Libor’s long goodbye

This is an audio transcript of the Behind the Money podcast episode: ‘Libor’s long goodbye’

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Michela Tindera
There’s been a looming deadline hanging over financial markets. It’s coming to an end this summer. And the deadline has to do with shifting away from this notorious benchmark rate called Libor. It was used for decades to price different kinds of investments like loans. When regulators announced a few years ago that the global financial system would be moving away from Libor, the task seemed kind of daunting. Here’s the FT’s US capital markets correspondent Harriet Clarfelt. 

Harriet Clarfelt
I spoke with a director at the investment firm KKR who has been involved in the Libor transition, and she said something which really stuck out to me about basically the deeply ingrained nature of Libor just because it’s been used for such a long time. She said Libor is like salt. It’s in everything. It’s very hard to take out once it’s in the cooking. 

Michela Tindera
In fact, in a 2018 article, the FT quoted one banker who said that the transition could be a task so large that it could be, quote, “bigger than Brexit”. However, as it’s turned out, things have overall gone pretty well. Here’s the FT’s Philip Stafford, who reported on Libor for several years. 

Philip Stafford
Actually, it’s been surprisingly smooth. You know, they, if this is, this has a, has an existential threat of a potential systemic risk to financial markets, and, you know, it’s gone wrong at any point and then you would certainly know about it. And it kind of hasn’t been that way. 

Michela Tindera
But there is one part of the financial system in the US that’s been taking its sweet time. Last week, Harriet came across a sternly worded statement from an industry group called the Alternative Reference Rates Committee, or ARRC. 

Harriet Clarfelt
With only 30 days remaining, the ARRC urges market participants with Libor exposures to complete their transition efforts now. 

Michela Tindera
And the statement pointed to firms who still had exposure to the dying benchmark rate. 

Harriet Clarfelt
They then later said by now, firms should be fully aware of and prepared for this fast approaching deadline. And those that are not prepared risks significant ramifications, including uncertain and potentially unfavourable outcomes. So part of what seems to be standing in the way are companies who are the borrowers in the loan markets and investors, the people lending to them have been scrapping over the fine print of documentation. 

Michela Tindera
That fine print could be the difference between where a lot of money ends up — in the pockets of borrowers or in the pockets of lenders, depending on how things shake out by the end of this month. 

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I’m Michela Tindera from the Financial Times.

Libor — it’s one of the longer-running stories in financial markets, but it’s almost gone for good. So today on Behind the Money, we’re looking back at what it was and how one part of the financial world is racing to the finish line to move away from it. 

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Let’s travel back about 40 years to the dawn of Libor, which, by the way, is an acronym that stands for the London Interbank Offered Rate. L-I-B-O-R. 

Harriet Clarfelt
As the acronym kind of suggests, it started off in the UK. So it started the 1980s with the British Bankers’ Association. 

Michela Tindera
Back then, Libor was established to be a benchmark that banks could use to figure out what interest rate they should charge when they were giving out loans. And the way that benchmark was created every day worked like this. Essentially every morning, a group of about 15 to 20 major banks would come up with a number that would represent how much they would charge to lend money to another bank. 

Harriet Clarfelt
The various banks would put forward that number every morning and on to the working days, and then an average would be taken of those and that would be what was taken to be Libor. 

Michela Tindera
It started off as a way to have a standardised rate for corporate loans, but from there it sort of spread like wildfire. It went on and started being used for all kinds of loans. We’re talking about corporate loans, but also mortgages and credit cards. OK, Now admittedly this sounds a bit abstract, but the FT’s Phillip Stafford, who we heard from earlier, says to picture it like this. 

Philip Stafford
When you will, you take out a credit card or a mortgage or a loan of some kind and you’ve . . . If ever you’re wondering where that interest rate comes from and why it’s seemingly plucked out of thin air, well, it’s usually because that interest rate is based on whatever Libor is. Then the bank will add in a little premium for itself. And then that effectively creates what is the interest rate that you’re paying. It works exactly the same for every kind of loan, effectively. 

Michela Tindera
And so Libor became a truly central part of international financial markets for decades to come. And every day this group of banks would publish their Libor rates. And that’s how the interest rate terms for new corporate loans, mortgages and credit cards would get decided. One rate to rule them all. But then, in the aftermath of the financial crisis, a very big scandal broke. It turned out that some of these banks were manipulating numbers that they were submitting to be included in the average that form the daily Libor rate. 

Philip Stafford
And what they found was that banks and especially their traders were submitting rates that were beneficial to them that maybe helped positions in the derivatives markets, desks, trading positions, rather than what might be called the more honest and, say, accurate number. 

Michela Tindera
This had a massive fallout. Bank CEOs had to resign. Banks in total paid more than $10bn in fines. Now, while the bulk of these scandals came out in 2012, five years later, in 2017, regulators had finally had enough. They said, OK, we’re done with Libor here. We got to do something else.

Now, in order to leave Libor behind, a new system needed to take its place and various ones have been created for different parts of the world and different currencies. 

Harriet Clarfelt
For example, there’s also a new rate called Sonia, S-O-N-I-A, which in the UK is being used, and there are other rates around the world. 

Michela Tindera
But the big deal is the one that’s happening in the US to replace a certain flavour of Libor, which is known as US dollar Libor. That’s because, as you’ve probably heard before, you know, US markets are just so big and dominant compared to the rest of the world. And so this new one, the US dollar Libor replacement is called SOFR. And yep, you heard right. That’s another acronym, S-O-F-R. And what does that stand for? 

Harriet Clarfelt
It stands for the Secured Overnight Financing Rate. More acronyms for you. And it was designed by the Federal Reserve Bank of New York and the US Treasury Office of Financial Research. 

Michela Tindera
Now, remember, Libor was created by a bunch of banks coming together and saying, hey, we think this should be the rate today. Here’s the average of those figures. And then that was sent out into the world. So SOFR is quite different from this. 

Harriet Clarfelt
SOFR is essentially a daily interest rate which is calculated based on actual financial transactions instead of banks’ estimates. And I think the idea is that that can help to make it less vulnerable to manipulation and the fact that it’s not based on estimates, so it’s more standardised and the idea is that it’s more transparent as well. 

Michela Tindera
So while Libor was based on estimates, SOFR is based on cold hard data. So to get people off this old US dollar Libor, US regulators said that starting last year, all new loans had to use SOFR instead. So our story is done here, right? Everyone’s happy. There’s no more Libor. Everybody’s on to the SOFR team now. 

Harriet Clarfelt
No, not quite. The story doesn’t end just there. 

Michela Tindera
Why not? 

Harriet Clarfelt
That’s because any existing loans that were referencing Libor needed to switch over to the new benchmark SOFR. And that process isn’t really like turning a light on. It’s not necessarily what I’d call a plug-and-play exercise. So there’s paperwork and administrative processes that need to be done quickly now because the deadline is June 30th. But it’s also about making the main parties involved — the companies who are the borrowers and the investors who are the lenders in the market — happy about the terms of switching over to the new benchmark. 

Michela Tindera
And is this a concrete deadline? Is there any pushing this step? 

Harriet Clarfelt
No, I’m gonna say that over the, over time, various bits of deadlines have been pushed around and around the broader Libor transition. But no. Hard and fast — June 30th. 

Michela Tindera
Harriet mentioned to me that there are some loopholes to this, but we won’t get too into the weeds on what those are here. So that’s where this one last hurdle and the switch away from Libor pops up and the deadline to do it is getting closer and closer. 

Harriet Clarfelt
So Libor will end for good on June 30th, 2023. But there has been sluggish progress in the lead-up to this deadline within the so-called US junk loan market. And when we reported on this, I think back in February, roughly three-quarters of the junk loan market was still linked to Libor. And then we wrote another piece in late May when the latest tally showed that roughly half of the market still needed to transition. So the process has accelerated, particularly in recent weeks, but there’s still stuff to be done. 

Michela Tindera
Now you might be thinking, junk loans? Don’t those inherently sound, well, junky? Who cares? 

Harriet Clarfelt
So junk loans are also known as leveraged loans. Leverage loans are loans issued by companies with weaker credit quality and usually large existing debt piles. And we use the word junk because their credit quality is below investment grade. So they are companies with weak credit ratings. Junk-rated debt usually offers investors a higher yield or a better return than they could get from better-quality investment grade debt. But that’s because of the greater risk associated with it. 

Michela Tindera
So despite the way the name sounds, the junk loan market in the US is quite important. 

Harriet Clarfelt
So I’d say, looking at the market itself, it’s huge. You know, it’s, in the US, that, the leveraged loan market or the junk loan market is more than $1tn. And it’s really grown significantly in recent years when companies engaged in this borrowing frenzy, while money was much cheaper, when interest rates were much lower. 

Michela Tindera
So to clarify, when Harriet mentioned that based on the FT’s latest tally, that roughly half this market still needed to transition off of Libor, she meant that at least $700bn worth of these loans still needed to transition. So what’s the reason for the hold-up in the junk loan market? Well, there are a few. And first it comes down to that fine print that Harriet mentioned before. 

Harriet Clarfelt
So investors in loans who are also known as lenders in the market, often expect to receive SOFR plus a bit extra. And I mean by that, a bit extra interest when companies switch over from Libor. But companies won’t always want to go with those adjustments. Sometimes they’d like something a bit smaller or indeed nothing at all. 

Michela Tindera
To be clear, the difference between Libor and SOFR rates might sound small. A few months ago, when Harriet reported on this transition in the FT, she noted that SOFR’s rate was 4.55 per cent. And that’s compared to the most widely used Libor rate, which was 4.95 per cent. And, you know, those figures don’t really sound that different. But when you’re dealing with huge sums of money, that can really add up. This has led to some tension between the borrowers and the lenders in this market. That’s because the companies issuing these loans don’t want to have their costs lifted any higher than they have been already. 

Harriet Clarfelt
Investors want to maximise the returns they can get from the loans that they’re investing in. And companies who are, who those loans are, basically that borrowings, want, if they can, to limit how much interest they’re paying. So they’ve been, there’s been a bit of back and forth in terms of trying to agree on terms that everyone’s happy with. 

Michela Tindera
But there’s been more to it than just haggling over the fine print. Bigger picture things like the rise in US interest rates. 

Harriet Clarfelt
When interest rates were very low in the lead-up to the pandemic and then even lower during 2020-2021, corporate borrowers went on a bit of a dealmaking frenzy because it was really cheap to borrow, and so they took out lots of loans then. And now here we are. And they don’t have an, had a real need to go back to the market last year or this year. And going back into the market would have provided a good opportunity to amend smaller loans and also issue new ones linked to SOFR. 

Michela Tindera
So this deadline is less than a month away and after decades of use, Libor will be pretty much gone for good. As I mentioned, Phillip Stafford covered Libor for a long time at the FT, so I wanted to speak with him and ask him about what we can learn from this transition. 

So what do you think we can take away from this whole Libor transition? 

Philip Stafford
What we’re seeing effectively is sort of the passing of an era in financial markets. And I would imagine that students at some point will go (sigh) and have to pay for work, a system like that. And they did for many years. 

Michela Tindera
Mmm. Yeah. I wonder maybe you could compare it to when we went off the gold standard. 

Philip Stafford
Yeah. Yeah. No, that’s a pretty good comparison. Yeah. Markets aren’t something that are easily created and planned, and something can just grow up organically into something very, very important, but hasn’t very fundamental flaws in it. But everybody uses it because it’s useful. And before you know it, it can be absolutely central.

I think it will say something about the fact that more and more of finance is now driven by whatever the actual market price is, not what you think it might be, that based on actual real transactions, which are much easier to follow and process because we are in a much more technologically advanced age than we were back then. You know that this is, this represents a fundamental change in the way that the markets operate and operated and the fact that it will be gone without a big bang, which is a testament to the people who’ve worked behind it. And let’s face it, the regulators, because everyone likes to give them a good kick. And on this occasion, they seem to have managed some things smoothly. 

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Michela Tindera
Behind the Money is hosted by me, Michela Tindera. Saffeya Ahmed is our producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Cheryl Brumley is the global head of audio. 

Thanks for listening. See you next week. 

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