Why I bother to write about the SOFR transition at this point is a bit of a mystery. Does not have this subject finally exhausted both our energy and our interest? Oh, and a european war is being fought as I write which, to say the least, makes the LIBOR kerfuffle a little less than substantial. But insignificance didn’t stop me before.
To upgrade, SOFR appears to be the winner of the LIBOR replacement derby. Credit-sensitive rates, including Ameribor and BSBY, were runners, and while still hanging around the edge, seem to be fading a bit under the huge weight put behind SOFR by the Fed.
And yet, did anyone notice a few weeks ago that the Wall Street Journal reporting that US Government Says “Never Mind” on LIBOR-rigging Lawsuits? Now all US LIBOR convictions have been overturned. The Court of Appeals for the Second Circuit concluded, (surely influenced by my insightful comment on this point), that you can’t really fake a bogus rate. Remember that the best definition of LIBOR has been, and remains, that it is a rate at which a bank would borrow money on an interbank basis if it borrowed money on an interbank basis… but of course it does not borrow money on an interbank basis. interbank basis. There is actually no objectively observable rate here! Therefore, it is quite difficult to convict someone for taking nefarious advantage of their ability to set the rate when the rate itself is, in effect, invented.
It seems that it was these criminal prosecutions that really gave the effort to eliminate LIBOR its energy and the government its conviction. Without this fuel of political “outrage” (real or fabricated), could we really have defenestrated LIBOR, saying that we had only just become aware of the underlying difficulties of the whole LIBOR and that we absolutely had to do something something about it? A Captain Renault moment for sure. The market knows that LIBOR has largely been a subjectively fixed rate for decades. Rather embarrassing isn’t it to pretend that we have just noticed this and that it absolutely must be remedied now! And the solution was a credit-insensitive rate? And that’s a problem.
For all its flaws, LIBOR gave us an index that worked well for the market until the regulatory establishment decided it was totally unacceptable and should be tossed out of history. Really? Was it all really related to the lack of real underlying transactions or was there something else at play? Was it perhaps that part of the regulatory establishment no longer wanted a credit-sensitive index?
Look at what happened during the Global Financial Crisis (GFC). The GFC amounted to a huge liquidity problem resulting from the mispricing of assets, especially assets in the subprime residential market. Some commentators have noted that LIBOR actually contributed to the financial disruption because it rose when the crisis hit and fell when it subsided. Arguably, LIBOR behaved rationally. However, as it rose, it thwarted, to some extent, the Federal Reserve’s efforts to reinject liquidity into the market and stabilize it. Boring, but isn’t that what LIBOR was supposed to do?
One might wonder if residents of regulatory heights might have had the mojo to dump LIBOR just because they didn’t like the fact that it passed credit risk on to the market? Was the “discovered” lack of data integrity around the LIBOR set used as the necessary opener to kill LIBOR?
Okay, maybe this is speculation in a tinfoil hat, but to be clear, the reality is that when (not if) we have another GFC-like credit event, billions of Floating rate paper linked to SOFR will not respond to deteriorating credit conditions as it has. when LIBOR walked the earth and it’s not an unmitigated good.
I’m not going to recap all that has been said (and I have said) about the cost of LIBOR dying and the wastage, except to note that it has been costly and disruptive. Now I’m going to move on and focus on learning to live with SOFR. I see two rather material problems. First, we really don’t know how SOFR will perform in a credit crunch or under difficult credit conditions. Pin your favorite economist on this topic and ask. Sprinkled with plenty of gibberish from professional economists, you’ll eventually hear him say something like “we just don’t know”. This kind of indeterminacy about how the index underpins trillions of dollars of debt in our market is simply not a good thing. At best, SOFR will not accurately reflect credit risk and its movements will not be positively correlated with credit risk, but really, who knows?
The second problem is that the risk transition mechanism that has helped us assess risk for forty years will not be there. Are we going to miss critical signs the market should be aware of as conditions deteriorate? What if a failure to assess risk could actually make credit unavailable and cause the price of silver to skyrocket far beyond what it could have been had there been a reasonable transparency on macro credit risk? It could happen.
For lenders looking for macroeconomic risk protection, it is little comfort to be told to factor it into the spread. Eh? We don’t have reliable models telling us how to do this. The only useful data set we will ever see here is when spreads are rising in real time. It’s a bit late, isn’t it? You don’t put the “Danger Road Out!” warning sign on the rocks at the bottom of the cliff. We will know when it happens, but what can we do about it? Our exceptional book will not change in price! Loans that were valued twelve months ago at SOFR +200 now come out at SOFR +400. In the “good old days” of LIBOR, LIBOR rose to reflect deteriorating credit conditions and therefore risk would have effectively been repriced.
So do lenders need, and can they develop, some sort of repricing opportunity when new issue spreads are rising aggressively, signaling tight credit conditions? Is it reasonable to say that if a lender’s variable rate is very poorly priced in a future market, the lender should have an exit ramp? It certainly makes sense, though I can’t imagine much excitement on the borrower side of the equation for such a mechanic right now.
All of this uncertainty will go down as a dull reminder that the criminal activity that predicated LIBOR’s defenestration looks like an increasingly dubious base on which to have spent millions and millions of dollars and wasted so much time and effort. ‘energy.
The ships were launched, but Helen was indeed photographed.