Coronavirus and the end of LIBOR

The world has changed since the NHF’s update last December on the end of the LIBOR benchmark rate. 

Following that update and pre-lockdown, the Bank of England and Financial Conduct Authority had increased pressure on the financial sector to implement the transition from LIBOR to risk free rates (RFRs), long before LIBOR will no longer be available.

In their latest announcements, there is some recognition that the pandemic will have an impact on the timing of aspects of the transition away from LIBOR, particularly in some segments of the UK market. However, for the time being, at least, the December 2021 deadline is being maintained.

The NHF is actively looking after the sector’s interests as a whole and has encouraged housing associations to consider the impact of LIBOR’s replacement upon them. That is worth doing as soon as is practical even while the country emerges from lockdown (and the first bilateral loan referencing an RFR (SONIA) in the social housing sector has already been issued). Existing agreements don’t cater for the permanent end of LIBOR, so new terms will have to be agreed.

This provides an opportunity for housing associations to engage with lenders to achieve the best outcome for them – all the more important in the current environment. The December update mentions two steps that need to be agreed before housing associations can move to a SONIA rate that reflects three-month LIBOR in existing contracts: first, whether a term rate or a compounded in arrears rate should be applied, and second, what a credit adjustment spread should be based on.

These points arise because:

• Sterling LIBOR is a forward-looking term rate – i.e. it’s set at the beginning of the interest period based on projections of the cost to banks of raising funds to on-lend over the interest period (e.g. 3, 6, 9 or 12 months).
   
  SONIA is a backward looking overnight rate – i.e. it is re-priced daily based on the prior day’s realised/actual rates. LIBORs in other currencies will also be replaced with RFRs. For 90% by value of the sterling LIBOR loan market, SONIA compounded in arrears is likely to be appropriate (i.e. based on compounding daily values of the overnight rate, throughout the relevant term period) with alternative rates (e.g. a forward-looking term rate based on SONIA) appropriate only for the remaining 10%. However, housing associations and financial institutions may have differing views on the most appropriate form of replacement rate.     
• LIBOR produces a higher figure than SONIA partly because LIBOR includes the risk of institutional/bank failure that is not present in SONIA. To compensate for this disparity, an appropriate margin will have to be negotiated for adding to SONIA.

With these points in mind, housing associations should prepare for negotiations by:

1. Reviewing their financial agreements to determine which reference LIBOR and the economic impact LIBOR has on those agreements.
2. Assessing the net impact of LIBOR where multiple agreements are linked – e.g. a swap hedging a loan’s interest rate risk.
3. Assessing whether the housing association is a net LIBOR payer under linked agreements.
4. Assessing whether the swap remains an effective hedge after a switch to SONIA under a linked loan agreement.
5. Checking how financial covenants are affected by changes in the interest rate to avoid a breach – particularly in the context of the pandemic.
6. Assessing whether a backward looking overnight rate like SONIA is appropriate for the housing association’s financing needs.
7. Checking the potential impact on accounting practices (e.g. hedge accounting) to ensure they remain valid.

Only when the impact of LIBOR’s demise is fully understood can housing associations properly negotiate a replacement rate. 

Join us at the Treasury in Housing virtual conference on Tuesday 14 July where we’ll delve deeper into the transition from LIBOR to SONIA and how you can be more prepared.