LIBOR to SOFR Transition

Since 2007 regulators have been concerned about discrepancies found in LIBOR and have identified SOFR as a preferred benchmark rate.

For new loans, no USD LIBOR-based contracts will be allowed after December 2021.

All existing LIBOR contracts will need to convert to SOFR no later than June 30, 2023.

SOFR is a transaction-based, risk-free overnight rate. Historically SOFR and 1-month LIBOR have been highly correlated (97%) and over the last 5 years LIBOR exceeded SOFR by an average of 11.448 bps.

For Term SOFR loans, rates will mirror LIBOR terms (1 month, 3 months, and 6 months). Most loan pricing models will use the SOFR forward curve plus a spread adjustment to ensure consistency of transaction economics

SOFR is recommended because it is

1.) Deep, broad and diverse enough that it does not dry up in times of market stress,
2.) Resilient even as markets evolve over time,
3.) Entirely transaction based, so it cannot be easily manipulated.

SOFR is a risk-free rate and may not reflect changes to lender’s cost of funding especially during periods of credit stress. This is a challenge primarily for variable rate debt, but lenders are expected to include a spread adjustment to compensate for access to market liquidity over and above the risk free rate. The spread adjustment will maintain the consistency of transaction economics compared to LIBOR.

SOFR is not the sole index available to lenders post LIBOR. Borrowers may see some financial institutions offer Prime, Fed Funds, Ameribor, BSBY and other indexes. It is anticipated that the majority of the lending market will move to SOFR-based pricing. SOFR is expected to be the most liquid and widely quoted index for commercial banking products. Washington will offer SOFR as the benchmark reference rate as the replacement for LIBOR.

All banks must cease using LIBOR as a reference rate for new loans by December 31, 2021. Most financial institutions will be transitioning to an alternative reference rate between now and the year of the calendar year. Many national and large regional banks have already outlined their plans to transition to SOFR.

Existing loans and assets will be required to transition away from LIBOR prior to June 30, 2023.

• Daily SOFR: https://www.newyorkfed.org/markets/reference-rates/sofr

• 1-month, 3-month, and 6-month SOFR Averages: https://www.newyorkfed.org/markets/reference-rates/sofr-averages-and-index

• 1-month, 3-month, and 6-month term SOFR: https://www.cmegroup.com/market-data/cme-group-benchmark- administration/term-sofr.html

LIBOR (London Inter-Bank Offered Rate) is the benchmark interest rate banks charge each other for overnight, one-month, three-month, six month, and one-year loans. The LIBOR rate is published daily in five currencies: the Swiss franc, the European euro, the British pound sterling, the Japanese yen, and the U.S. dollar, so the migration away from LIBOR will be a global event in the financial markets. In fact, it’s estimated $370 trillion in commercial loans, mortgages, investments, and financial derivatives are tied to LIBOR.

The underlying market that LIBOR is derived from is no longer used in any significant volume. Therefore, the submissions made by banks to sustain the LIBOR rate are often based on expert judgement rather than actual transactions. In 2017, the Federal Reserve tasked the Alternative Reference Rate Committee (ARRC) with determining a new reference rate to replace LIBOR, which will be phased out by June 30, 2023.

In July 2017, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as the reference rate that represents best practices for use in the United States for financial contracts and derivatives. SOFR, published daily and administered by the Federal Reserve Bank of New York, is based on more than $700 billion in overnight repurchase transactions secured by US treasuries. This transition will be highly complicated and will impact both borrowers and their banks.

As an overnight secured rate, SOFR better reflects the way financial institutions fund themselves today. The transaction volumes underlying SOFR regularly are around $1 trillion in daily volumes. The volumes underlying SOFR are far larger than the transactions in any other U.S. money market. This makes it a transparent rate that is representative of the market across a broad range of market participants and protects it from attempts at manipulation. Also, the fact that it’s derived from the U.S. Treasury repo market means that, unlike LIBOR, it’s not at risk of disappearing.

LIBOR is the composite interest rate that banks report they would have to pay to borrow, on an unsecured basis and is a fundamentally different interest rate than SOFR. LIBOR represents an unsecured forward-looking term rate (overnight to 12 months) while SOFR is a backward looking, secured overnight risk-free rate. As a result, SOFR will tend to be lower than LIBOR. A spread adjustment to SOFR will be necessary to make it commensurate with LIBOR. The goal of the spread adjustment is to ensure the consistency of transaction economics compared to LIBOR.

No new LIBOR-based loans or assets will be originated after the end of 2021. Existing loans and assets will be required to transition away from LIBOR prior to June 30, 2023. For new loans Washington Trust expects to cease quoting LIBOR as a reference rate after August 31, 2021.

At Washington Trust, LIBOR-based commercial loan contracts generally include language that describes the conditions and process for a switch to an alternative benchmark. If such language does not exist, your relationship manager will contact you to discuss an amendment to provide for an alternative benchmark rate. For loans currently based on LIBOR, including commercial loans and commercial real estate (CRE) loans, the move away from LIBOR will likely take place beginning in 2022. Once a loan converts, future interest rate accruals will no longer be calculated using LIBOR. Instead the interest accrual will be based upon SOFR.

For LIBOR based loans you should determine if there is benchmark replacement language already in place. Your loan agreement may contain a section which describes the replacement benchmark if LIBOR is unavailable. If you find that the replacement language is not adequate, discuss your options with your Washington Trust Relationship Manager.