Next month may bring an unpleasant surprise for some businesses: Their borrowing costs may rise sharply after banks finally retire the once-ubiquitous Libor interest rate.
Banks, lawyers and business leaders are spending the next few weeks working to avoid rate spikes, reflecting the need for last-minute work despite years of preparations. The London Interbank Offered Rate, which underpinned financial contracts across the world before being felled by a rate-rigging scandal, is finally going away in July.
The transition to new rates has so far gone smoothly. U.S. banks started making loans
Now comes the final leg: Switching old loans that still refer to Libor onto different rates. Some loans have easy fixes, but others have contractual language requiring that the interest rate charged should be the Prime rate when Libor isn't available.
That's a problem for borrowers, since banks' Prime rates are above 8%, while Libor rates are closer to 5%. Though banks have alerted many clients to the situation, some borrowers may still be unaware of the looming cost increase, a sign that the Libor transition for loans is behind despite years of work.
"Frankly, I think it's not where it should be," said Joyce Frost, co-founder of the advisory firm Riverside Risk Advisors.
The higher interest payments could cause some borrowers to breach loan covenants, such as those measuring companies' ability to repay their debts, Frost noted. At the very least, the issue is expected to cause some late nights for bankers and lawyers as they try to rework loan contracts. Legal disputes are also possible.
Observers don't anticipate that borrowers will be stuck with the Prime rate for too long. Once companies realize they owe more interest, they will likely dial up their bank to figure out how to return to a cheaper option.
Bank lawyers say the industry is spending the next few weeks trying to get ahead of those phone calls — by following up with affected borrowers who may have missed previous communications about the issue.
While banks would make more money by charging the Prime rate, they are wary of negative surprises, which could sour client relationships.
"Everyone is trying to get to the same end goal, because no one wants to deal with: What happens if we start charging you Prime?" said Edward Ivey, a lawyer at the firm Moore & Van Allen.
It's hard to say just how many customers will be affected, since many business loans involve only the bank and the borrower, and precise data isn't public. The borrowers are more likely to be smaller and middle-market companies, which may have less sophisticated finance departments than larger firms.
Data from the leveraged loan market — where loans are made to larger and heavily indebted companies — shows that a small subset of contracts are at risk of switching to Prime. Roughly 8% of leveraged loans, or perhaps a bit more, may be at risk if the parties do not take action, according to Covenant Review data.
Regulators have spent years warning banks and borrowers to switch away from Libor as quickly as possible. In December, Federal Reserve Vice Chair for Supervision Michael Barr cautioned against a "pile-up of contracts all waiting" for a change to a non-Libor rate.
The Alternative Reference Rates Committee, the group of market participants that is leading the U.S. Libor transition,
"Those that are not prepared risk significant ramifications, including uncertain and potentially unfavorable outcomes regarding their legacy Libor contracts along with operational disruptions," the ARRC said. "These risks underscore that it is essential that all market participants complete their transition of remaining Libor contracts now."
In preparation for Libor's demise, the ARRC developed fallback contract language that lenders could use in the earlier stages of the Libor transition — providing a clear sense of what will happen when Libor ends.
Because some old contracts did not have any workable fallbacks, Congress passed a law that automatically transitions them to new rates and further limits Libor transition risks.
But the law did not fix any contracts that had workable fallbacks in place — even those where plan B was using the more expensive Prime rate. That language was long a standard in the industry. But it was intended to address situations where Libor wasn't published temporarily for whatever reason — not a scenario in which it goes away forever.
The next month will be "quite busy in this space," as banks and borrowers work to amend contracts at the last minute, or give themselves more breathing room, said George Cahill, a partner at the law firm Alston & Bird. It helps that lenders have dedicated Libor teams in place to talk borrowers through their options, and that policymakers and industry officials spent years on the issue.
"There will be some bumps along the road, but I think the amount of time that these industries have put into trying to solve this problem will go a long way," Cahill said.
The best-case scenario is for banks and borrowers to switch to a new rate by the end of the month, though actual deadlines for specific loans may be several weeks later, depending on when the borrower's next interest payment is.
And though Libor will soon be buried — the U.K. panel banks whose funding estimates make up U.S. dollar Libor will no longer submit those numbers — a fake version of Libor will live on until Sept. 30, 2024.
U.K. regulators are requiring the publication of "synthetic U.S. dollar Libor" for one-month, three-month and six-month tenors. The actual rate will be the CME Term SOFR, which has quickly become popular in business loans, plus a small add-on figure that's meant to adjust for credit-related risks. Term SOFR is a forward-looking rate based off the Secured Overnight Financing Rate, which is replacing Libor in most cases.
Lawyers are getting questions on whether specific contracts allow for the use of synthetic Libor, which would avoid an automatic switch to the Prime rate.
But some contracts have clauses specifying that Libor rates must be "representative" of interbank funding costs, which allows for less wiggle room, said Graham Silnicki, a lawyer at the firm White & Case. That's because the panel of U.K. banks will no longer submit what's long been seen as representative of what banks would charge for loans to each other.
Lary Stromfeld, a partner at Cadwalader, Wickersham & Taft, is recommending that banks and borrowers carefully review their contracts for any such nuances.
"Remember what your mother told you: Watch your language," Stromfeld said.
