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Financial firms are expecting considerable costs and risks from the transition from LIBOR. The Vega team is currently engaged by one of the world’s largest banks to provide consulting and research support in connection with the LIBOR transition. For certain RMBS transactions, Vega analyzed the range of possible replacement rates, including the various alternatives set forth in the fallback provision, as well as other reference rates that have been commonly discussed.
Four General “Buckets” of Replacement Rates
- Fallback provisions in the governing agreements describe various replacement alternatives, such as the last available LIBOR and/or an average of reference bank rates.
- Existing reference rates such as SOFR or AMERIBOR.
- New reference rates that take a simple function form of existing indices (such as averages).
- Newly-developed reference rates designed to match LIBOR’s term and credit spread.
What are the tradeoffs between different buckets? Usually, when the replacement rates match LIBOR closer, more complex methodologies will be required to calculate the rates. Below we discuss each of the four buckets in more detail.
Bucket 1: LIBOR Fallback Provisions
The relevant language in the governing agreements and offering documents specify these unique elements in varying order and combination. They can include the following elements:
- Alternative comparable rate
- Reserve interest rate
- Quotes from reference banks
- Previous LIBOR rate
Consider one of these elements as an example, average of two quotes from reference banks. We used historical data to see if that would mimic the actual LIBOR. There were 15 quotes submitted by reference banks on 8/23/2007. On that same date, the LIBOR was 5.505.
If we randomly select quotes from two banks, say HSBC and Deutsche, and average them, the average quotes from two reference banks would be 5.495, which is fairly close to the actual LIBOR on the same day.
We repeat this simulation exercise for the time period between January 2005 and August 2008. The averages of two randomly selected quotes from panel banks track the actual LIBOR rates closely.
Bucket 2: Existing U.S. Reference Rates
SOFR and AMERIBOR are most commonly discussed. These rates are highly correlated with LIBOR but do not perfectly match. They are straightforward to implement and require no additional methodology or additional calculations.
Bucket 3: A Simple Function of Existing Indices
The averages of existing indices track LIBOR closer than the "raw" indices. They do not rely on complex methodologies but do require additional steps to calculate. Compounded average SOFR in arrears is the most discussed in this bucket.
Bucket 4: Newly-Developed Rates Designed to Match LIBOR’s Term and Credit Spread
Bloomberg has created a new SOFR-based LIBOR-like index by adjusting SOFR’s term and credit spread. ICE also proposed a new Bank Yield Index that mimics LIBOR. Both indices are based on complex and potentially evolving methodologies, but they match LIBOR the best.
Important Dimensions of Alternative Rates Relative to LIBOR
All considered indices track LIBOR closely but, historically have slightly lower rates and higher volatility. Complex indices track better, but use more opaque methodology. Separately, futures or swaps market exist for SOFR and AMERIBOR, indicating opportunities for investors to hedge their exposure to these rates.
|Alternative Rates for 1M LIBOR||Level||Standard Deviation||Correlation||Hedging Opportunity|
|Last Available LIBOR||-0.91046||0||-|
|Averages of Two Quotes||-0.00007||0.00139||1|
|Averages of SOFR||0.00034||0.00134||0.958|
|Averages of AMERIBOR||-0.00026||0.00043||0.974|
|Bloomberg's Fallback Rates||-0.00049||0.00105||0.976|
|ICE's Bank Yield Index Test Rates||-0.00002||-0.00005||0.996|