In 2022, SOFR became the dominant benchmark interest rate for floating-rate commercial real estate loans, replacing LIBOR, which had been used for decades. SOFR stands for Secured Overnight Financing Rate, and it is the rate charged for overnight loans secured by U.S. Treasuries made among financial institutions and governments. These overnight loans are part of the multi-trillion-dollar “repo market,” which provides not only crucial liquidity to markets, but also ironclad pricing data, a feature LIBOR could not offer.
In September 2008, Economist Willem Buiter famously described LIBOR as “the rate at which banks do not lend to each other.” LIBOR was not determined via transactions; rather, a survey was conducted among 18 banks asked to estimate their cost of funds in the unsecured interbank market. A trimmed average was calculated by discarding the highest four and lowest four responses, and this number was broadcast to market participants. The most common form of LIBOR was for borrowing USD overnight, for one month, and for three months, but other currencies and tenors (maturities) were also quoted.
During the Great Recession, reports of LIBOR manipulation began to surface. As early as 2008, the New York Fed and the Bank of England knew Barclay’s and other major banks were lowballing their LIBOR submissions to look more creditworthy during the financial crisis. Other instances of manipulation primarily involved nudging LIBOR submissions up or down based on banks’ derivative portfolios to either receive additional income or reduce payments. $9 billion of fines later, the Federal Reserve began to assess LIBOR alternatives.
A Brief History of SOFR
Nine years later, the Fed’s Alternative Reference Rates Committee (ARRC) recommended SOFR to replace LIBOR in June 2017, and the first securities priced in SOFR were sold in July 2018. While the transition was initially slow, U.S. banks were required to stop using LIBOR in new loans after December 31, 2021. Existing loans could remain on LIBOR, but by June 30, 2023, the publication of LIBOR will end, and the sun will set on the British benchmark.
When the transition away from LIBOR became apparent, credit agreements started adding fallback language. Per the New York Fed, these are “contractual provisions that specify the trigger events for a transition to a replacement rate, the replacement rate, and the spread adjustment to align the replacement rate with the benchmark being replaced – in this case USD LIBOR.” If LIBOR no longer exists, borrowers and lenders still need to price their loans, and in a similar manner to what everyone has been accustomed to.
Switching a LIBOR loan to SOFR wasn’t quite as easy as changing a line on the screen. Astute borrowers will remember that while LIBOR is an unsecured rate, SOFR is a secured rate. While the risk of unsecured lending to major banks overnight or even for a month isn’t (often) large, it’s also not zero, and SOFR is usually lower than LIBOR.
For a while, banks typically approximated this difference, and converted one-month LIBOR to SOFR +0.1%. After evaluating years of transaction data, Bloomberg eventually published a go-forward adjustment on March 5, 2021, with one-month LIBOR deemed equal to SOFR + 0.11448%.
How is Term SOFR Determined?
Because SOFR is based on actual transactions, its biggest criticism was that it is a backward-looking rate. Last night’s SOFR is published by the New York Fed around 8am Eastern Time the next morning.
One of LIBOR’s benefits was the ability to lock in a known interest rate, usually for the next one or three months. In the early days of SOFR, this was not only impossible, but a difficult problem to solve. Market participants considering SOFR wanted a robust forward-looking rate, and without market participants choosing SOFR, there wouldn’t be enough data to determine an accurate forward-looking rate.
SOFR futures were launched in May, 2018. But it wasn’t until July 2021 that the ARRC recommended CME Group as the administrator of term SOFR rates, which are based on those futures. This was the final piece of the puzzle to allow the full transition to SOFR.
Term SOFR is calculated by determining projected overnight SOFR rates based on futures pricing, and then compounding those rates daily over one, three, six or twelve months. Loan documents will now point to CME’s term SOFR website, where last night’s SOFR is displayed along with today’s term SOFR rates.
Now We’re Stressed Out
As the SOFR market began to ramp up in 2018 and 2019, it traded at the upper limit of the Federal Funds Target Range. On certain days where demand for cash was higher than usual, such as the end of a month or a quarter, SOFR would trade above the Target Range. This issue became recurring, but the difference was typically no more than a few basis points. However, on September 16 and 17, 2019, the combination of the corporate tax due date and increased Treasury issuance caused enough stress in the market that SOFR spiked to 5.25%, a full 3% over the upper limit of 2.25%.
The New York Fed quickly responded to provide additional liquidity to the market by offering its own repo operations, and SOFR traded inside the Target Range again two days later. The extra liquidity remained in place after the markets settled, and these issues did not repeat at the end of December 2019. The SOFR market continued to improve in 2020, the excess liquidity was eventually withdrawn, and SOFR did not breach the upper limit again. Following this intervention, SOFR moved down to trade near the lower limit of the Target Range as the benchmark matured.
Fifteen Years of Transition is Finally Paying Off
With hundreds of trillions of dollars in loans and derivatives priced in LIBOR, it is not surprising that a replacement benchmark interest rate took almost 10 years to identify and another five years to take over. SOFR faced several serious issues along the way, but these were resolved thoughtfully, if not quickly. Borrowers today can have full confidence that their floating rate loans are priced using transparent data from one of the largest and most liquid markets in the world.