LIBOR And SOFR: Buy-Side, Take Over

Summary

• Why is it so hard to find a three-month interest rate to replace the fallen LIBOR?
• The problem results from a sea change in the sources of funds supporting commercial term borrowing.
• Forced by circumstance to replace LIBOR, the Fed fell back on SOFR, a measure of overnight secured borrowing.
• The Fed is the wrong group to find a rate for unsecured commercial credit.
• It's the buy-side that has a dog in this fight.

Put yourself first, girl. Worry ‘bout yourself."

- Crazy Ex-Girlfriend Cast

Never have so many borrowers made such a simple request of the global financial system, only to be told they are asking the impossible. How is it that a simple, fundamental-to-lending, act - providing borrowers with an index that measures the cost of unsecured credit to finance a three-month loan – became too much for our financial system? Why is it that an army of quants, the cream of our global system of higher education for decades, steeped in mathematical and computer training, cannot devise a way for banks to price three-month money?

The reason is simple. There is no such thing as a single cost of short-term unsecured money at present. What the world had with LIBOR was a markup on the cost of money to the average megabank. LIBOR was killed in two strokes.

• First, the banking system is no longer the primary source of commercial loan finance.
• Second, the buy-side has not stepped up to deal with the problem. The need for a single cost of wholesale term debt is, after all, a need of the buy-side. The sell-side is predictably more concerned since the Crisis with defending its own tenuous survival.

The reason no bank-sourced interest rate meets the buy-side need is that each bank’s cost of money is unique. Each bank pays a different rate as changing financial conditions impact each bank differently. When the 18 banks that provide LIBOR submissions (guesses) today were truly 18 global-scale financial institutions, and when individual large banks were less vulnerable, the world could get away with averaging three-month rates from 18 different, but like, sources. But the realities have changed. Most of these banks are now global wannabes. The number of for-real global wholesale dealer banks is closer to four. Too few.

Perhaps the LIBOR impasse is based upon a false assumption. To wit, is it true that only banks can produce a market-priced source of funds for pricing to commercial borrowers? The answer is no. Our financial system has long since ended its direct dependence on banks for the production of funding. As the chart shows, more than twice as much credit now comes from non-banks as that provided by banks.

SOFR (the Fed’s Secured Overnight Funding Rate) is the first, tentative, step in the logical pursuit of a LIBOR replacement. It and its repo-related cousins have replaced unsecured bank debt as the largest source of dollar funding. But for a genuine, reliable, global-scale, source of money, that reflects the risks of commercial lending, we must look somewhere other than repo-related rates like SOFR. These collateral-based sources of funds vanish in periods of financial stress. Collateral is like your ex-significant other. She/he looks good again when the pool of new collateral dries up. Suddenly in times of financial duress, collateralized borrowers find themselves in danger of being left out of the conga line of many borrowers latched onto one piece of safe paper.

Today’s megabanks are large, and, admittedly, a lot alike. Perhaps too alike, when all is said and done, for their own good. But unless the megabanks are nationalized (God forbid) they still are too dissimilar and too few to be a single source of funds backing $200 trillion in loans, on one hand, and to be the source of a single market-driven derivatives price, on the other. The LIBOR replacement must be sufficiently sensitive to market conditions to price more than $400 trillion in interest rate derivatives. SOFR, with its ties to Treasury rates, is insensitive to the risks faced by commercial borrowers who cannot rely on taxpayer bail-outs.

Is SOFR our only choice?

It is easy to understand how the trend from bank financing to financing by non-bank financial institutions led regulators to pick SOFR. SOFR prices repo, now the globe’s most monolithic pot of dollars. Moreover, by all accounts, repo is the primary source of funding for the growing, nonbank source of lending funds. Among the existing short-term rates, it’s the only choice that comes close to meeting the two global objectives: a broad, representative cost of funding; a market-transaction-priced instrument. So, if the government is going to replace LIBOR, sadly, it will be with SOFR. SOFR is government’s only alternative.

But SOFR doesn’t work

And therefore, the dollar borrowers of the world need to focus. If SOFR is the choice, these borrowers will pay dearly. In a world where the buy-side accesses its money from a non-government source, financial institutions, these borrowers will pay a steep price if they rely on the government’s cost of money to determine their own.

The 2007-2008 Financial Crisis was a horrific global preview of the consequences of depending on repo-based funding when the financial system becomes vulnerable to risk. Repo funding drove the entire American financial system into the foster care of the federal government. The system eventually got back on its own two feet – with the very instructive exception of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). But why were Fannie and Freddie left behind? They were permanently committed to raising money at Treasury-subsidized rates. SOFR will lead the rest of corporate wholesale finance into the same trap.

It is tempting to think that we have nothing to fear from reliance on government-based funding, now that the crisis is passed. Isn’t the difference between the cost of commercial debt and government debt sufficiently stable in normal times? Like, for example, now?

The answer is a ringing no. As recently as the beginning of March, the LIBOR-OIS spread expanded rapidly from less than 20 basis points to almost 60 basis points. The OIS (Overnight Index Swap), kin to SOFR, is basically a vague attempt to capture the near-term direction of short-term, Treasury-related rates. Thus, the LIBOR-OIS spread provides an idea of how far a Treasury-based overnight rate like SOFR would stray from the cost of commercial lending at the kind of magnitude LIBOR has been used.

Will the buy-side step up?

There is no existing LIBOR replacement that will serve the indexing needs of the buy-side. And the sell-side is neither positioned nor disposed to help. Passivity, the buy-side weakness, must be overcome. Moreover, a single buy-side institution cannot solve this problem alone. The task is to create a commercial short-term (1-, 3-, 6-month) instrument with sufficient volume traded to reliably produce a market yield that could serve as an index for loans, futures, and swaps. How do financial institutions act collectively? Once upon a time, it was through self-regulatory institutions – the stock exchanges.

But the mutually held exchanges of days gone by are no more. They have been replaced by profit-driven exchange management firms. And these firms have, through SEC protection, become parasitic, reactionary entities. They no longer serve customers, but use them.

But a mutually-held membership exchange, the good-old way of gathering traders together to meet their common interests, would afford the buy-side the answer to Archimedes’ request, “Give me a lever and a place to stand and I will move the earth.” The buy-side needs a place to stand; a platform, a clearinghouse, and other accouterments required to take on the challenge of designing, listing, clearing, and housing short-term, high-volume, instruments that would generate the short-term rates that are missing right now.

A financial instrument that meets the needs of the buy-side, [call it UNICOM (the Unit Cost of Money)] would not represent a single corporate name, but the average interest cost of a portfolio of high-quality unsecured commercial debt. Market-representative prices of traded instruments like this exist in the markets for common stock, and to a degree in the market for Treasuries, but LIBOR no longer fills the bill in the market for term unsecured debt.

The current LIBOR market suggests that once an appropriate marketplace is established, the creation of a large quantity of the short-term instruments themselves may be of secondary importance. Consider the amazing LIBOR futures market! Despite the fact that the head of the UK Financial Conduct Authority, Andrew Bailey, has noted that LIBOR itself is based on actual transactions that number as few as three in a week; Eurodollar futures – purportedly a market trading forecasts of the nearly-invisible spot LIBOR – trade an average volume of $4 trillion each day.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Kurt Dew]

And quickly getting crowded. http://bit.ly/2GTtERH

[Donald van Deventer]

Great read, Kurt. It's a whole new ballgame.

[JANFA]

So what will happed to fix-to-float preferred whose dividend rate is tied to LIBOR?

[Kurt Dew]

As with everything else tied to LIBOR, it will still be based on LIBOR.