the derivatives market is completely opaque.
According to the International Swaps and Derivatives Association, as of the week ending July 27, there were more than six million interest rate swaps outstanding in the U.S. with a total notional amount of almost $583 trillion. But the data doesn’t show how many of those are based on LIBOR or how many are muni-related, according to an ISDA spokeswoman.
Neither the Securities and Exchange Commission, the Municipal Securities Rulemaking Board, the Securities Industry and Financial Markets Association, nor Thomson Reuters has any data on private placements or muni interest rate swaps.
The FCA and the Federal Reserve Board are working to develop an alternative replacement index to LIBOR. The Federal Reserve Bank of New York announced in June that it was developing the Revised Broad Treasuries Financing Rate.
Wakschlag said a new benchmark index, or several of them if more than one is developed, will have impacts on LIBOR-based floating rate notes and interest rate swaps in the municipal market.
“It will have a big impact,” he said. “How we can deal with it is yet unknown today,” he added, noting that it is unclear what alternative benchmark indexes will be developed or how similar they will be to LIBOR.
“The question is, will there be an alternative index that is as accepted by the municipal market as LIBOR,” said Wakschlag. “A common formula for a variable interest rate for bank loans as well as swaps is 70% of LIBOR plus a fixed amount that represents a credit spread.” The fixed amount takes into account the borrower’s credit and other risks.
A new benchmark index will require bond and swap documents to be rewritten in order to achieve the same economic results that were occurring with LIBOR. That will raise business questions as to whether the parties involved in the transactions will still be able to benefit from the transactions in the same way.
Some see the loss of LIBOR as a boon for lawyers who will have to rewrite all of the documents in these transactions.
Sam Gruer, managing director in the New Jersey office of Blue Rose Capital Advisors, said, “To the extent that LIBOR-based loans and swaps can both be modified to reflect a replacement index, that potentially addresses the hedge effectiveness for accounting purposes, but there’s still the question of what the resulting yield curve for this new index will look like and how it will impact the valuation of a swap. If the issuer is posting collateral or terminating the swap, the economics will change.
Tax issues will also occur. One tax issue is reissuance. If floating rate bonds based on LIBOR switch to another benchmark rate, the switch may be considered a material change to the bonds that causes them to be considered newly reissued and possibly taxable under the federal tax law.
Reissuance is also an issue for a LIBOR-based swap where the index is changed. The swap could be considered reissued, but ordinarily that wouldn’t affect the tax-exempt status of the bonds.
Another tax issue relates to qualified hedging and arbitrage integration. Take for example an issuer that has bonds with a floating rate indexed to LIBOR which is converted to a synthetic fixed rate through a LIBOR-based interest rate swap. If the issuer has elected to treat the swap as a qualified hedge, it can integrate the payments received or made on the swap with the bond payments in determining the bond yield.
But if the benchmark index is changed, the issuer is faced with the question of whether the new rate on the swap will coincide over time with the bond rate, as would be required for a qualified hedge. If the issuer doesn’t have a qualified hedge, the bond yield will only reflect the bond rate, which often is lower than the bond yield with integration of the swap payments. The lower bond yield would mean the issuer’s investment yield would have to be lower and if it hasn’t been, the issuer may have generated impermissible arbitrage.
Some lawyers in the muni market predict that as 2021 nears, they will all be racing to the Treasury Department to seek relief from the tax-related impacts of LIBOR-based deals having to switch to another benchmark rate.
“At this point, it is reasonable to expect as this develops that the Treasury Department and other regulators will take steps to address the issues created by the change from LIBOR on a global basis,” said Wakschlag.
Rich Moore, a partner at Orrick Herrington and Sutcliffe in San Francisco, said some swap documents have provisions specifying what to do if the LIBOR rate is no longer published.
“Every deal is different but a lot [of swap documents] have a default of going to referenced dealers for quotes on the short-term borrowing rate,” he said.
That sounds like a cumbersome process. “It’s unclear whether those dealers or banks will be able or will even want to give those quotes,” said Gruer.
The loss of LIBOR may also impact the SIFMA swap curve, which ultimately is based on the LIBOR swap curve, according to Gruer. That will affect transactions based on the SIFMA index, he said, adding that right now he’s not sure what that impact will be.
Gruer said issuers are going to need to consult with their lawyers and advisors to assess the specific impacts of the change indexes to their LIBOR-based transactions.”
Moore said he’s optimistic. “I don’t think it’s going to have a huge impact on a lot of issuers,” he said. “If the Fed does this right, [the alternative index] is going to generate a lot of paperwork but it’s not going to impair the economics of swaps that issuers have already entered into.”
“But time will tell,” he added.