The interbank borrowing rate used for hundreds of trillions of US dollar and UK sterling financial contracts is destined to become defunct by the end of 2021. Specialist property lenders who link their interest rates to LIBOR need to start considering their options (and their contractual terms) well in advance of this date, as some contracts are already being written that will extend beyond the end of 2021.

Libor – or the London Interbank Offered Rate – has been described as the world’s most important interest rate.

Having emerged on the scene about 50 years ago, it took off in the 1980s as bankers in the UK, US and Japan were looking for a standard benchmark for the pricing of the nascent but fast-growing global futures market. A dependable and uniform rate was needed to settle those contracts.           

Since then, the London-based risk-free borrowing rate, meant to be the average rate at which the world’s largest banks believe they can borrow from one another without offering security as collateral, has become at the cornerstone of international finance and embedded in the DNA of the financial system.  

Estimates suggest that, in 2019, Libor underpins at least USD $350 trillion of loans – and could be much higher. It is used to set the base reference rate for a wide variety of financial products including mortgages and other property-backed loans, student loans, municipal bonds, interest rate swaps, futures contracts and other derivatives around the world.

But this is due to change at the end of 2021…

What is changing, and why?

Libor has been thoroughly discredited in recent years by major scandals involving bankers manipulating the risk-free rate for their own financial advancement.

Altogether banks have been fined USD $9bn for Libor rigging[1], the worst cases of which were found to be at the height of the financial crisis in 2008 when the contributor banks were found to have been submitting artificially low rate quotes to disguise higher funding costs, and their weakening financial position.    

Since 2017, regulators have been proactively pushing financial markets to switch to alternative risk-free reference rates (RFRs) that they believe are more reliable, and representative of modern market behaviour. Pressure to find an alternative has really stepped up this year, as the 2021 deadline for Libor’s cessation starts to come into sharp focus.    

But there is still a long way to go before agreement can be reached on the best alternative option – or options. The current frontrunners include the Sterling Overnight Index Average (Sonia) in the UK, and the Secured Overnight Financing Rate (SOFR) in the US; but these are, as yet, largely untested. The world’s most influential regulators will be looking for a smooth transition; a slow, gradual and uneventful repapering of the worldwide financial markets with a Libor replacement that looks and acts in a very similar way – without the widespread abuse potential.

What are the implications on property developers, and lenders?

While regulators are starting to make more noise about the need to replace Libor, the property industry has still been relatively quiet on the topic. However, with many development loan timeframes stretching beyond 24 months, some of the loans that are being structured today are already based on a reference rate that is expected to be replaced before the loan matures.

Development loans can be for significant sums (in the tens or even hundreds of millions of pounds) so if the replacement RFR results in even a small upwards variation in the variable rate being charged, this could have a significant cost implication to the developer; equally, if the replacement RFR is lower, interest payments should reduce accordingly. When lenders are writing development loans that will stretch beyond the end of 2021, they should ensure that the lending agreement adequately covers what will happen in the event of a switch to a new RFR. Oblix Capital offers development loans of up to 24 months and as such, all agreements issued from the beginning of 2020 will include reference to the ability to switch the interest calculation to a new RFR if needed, even if it is not yet known which RFR will be adopted yet. In the interests of transparency and clear communication, all affected borrowers will be contacted as soon as the replacement RFR is known.

Jeremy Stevens

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