This is an update to a previous post. This update highlights the formal endorsement of Term SOFR by the ARRC, expands the discussion to include Ameribor and dives more deeply into the issues associated with Term SOFR swaps resulting in a mismatch with any related hedge by the Lender.
The ARRC has endorsed (HERE) CME’s Term SOFR. One of the bigger pieces to this announcement and earlier related announcements (Scope of Use Cases), is that U.S. regulators will also permit Term SOFR Swaps, when one of the parties is an “end-user”. When looking only at the loan market, what new reference rate will be the most common? Term SOFR, BSBY, Ameribor or one of the other SOFR rates? A few thoughts below, but at this point I think Lenders need to begin considering how rate options for their loan (e.g., how rates are different, advantages, disadvantages) will be discussed with Borrowers. We have worked with clients to develop guidance on this topic, which is complicated given there are issues with such discussions under bank regulations and CFTC swap regulations.
If this is something Moore & Van Allen could assist with, please let us know. A huge benefit of MVA is just how keyed into the loan market we are, and the ability to manage the bridge between your loan desk and the swaps desk, to make sure issues and concerns with both products are being considered.
The “Winning” Rate will be the swap with the lower Fixed Rate
As I have mentioned in the past, I would expect the rate most commonly used by Lenders will be the floating rate that can be swapped out for the lowest fixed rate. I am assuming that most Borrowers will be less focused on the nature of the floating rate, and more focused on the cost of any hedge.
I am not sure non-term rates will have much use in the loan market, today. Maybe, if Borrowers notice that, traditionally, Term SOFR is overestimating Daily Simple SOFR, then Borrowers will move towards Daily Simple SOFR? Term SOFR > Daily Simple SOFR should be the case, since Term SOFR should more closely align with SOFR Compounded In-Arrears. Is that delta enough to make a difference to a Borrower? Alternatively, if the Borrower has no issues with managing the payment requirements of Daily Simple SOFR, then they may prefer this rate today. I just have not seen or heard of too many Borrowers eager for an in-arrears rate.
Issues with Term SOFR Swaps – Dealers will have mismatch issues
Although a Lender will be able to package a Term SOFR Loan and Term SOFR Swap, the Lender will now be hedging the Term SOFR Swap with a SOFR compounding in-arrears swap. There will be a mismatch here. This mismatch may increase the costs (i.e., increase the Fixed Rate) on a Term SOFR Swap, so that the Lender can capture some profit that will be used to cover risks associated with this mismatch. Alternatively, a Lender may find other methods to internalize this risk. Overall, this should be top-of-mind for Lenders to determine how this mismatch will be addressed. The Floating Amount received by a Swap Provider based on SOFR Compounding In-Arrears should be close to the amount owed by the Swap Provider on a Term SOFR payment amount for a similar tenor/calculation period, but it will not be 1-for-1.
BSBY/Ameribor – No mismatch, but liquidity is still uncertain
BSBY and Ameribor should not have the mismatch risk – i.e., the Floating Rate in the Borrower’s swap and the dealer-market swap can be the exact same. However, it is still uncertain what liquidity will look like in the Dealer-to-Dealer Market, which impacts pricing. SOFR benefits from the ARRC’s support and the CFTC’s “SOFR First” best practices, which should promote the growth on a SOFR swaps market. Even if Term SOFR Swaps have a mismatch risk, and this risk impacts pricing, it could be the case that the pricing impact is minimal due to SOFR-liquidity already creating tighter spreads and lower pricing. Lastly, if SOFR swaps have a clearing requirement, and BSBY/Ameribor swaps are never cleared (unless parties elect), this could greatly impact the market too. I know banks tend to prefer hedging their portfolio of Borrower-facing swaps with cleared swaps, but if BSBY/Ameribor swaps are not subject to a clearing requirement, this may or may not impact the adoption of BSBY/Ameribor. Since exchange traded swaps really go hand-in-hand with clearing, the exchange trading of SOFR swaps could further benefit SOFR pricing.
In short: BSBY/Ameribor will not have mismatch risk. In the Dealer-to-Dealer Market, SOFR may have greater liquidity and are clearable. It will be interesting to see which has better pricing for Borrower-facing swaps. Also, noted further below, maybe Dealers will not hedge a BSBY swap differently than a Term SOFR – i.e., both Borrower swaps are priced based on the Fixed Rate in the Dealer-to-Dealer SOFR Market? If that is the case, maybe the “Fixed Rate” of the Borrower’s swap is agnostic to whether the Floating Rate is BSBY or Term SOFR? Ameribor, since it is traditionally a rate higher than LIBOR, I am less inclined to think a bank would be agnostic (and instead, require Ameribor in its back-to-back swap).
Small Banks – Can they use Term SOFR in swaps with their Dealer+Liquidtiy Provider?
Some background: Small banks can elect a clearing exemption, generally referred to as the “End-User Clearing Exemption”. Also, many of these small banks really do execute 1-for-1 between a Borrower’s swap and the small bank’s hedge that is counterparty to a Swap Dealer.
The issue here, is that the ARRC did not state in its Conventions or Scope of Use Cases how they are going to define “end-users”.
What is an “End-User”?
The above issue is really much broader. There are Treasury Affiliates, special securitization vehicles, cooperatives and other entities that are in the business of predominately engaging in financial activities, but think of themselves as “end-users”.
Not all end-users make widgets. The more recent margin rules for swaps have expanded out what buyside entities believe themselves to be eligible for treatment as an “end-user”. We should get more clarity on this point, and I would expect/hope it tracks those buyside parties exempt from the U.S. swap margin requirements.
Small Banks will use BSBY?
If Small Banks are not qualifying as “end-users”, then I would expect them to prefer BSBY or Ameribor, with the “winner” possibly being whichever has the least expensive hedge. Ameribor will better track the institution’s costs of funding, but if the loan package for BSBY is more attractive/sellable than Ameribor, this could push smaller banks to BSBY. With that said, Ameribor as a better approximation for their cost of funds, may mean that the “margin” added to Ameribor is lower than that added to BSBY…here, this could result in the Ameribor-based loan package, overall, being less expensive to the borrower.
Either way, BSBY or Ameribor, this rate will more closely match smaller and regional banks’ dynamic cost of funds over the life of the loan, and (1) they will want a 1-for-1 match and (2) many may not have systems in-place to confirm any compounded in-arrears calculation or otherwise just prefer to not have cash flow management based on this sort of floating rate calculation.
Larger Banks with Flat Books?
The issues with mismatch described above will also be an issue for a number of larger banks that run a “flat book”. If they will want to continue running a flat book, this could also increase demand for BSBY and Ameribor. This demand, particularly if these larger banks leverage contacts and relationships with smaller banks, could give Ameribor and BSBY a major advantage in their relevant markets such that Term SOFR struggles to gain traction.
This could increase demand and liquidity in the BSYB/Ameribor swaps market, thereby lowering costs.
Credit Sensitive Rates other than BSBY/Ameribor?
If you are using something other than BSBY or Ameribor, we should talk. All of these talking points about BSBY or Ameribor apply similarly to any other CSRs, but at this point it seems like other CSRs are not picking-up, which also means it is more likely they will have a higher cost to hedge. So, rather than constantly refer to “Credit Sensitive Rates”, I am sticking to BSBY and Ameribor in the event there are unique nuances to this rate.
Regulatory Concerns with BSBY?
I have been on various industry calls and the view: There is no regulatory risk with BSBY – i.e., no bank or other regulator is going to make BSBY illegal or otherwise go away, in an effort to promote SOFR. It seems like many people other than me were also very critical of Gensler’s comments as being misleading/inaccurate.
Any other reasons to prefer BSBY/Ameribor vs Term SOFR, or vice versa?
Yes. If only focused on a loan portfolio, Term SOFR will (likely) always be lower, but that is why the “SOFR Adjustment” is there. Lenders may want to start to compare how BSBY/Ameribor vs Adjusted Term SOFR Rate compare. That could be helpful information for a lending desk when talking to Borrowers. Alternatively, if we ever do see rates rise, then BSBY/Ameribor may be higher than an Adjusted SOFR agreed to during a low interest rate environment.
With all that said, people much smarter than me have very likely already thought this one through and can discuss forward looking curves for both rates.
SOFR is also manipulated by the Federal Reserve, so in times of stress the Fed can force this rate to drop and keep the rate there. The SOFR Adjustment is intended to help with this, but the interest rate environment over the last 5 years (the time period the adjustment is based on) is unique if considering a longer window. In past publications on this topic, I have talked about market shocks where SOFR drops below the cost of funding, but it should also be noted that SOFR is not so much a rate purely based on free market activities, but is one that the Fed can manipulate and has before (HERE). If Jay Pow continues to make the Fed’s printers go brrrrr (might not want your sound up), he and future Feds will keep SOFR low.
An artificially low SOFR could negatively impact a loan portfolio that could otherwise better perform if the same loans were priced based on BSBY or other CSR. On the flipside, the more an institution has exposure to swaps, the lower rate environment would increase the likelihood that the Borrower-facing swaps are in-the-money to the banks (but the bank’s portfolio hedges are out-of-the-money, so this may be a wash).
Overall, the more I look and think about the new rates, it seems like a bank is “best positioned” if it has exposure to multiple rates, particularly banks that are looking at credit sensitive rates from a perspective of safety and soundness issues, were their book of loans to ever have a baseline rate that drops below their costs of funding.
On the swaps, if BSBY and Adjusted Term SOFR are supposed to roughly track each other (because both are an approximation of LIBOR), maybe a swap desk gets comfortable with not caring if the Borrower swap is Term SOFR or BSBY for pricing purposes, because any effort to hedge/price that risk will depend on the Fixed Rate in the Dealer-to-Dealer SOFR Compounding In-Arrears market? Here, would having two reference rates for which both rely on the same pool of liquidity to hedge mean they will always have the “better” pricing than Ameribor? Or will Ameribor, as a more accurate cost indicator for some banks, have a lower margin added to the loan (and therefore, an overall lower costing product for the borrower)?
For right now, maybe it is best to not put all your eggs into one basket.
Ed's practice is focused on swaps, derivatives, general corporate matters, and advising clients on various types of debt and equity capital market activities (e.g., security private placements, loans and revolving credit ...
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