Why debate over credit sensitive rates won’t go away…
It’s not a debate being played out around weekend barbeques, and it’s not likely to gain regular billing on 6 o’clock bulletins, but the question of whether finance needs credit sensitive benchmarks is one we’ve looked at many times – and yes, debated.
In my latest blog post I look at a rather obvious pitfall that seems likely to arise if corporate finance doesn’t settle on a credit sensitive lending solution.
Urban Jermann
Urban Jermann is Safra Professor of International Finance and Capital Markets at the Wharton School of the University of Pennsylvania. In December 2021, Professor Jermann released a topical research paper titled: Interest Received by Banks during the Financial Crisis: LIBOR vs Hypothetical SOFR Loans, which was a formal study into the cost to the US banking sector that might have been incurred (interest earnings foregone) had US business loans been indexed to SOFR reference rates (instead of LIBOR) during the two years of the GFC.
Jermann’s work is interesting from several standpoints:
He uses the expression “insurance payout” to describe the credit sensitive component of the lift in LIBOR rates through the GFC, which is both interesting and, in our view, a healthy development since banks may like to consider actuarial approaches in assessing their long run risk to credit sensitivity, and,
He calculates estimates of the “payout” LIBOR lenders received over what they would have had their loan books referenced SOFR in both compound and term formats.
He notes that:
The cumulative additional interest from LIBOR during the crisis is estimated to be between 1% to 2% of the notional amount of outstanding loans, depending on the tenor and type of SOFR rate used.
And the amounts estimated that would have been forgone by banks on loans whose economy-wide balance “may have been as high as $2trln” are meaningful:
U$32.1 billion if loans had instead followed compounded SOFR; and
U$25.0 billion had they instead followed Term SOFR.
It’s important to note, these numbers are the hypothetical reduction in interest income US banks would have borne if loans had been struck against compound or term SOFR, instead of LIBOR between June 2007 and end June 2009, and incorporate the quantum of the following US loan-types:
Syndicated loans;
Corporate business loans (bilateral),Noncorporate business loans;
Corporate Real Estate loans
Professor Jermann obtained his data from the Shared National Credit (SNC) Program for syndicated loans, and the Financial Accounts of the Federal reserve for the other categories.
All of which unearths an important question: does the loss of LIBOR’s insurance-like credit sensitivity reduce banking sector returns if not compensated?
Our answer is probably, but not if average bank funding costs settle below their long run spread to risk-free rates and stay there indefinitely.
Which makes us wonder what kind of numbers Professor Jermann might have found had he chosen to analyse the post-GFC environment since major bank funding mixes been altered so dramatically in the aftermath of the GFC?
We think it’s also interesting to note that the interest foregone by banks would have been worsened under compounded SOFR compared to Term SOFR.
Credit sensitivity since the GFC
The post-GFC numbers are relatively easy to calculate, and while we’re not going to attempt to research the quantum of loans financed through that period, we will use post-GFC USD LIBOR/SOFR OIS spreads to estimate the potential loss in basis points per annum.
We find that mean and median loss of credit sensitivity as follows:
In other words, the average annual loss of credit sensitivity yield since the end of the GFC (June 30th, 2009), was 21.4 basis points (BP) for USD facilities.
Market anecdotes
Our most recent market soundings indicate that in loan markets in the US and elsewhere lenders are:
increasingly moving towards CME (Chicago Mercantile Exchange) Term-SOFR as the basis for new USD deals, in a clear move away from compounding;
that there is no clear consensus on credit adjustment spreads (CAS); and
that lenders appear to be simply adjusting credit margins where they can do so.
By the way, this latter practice results in the same outcome as lenders negotiating a fixed CAS and simply adding this to compound or term SOFR, i.e., analogous with the basic mechanic used in the ISDA (International Swaps and Derivatives Association) Protocol for derivative transitions.
The key point is that lenders who adopt this approach are fixing the credit sensitive component of the facility, and therefore foregoing the potential “insurance payout” of a credit sensitive alternative.
Our point is (and has been) that this practice may prove problematic depending on the extent to which recent credit spreads are reflective of future.
A long-term 3-month LOIS (LIBOR/OIS spread) proxy
To prove the possible problem, we have constructed an indicative 3-month USD LOIS proxy based on an adjusted TED-Spread (3-month USD LIBOR less Treasury Bill yields) going back to 1986.
It supplies an interesting picture of the peaks and valleys of a proxy credit-sensitive rate going back well into the distant years of modern finance.
The long run statistics on the proxy are as follows:
But we think it’s important to consider the historic levels of the proxy across differing periods and differing credit environments to prove how times can change; hence we have broken the data into 5-year periods to give a perspective based on different historic periods:
This approach shows that based on 5-year bucket analysis, banking sector credit was more expensive than the ISDA 3-month spread (26.15 basis points) in all prior periods and has been relatively rarely below the mid-20s.
It also appears somewhat correlated to the general level of interest rates, which makes intuitive sense. This should give those in favour of static CAS pause for thought (a possible topic for a future blog).
AXI has gone live
Which is why we can’t see the credit sensitivity debate disappearing anytime soon.
It’s also why we took a keen interest in the recent official release of Invesco Indexing and SOFR Academy’s Invesco USD Across-the-Curve Credit Spread Indices (AXI):
The AXI and FXI indices are forward-looking credit spread indices designed to work in conjunction with the Secured Overnight Financing Rate (SOFR).
AXI and FXI work to form a credit-sensitive interest rate when used in combination with Term SOFR, Simple Daily SOFR, SOFR compounded in arrears, or SOFR Averages.
AXI is a weighted average of the credit spreads of unsecured bank funding transactions with maturities out to multiple years.
The relevant methodology can be found here.
AXI’s release joins BSBY, and IHS-Markit’s USD Credit Inclusive Term Rate (CRITR) & Spread (CRITS), in the credit sensitive reference-rate stakes.
In conclusion
It’s impossible to accurately predict which mode markets will eventually settle on, fixed estimates, or dynamic credit. Our hunch is that credit sensitive rates will become an economic necessity once the unprecedented recent compression of financial market spreads and interest rates abates.
The use of fixed spreads based on recent LOIS history could be thought to weaken the overall financial system, since it’s hard to see how the lost revenue of Professor Jermann’s “insurance payout” gets made up for in any repeat of GFC-like credit conditions, but we are not forecasters.
There is, though, the possibility that like El-Nino and La-Nina we have recently traversed a period of an unusual credit risk drought in what is a cyclical system. In that case credit sensitivity should be considered of long-run benefit.
If banking serially misprices its own costs, there can be few actual winners.