Why I’m bothering to write about SOFR transition at this point is a bit of a mystery. Hasn’t this topic now finally exhausted both our energy and interest? Oh, and a European war is being fought as I write which, to say the least, renders the kerfuffle over LIBOR somewhat less than consequential. But irrelevancy has not stopped me before.
To level set, SOFR appears to be the winner in the LIBOR replacement derby. The credit-sensitive rates, including Ameribor and BSBY were runners, and while still hanging around the rim, seem to be fading a bit under the enormous weight put behind SOFR by the Fed.
And yet, did anyone notice a few weeks ago, the Wall Street Journal’s reporting that the US government has said “Never Mind” on LIBOR-rigging prosecutions? Now, all US LIBOR convictions have been overturned. The Second Circuit Court of Appeals concluded, (surely influenced by my insightful commentary on this point), that one cannot really falsify a false rate. Remember, 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 did borrow money on an interbank basis… but of course it doesn’t borrow money on an interbank basis. There is actually no objectively observable rate here! Therefore, it’s pretty hard to convict someone of nefariously taking economic advantage of their ability to set the rate when the rate itself is, indeed, made-up.
It seems that it was those criminal prosecutions that really gave the effort to do away with LIBOR its energy and the government its conviction. Without that fuel of policy-making “outrage” (real or fabricated), could we really have defenestrated LIBOR, claiming that we’d just now became aware of the underlying difficulties in the LIBOR set and absolutely need to do something about it? A Captain Renault moment to be sure. The market has known that LIBOR has been largely a subjectively fixed rate for decades. Rather embarrassing isn’t it to pretend that we’ve just noticed this and need absolutely to fix it right 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 fine for the market until the regulatory establishment decided it was entirely unacceptable and need to be tossed on the midden heap of history. Really? Was all this really about the lack of actual underlying transactions or was something else in play? Was it perhaps, that some portion of the regulatory establishment just did not want a credit-sensitive index anymore?
Look what happened in the Global Financial Crisis (GFC). The GFC amounted to a massive liquidity problem resulting from the mispricing of assets, notably assets in the subprime residential marketplace. Some commentators have noted that LIBOR actually contributed to the financial disruption because it went up when the crisis occurred and went down when it abated. Arguably, LIBOR behaved rationally. However, as it ran up, it frustrated, to some extent, the efforts of the Federal Reserve to pump liquidity back into the market and stabilize it. Annoying, but isn’t that what LIBOR was supposed to do?
One might wonder whether the residents of the regulatory heights could have had the mojo to dump LIBOR simply because they didn’t like the fact that it transmitted credit risk to the marketplace? Was the “discovered” lack of integrity of data around the LIBOR set used as the can opener needed to kill off LIBOR?
Okay, maybe that’s tin foil hat speculation but to be clear, the reality is that when (not if) we have another GFC-type credit event, trillions of floating rate paper tied to SOFR will not respond to deteriorating credit conditions the way it did when LIBOR walked the land and that is not an unalloyed good.
I’m not going to recapitulate all that’s been said (and I have said) about the cost of the death of LIBOR and tut-tut about the waste, except to observe that it has been costly and disruptive. Now I’m going to move on and focus on how to learn to live with SOFR. I see two fairly material problems. First, we really don’t know how SOFR will perform in a credit crunch or during difficult credit conditions. Pin down your favorite economist on this and ask. Larded with lots of professional economist mumbo jumbo, eventually you will hear him or her say something along the lines of “we just don’t know.” That sort of indeterminacy about how the index underlying trillions of dollars of debt in our marketplace is simply not a good thing. Best guess, SOFR will not accurately reflect credit risk and its movements will not correlate positively with credit risk but really, who knows?
The second problem is that the risk transition mechanism that has helped us price risk for forty years will not be there. Will we miss critical signs that the market should be aware of as conditions deteriorate? What happens if an inability to price risk might actually make credit unavailable and cause the price of money to spike far beyond where it might have been if there had been reasonable transparency into macro credit risk? It could happen.
For lenders looking for protection on macro risk, it’s cold comfort to be told to price it into the spread. Huh? We don’t have any reliable models telling us how to do that. The only useful data set that we’ll ever see here is when spreads actually run up in real time. That’s a little late, right? You don’t put the “Danger Road Out!” warning sign on the rocks at the bottom of the cliff. We’ll know it when it happens but what can we do about it? Our outstanding book will not reprice! Loans that priced twelve months ago at SOFR +200 are now going out the door at SOFR +400. In the “good old days” of LIBOR, LIBOR ran up to reflect deteriorating credit conditions, and as a consequence, risk would have effectively been repriced.
So, do lenders need, and can they develop, some sort of repricing opportunity when new issue spreads move up aggressively, signaling credit-tightening conditions? Is it reasonable to say that if a lender’s floating rate is wildly mispriced in a future market that the lender should have an exit ramp? Certainly makes sense, although I can’t imagine a lot of enthusiasm on the borrower side of the equation for such a mechanic right now.
All this uncertainty will remain as an annoying reminder that the criminal activity that served as the predicate for the defenestration of LIBOR looks like an increasingly dubious basis on which to have spent millions and millions of dollars and wasted so much time and energy.
The ships were launched, but Helen was indeed photo-shopped.
