There’s no solace in this current environment. We are facing one of the most devastating economic outlooks in our lifetime. Amidst it all, the policies of the Federal Reserve and central banks globally have come back front and center. Many programs are from the 2008 playbook, but the most significant are new as we are faced with unprecedented dynamics.

Interest rates are the underpinnings of valuations within global capital markets. Yet, at the same time and since the 2008 crisis, the pathway that central banks have embarked on have been controversial. From negative interest rate policies oversees which have clearly not worked if judging by economic growth, to the Federal Reserve in the United States which began raising rates too late. The London Interbank Offered Rate has been equally, if not more, controversial. The LIBOR versus SOFR conversion is front and center amidst the covid-19 uncertainty.

The Fed runway has been long

When looking at the chart below: S&P, Federal Reserve Balance Sheet and Effective Federal Funds Rate, it is hard to not see the “easy money” influence on risk assets. It is also not difficult to envision a scenario where risk assets take another leg lower amidst the economic reality brought on by the coronavirus. From 2001 – 2006 and 2010 – 2015 rates were kept low, for too long. Interest rates will now once again remain low for a very long time and for different reasons. Unlike prior periods, the consequences for risk assets remain more uncertain.

The Federal Reserve

We strive to offer a balanced view of the Federal Reserve. In the end, as an institution, there have been many different leaders and mindsets over time. Within this most recent pocket of time, the Fed has been very active in utilizing the Federal Reserve Act in conjunction with both the Department of Treasury and with changes in the Dodd-Frank Act. The Federal Reserve Act allows the Fed to be the lender of last resort, more specifically, “in unusual and exigent circumstances.”

It is difficult in this window of time, with all the acronyms, to ignore SOFR. It is clear the Federal Reserve wants SOFR to replace LIBOR but market, end user opinions and behavior matter in this environment.

The secured versus unsecured debate

In the end, this is no longer a debate. To a large extent, LIBOR has done what it’s supposed to do; widen when unsecured rates widen. The below charts highlight some of the dynamics within the covid-19 crisis. Specifically, the flight from prime money funds into government funds with the overall pool of cash still growing. In addition, the behavior and widening of secured/unsecured (LIBOR/SOFR spread) versus the Five-year Investment Grade CDS Index. Additionally, the outright chart on three-month LIBOR coincides with the bottoming of the prime funds and implementation of the Federal Reserve’s Commercial Paper program in the middle of April.

Money market funds overall growing versus declining prime funds

SOFR/LIBOR spread widening versus Investment Grade Corporate Bond Volatility

LIBOR – OIS spread

SOFR is inherently a low volatility index

The Federal Reserve and other central banks have taken volatility out of the market. Yet, it doesn’t matter what indices you look at (rates, credit or currency), volatility wound up in an uncomfortable position heading into 2020; it was too low. The ability for the Federal Reserve to control the dynamics around SOFR lay in an ability to control volatility, including the covid-19 crisis. It is not only a matter of containment of secured funding, but the ability to compress unsecured funding is also part of the equation.

Examples:

Repo hiccup of 2019 (secured)

The secured funding hiccup of 2019 was never supposed to happen, but it did. It was a combination of many factors including market structure, cash versus collateral (at that time) and regulatory changes. Even before covid-19, the Federal Reserve was understanding of the need for change. What transpired was the involvement of the Fed with temporary (still with us and bigger) operations to smooth over factors that in many cases, they were accountable with regulatory and consequently market structure shifts.

SOFR 2019

From the New York Federal Reserve:

Effective October 15, 2019, the Federal Open Market Committee directs the Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 1—3/4 to 2 percent. In light of recent and expected increases in the Federal Reserve’s non-reserve liabilities, the Committee directs the Desk to purchase Treasury bills at least into the second quarter of next year to maintain over ample reserve balances at or above the level that prevailed in early September 2019. The Committee also directs the Desk to conduct term and overnight repurchase agreement operations at least through January of next year to ensure that the supply of reserves remains ample even during periods of sharp increases in non-reserve liabilities, and to mitigate the risk of money market pressures that could adversely affect policy implementation.

The Federal Reserve Commercial Paper Funding Facility (unsecured)

To a large extent, the Fed’s Commercial Paper Facility is designed to get LIBOR funding rates down versus OIS (federal fund) levels. Although this program was announced in March, it didn’t come online until the middle of April, coinciding with a swift decline in LIBOR levels versus its money market peers.

A1/P1 Commercial Paper versus LIBOR (2000—2020)

From the New York Federal Reserve: Commercial Paper Funding Facility (CPFF)

On March 17, 2020, the Board authorized the Federal Reserve Bank of New York (FRBNY) to establish and operate the CPFF. The CPFF provides a liquidity backstop to U.S. issuers of commercial paper, including municipalities, by purchasing three-month unsecured and asset-backed commercial paper directly from eligible issuers. Additional information concerning the CPFF can be found in the report provided to the Committees on March 24, 2020, and on the Board’s public website.

The CPFF began making purchases on April 14, 2020. As of this date:

• The outstanding amount of the FRBNY’s loans to the special purpose vehicle (SPV) was $249,262,500.
• The total outstanding amount of the commercial paper held by the SPV was $249,270,694.
• The fair value of the collateral pledged to the FRBNY was $10,269,788,841 (includes $10 billion equity investment from the Department of the Treasury).
• The amount of interest, fees and other revenue or items of value received by the FRBNY, reported on an accrual basis, was $0.00.
• The amount of interest, fees and other revenue or items of value.

Has the Fed been balanced in their view of SOFR as a LIBOR replacement?

Not entirely, but lately perhaps more realistic in terms of timetable.

LIBOR is in the Fed’s alphabet soup

• Commercial Paper Funding Facility (CPFF)
• Primary Dealer Credit Facility (PDCF)
• Term Asset-Backed Securities Loan Facility (TALF)
• Secondary Market Corporate Credit Facility (SMCCF)
• Primary Market Corporate Credit Facility (PMCCF)
• Municipal Liquidity Facility (MLF)
• Money Market Mutual Fund Liquidity Facility (MMLF)
• The Main Street Lending Program (MSNLF) – LIBOR
• The Paycheck Protection Program Lending Facility (PPPLF)

What about SOFR?

The Federal Reserve has not abandoned SOFR as a replacement for LIBOR. Yet, this unfortunate pocket of time with covid-19 has highlighted challenges. The conversion of LIBOR to SOFR is an extremely large task. When the unknown hits, you adapt. We are not being critical of the Federal Reserve, rather highlighting where things are at, given the environment and transition.

From the American Bankers Association: April 17, 2020

• The Federal Reserve is familiar with the operational challenges that a transition from LIBOR to SOFR presents and it has played a leading role, along with the Alternative Reference Rates Committee (ARRC) in addressing these complex issues.
• The Federal Reserve’s deep involvement in this transition has illuminated the need for lenders and borrowers to have sufficient time to make necessary adjustments. Transitions within loan administration, servicing and risk management are necessary to successfully execute and administer a large program of SOFR-based commercial loans. Furthermore, until there is a robust and liquid market for hedging instruments tied to SOFR, risk management strategies for banks and borrowers will be hampered. The market for these hedging instruments is progressing, but at present it remains relatively unfamiliar to many small and medium-sized businesses.”
• The ARRC has recommended robust contract language to address the risks of LIBOR termination in new commercial loans based on LIBOR. The Federal Reserve should affirm the ARRC’s recommended language and attendant transition timeline, while permitting immediate implementation of SOFR for prepared borrowers and lenders.

However, it is also true that community banks need further reference rate optionality under the MSLP. Often, community banks lend to small and medium-sized businesses at rates tied to a publicly available version of a base or prime rate, as published in The Wall Street Journal. Community bank customer familiarity with this rate will be particularly useful in facilitating MSLP loans and should bolster participation. We do not believe that the use of such a rate would increase systemic risk, which the Federal Reserve and other supervisors have rightfully sought to mitigate in promoting an orderly transition away from LIBOR.

The ABA suggests that the Federal Reserve permit the initial, short-term use of LIBOR so long as the lending agreements contain fallback language consistent with either of the two transition approaches recommended by the ARRC. Furthermore, the Federal Reserve should also permit other rates, such as a publicly quoted prime or base rate, when that alternative best fits the borrower’s needs.

From the Fed on the Main Street Lending Facility (SOFR IN): April 8, 2020

Eligible Loans: an eligible loan is an unsecured term loan made by an Eligible Lender(s) to an Eligible Borrower that was originated on or after April 8, 2020, provided that the loan has the following features:

• Four-year maturity
• Amortization of principal and interest deferred for one year
• Adjustable rate of SOFR + 250 – 400 basis points

From the Fed on the Main Street Lending Facility (SOFR OUT/LIBOR IN): April 30, 2020  

Eligible Loans: An Eligible Loan is a secured or unsecured loan made by an Eligible Lender(s) to an Eligible Borrower that was originated after April 24, 2020, provided that the loan has all of the following features:

• Four-year maturity
• Principal and interest payments deferred for one year (unpaid interest will be capitalized)
• Adjustable rate of LIBOR (one or three months) + 300 basis points

What’s happening on the ground?

When looking at the dynamics of this pocket in time, there is a clear distinguishing between the behavior of secured and unsecured funding. Spread adjustment matters and this environment certainly accentuates. This is a very big component of the LIBOR-SOFR conversion along with term structure. Let’s look at some recent developments.

About the ARRC:

The ARRC is a group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York in cooperation with the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of Financial Research, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and the U.S. Treasury Department. It was initially convened in 2014 to identify risk-free alternative reference rates for USD LIBOR, identify best practices for contract robustness and create an implementation plan with metrics of success and a timeline to support an orderly adoption.

ARRC Issues Supplemental Consultation on Spread Adjustment Methodology: May 6, 2020

“As noted in the announcement of the initial consultation, the spread adjustments are intended for use in USD LIBOR contracts that have incorporated the ARRC’s recommended fallback language or for legacy USD LIBOR contracts where a spread-adjusted SOFR can be selected as a fallback. Following its April 7, 2020, meeting the ARRC announced that its recommended spread adjustment methodology will be based on a historical median over a five-year lookback period, calculating the difference between USD LIBOR and SOFR. This methodology aligns with the International Swaps and Derivatives Association’s (ISDA) recommended methodology for derivatives and would make the ARRC’s recommended spread-adjusted version of SOFR comparable to USD LIBOR.”

ICE Benchmark Administration (IBA): May, 2020

IBA, a leading provider of global interest rate and other financial benchmarks.

“The U.S. Dollar ICE Bank Yield Index is designed to measure the average yields at which investors are willing to invest U.S. dollar funds over one-month, three-month and six-month periods on a wholesale, senior, unsecured basis in large, internationally active banks. The rates generated by the Index methodology implicitly incorporate several distinct elements including:

• An underlying U.S. dollar risk-free rate of return (for example, SOFR).
• A term structure for this risk-free rate (i.e. the expected average term-premium over the overnight risk-free rate for forward-looking time horizons).
• An average premium that investors expect to earn for accepting wholesale, senior, unsecured bank credit risk over the various forward-looking time horizons”