Market data provided in this post was accurate as of 8:00 AM ET on Monday, May 11, 2020, but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.
In our recent market updates, we have discussed how the Fed has reacted to the ongoing COVID-19 crisis and how the economic slow-down has impacted commercial real estate (CRE) investors with interest rate swaps in place. Taking a step back from day-to-day market activities, this economic disruption has also come during a transitional period for the entire CRE market, as investors, lenders, regulators, and other market participants prepare for the market’s transition from LIBOR to SOFR.
This update will summarize the impacts that the COVID-19 crisis has had on repo markets and SOFR, how market participants have responded, and the possible implications of the economic slowdown on the LIBOR-SOFR transition.
Overview of LIBOR-SOFR transition
In the summer of 2017, regulators announced a transition from LIBOR to a to-be-determined alternative index beginning in 2022. Since then, the relevant U.S. market authorities, notably including the Alternative Reference Rates Committee (ARRC) and ISDA, have been actively engaged in developing a plan to ensure an effective transition from USD LIBOR to SOFR (Secured Overnight Financing Rate), the recommended replacement index. Similarly, UK and European regulators recommended SONIA (Sterling Over Night Index Average) as the replacement for GBP LIBOR and the euro short-term rate (€STR) to replace EURIBOR.
Because LIBOR is a common floating-rate index for commercial real estate loans, CRE investors have a vested interest in the transition to SOFR, particularly in terms of how lenders will adjust LIBOR-indexed loans and the impact on any associated hedges. While SOFR is more directly market-driven (by overnight borrowings collateralized by U.S. Treasury securities) than LIBOR, there are some important distinctions between the rates for CRE investors to consider during this transitional period.
See FAQ: USD LIBOR Transition to SOFR for more background.
Fiscal response to COVID-19 and impact on SOFR
Fiscal policy in response to COVID-19 has impacted repo markets—and consequently SOFR—both directly and indirectly. In mid-March, the Fed commenced significant open market operations to promote market liquidity for short-term funding and to support a sufficient supply of reserves, offering $1 trillion per day in overnight funding and $500 billion per day in weekly short-term funding through repurchase agreements on underlying Treasuries, agency debt, and agency mortgage-backed securities. Since then, the Fed has purchased nearly $3 trillion in repo and reverse repo agreements. The Fed’s repo market activity has slowed thus far in May, as the Fed announced in April that it would reduce its trading limits by 50% beginning in May in response to signs that repo market liquidity had materially improved from when the Fed began to ramp up activity in March.
Because the lower bound of the Fed Funds target rate serves as the rate paid by the Fed for loans on its “reverse repo” facility, the emergency FOMC rate cuts that accompanied the repo operations caused spot SOFR to drop to as low as 1 basis point, as compared with spot LIBOR, which remained as much as 100 bps greater. This dislocation was driven by several factors, including illiquidity in the commercial paper market and an increased cost of unsecured borrowing in this environment. In mid-April, the Fed’s Commercial Paper Funding Facility (CPFF) began purchasing eligible three-month corporate, asset-backed, and municipal commercial paper from eligible issuers. The Fed has committed up to $100 billion under this program, with the goal of providing a liquidity backstop to U.S. issuers of commercial paper. Since the launch of CPFF, spot LIBOR has dropped steadily to approximately 19 bps at the time of publication, only 13 bps greater than spot SOFR.
In April, the Fed also introduced the Main Street Lending Program, which would provide up to $600 billion in loans originated by U.S. banks and then purchased by the Fed. The Fed initially announced that this facility would consist entirely of loans indexed to SOFR. In response to feedback from participating banks expressing concerns, the Fed revised the proposed terms to price the loans over LIBOR.
Impact of COVID-19 on timing of LIBOR transition
There has been no official announcement on a delay in the transition from USD LIBOR to SOFR. While the ARRC recently reinforced previously stated timelines (see ARRC FAQ, May 1, 2020), certain interim deadlines and programs have been extended.
- Extension of GBP LIBOR-SONIA transition deadline: The UK Financial Conduct Authority previously announced that GBP-denominated loans beyond Q3 2020 could not be indexed to GBP LIBOR and instead must be indexed to SONIA. In April, the FCA extended this deadline six months to Q1 2021.
- Extension of deadline for FHLBs to use LIBOR: The FHFA had previously announced that after Q1 2020, FHLBs could no longer enter into LIBOR-based transactions maturing after December 31, 2021. In mid-March, this deadline was extended by three months to Q2 2020.
In February 2020, the FHFA also announced that Freddie Mac and Fannie Mae could not purchase LIBOR-indexed loans beyond the end of 2020, and the agencies similarly announced that they would no longer accept applications for LIBOR-indexed loans after Q3 2020. As of the time of this publication, these deadlines have not been revised. On April 1, both Freddie Mac and Fannie Mae released indicative terms for single-family loans outlining ARM products based on a 30-day average of SOFR, with Fannie Mae announcing they would begin accepting single-family SOFR loans beginning August 3, 2020, and Freddie Mac setting the date at November 16, 2020. While neither agency has released similar dates or indicative terms for multi-family loans, these developments may suggest that the FHFA is working to meet the deadlines set earlier this year to continue the transition from LIBOR to SOFR.
We’ll continue to provide updates in our resource center as market conditions evolve and implications for our CRE clients change. In the meantime, please feel free to reach out to your Chatham representative if we can support your LIBOR transition efforts.
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. 20-0147
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