LIBOR Rate Phase-out — What’s Next?

Sometime in 2021, the most important benchmark for setting interest rates on commercial (and many variable rate residential) loans will be eliminated. Trillions of dollars of such loans are governed by LIBOR, which is short for the London interbank offered rate.  LIBOR is determined on a daily basis and is the interest rate that London banks would use to borrow amongst themselves.  There is a separate LIBOR rate determined for different time periods (e.g., a 30 day LIBOR rate, 1 year LIBOR rate, etc.). A lender making a variable rate loan based upon LIBOR will determine its interest rate by adding an agreed-upon spread to the applicable LIBOR rate on a particular date. For example, the interest rate may be equal to the 30-day LIBOR rate in effect on the first business day of each month plus a spread of 5%.  The advantage of this method of calculation is that the LIBOR rate is publicly disclosed on a daily basis and the corresponding interest rate under the loan is easily calculated.

Unfortunately, LIBOR has proven to be susceptible to manipulation. In response, bank regulators have called for the index to be eliminated. Given its pervasive use in capital markets, regulators determined that the rate cannot be abruptly replaced. Accordingly, regulators have given the industry a long lead time to establish alternative indices, however, that lead time will be coming to an end in 2021. To date, there is no consensus as to what index will become the predominant replacement for LIBOR.

New loans initiated today are still using a LIBOR benchmark. However, for loans which have a maturity date beyond the 2021 LIBOR phase out, there is a question as to what benchmark will be substituted by lenders.  Most loan documents contain generic language to the effect that if LIBOR can no longer be determined, that the lender has the discretion to pick a substitute index.  However, it is important for borrowers to make sure that there are limits on the lender’s method of replacing LIBOR.  While it should be relatively easy for lenders to pick a replacement index that is relatively stable and easily determined, there needs to be some consideration as to how that index compares to the corresponding LIBOR rate.  For example, if the replacement index is 0.25% higher than the LIBOR in effect as of the transition, it is important that the spread be adjusted so that the corresponding interest rate under the loan will be equivalent to the rate established by LIBOR.  Otherwise, a borrower could face an increased interest rate solely on account of the change in index.

Although the elimination of LIBOR is still some two years away, it is important for borrowers and lenders to address its implications in new loans with a maturity date that extends beyond the elimination of LIBOR.  Similarly, existing loans may have language that attempts to address the issue; however, those provisions may not have received much attention when the parties negotiated the loan documents.  As such, it is important for lenders and borrowers to review outstanding loan documents to determine if the language addressing the absence of LIBOR will lead to a fair and adequate substitute index and method for determining variable interest rates.

For further information regarding the consequences of the elimination of LIBOR and commercial lending in general, please contact Jeffrey M. Galkin at 312-368-0100.