Libor leaders: Webster Bank aims to clear big SOFR hurdles

Small Connecticut-based lender is focusing on client education and fallbacks

The bank intends to draw on support from industry groups, external lawyers and bigger dealers

This article is part of a Risk.net series on the practical aspects of Libor transition. Find the rest of the coverage here.

In Hartford, Connecticut, when it rains, it poos. And no, that’s not a typo.

Any time more than a quarter-inch of rain falls on Hartford and its neighbouring towns, it overwhelms the area’s antique sewer system – waste floods into basements and streets, as well as local rivers and streams. In total, this happens about 50 times a year, saturating the area with around one billion gallons of untreated sewage and rainwater.

A $2.5 billion overhaul of the system is now in its third phase, overseen by Hartford’s Metropolitan District Commission, and for at least one of the commission’s board members, Denise Hall, it could prove an instructive experience. 

Having piloted this huge and costly plumbing refit in her volunteer role at the MDC, Hall now faces something similar in her day job as a derivatives salesperson at Webster Bank, a local lender. Like every other interest rate market participant, Webster and its clients will be affected by plans to retire the market’s Libor family of interest rate benchmarks in the cause of health and hygiene. So, the $27 billion-asset bank is now preparing for its own public works project.

“I’ve been in banking since the early 1990s, and there’s no standing still in this industry. Every time you turn around, there is another hurdle to clear – and I don’t think everyone has yet digested how big this one could be,” says Hall, a senior vice-president of treasury sales with Webster at its Hartford headquarters. “People are saying: ‘Well, OK – we’re going to have to switch rates,’ but you don’t know whether that replacement rate will preserve the economics of your transaction, so what do you do?”

This is the question now being asked by the bank’s clients. Most of her swap clients are floating rate borrowers that want to fix their repayments, so as new loans and swaps are documented, Hall has been making them aware the Libor-based rate in their contracts could stop being published at some point after the end of 2021. She tells them the likely successor for US dollar contracts is the brand-new secured overnight financing rate (SOFR) – and, as an overnight rate derived from repo trading, it differs from Libor in some important respects – but the conversation pretty quickly gets down to brass tacks.

Many of our clients will only have done three or four smaller-size swaps, and while the big banks may also do those trades, they don’t have a team locally who will walk the clients through it and get them comfortable

Denise Hall, Webster Bank

“It goes like this: ‘OK, let’s say we do this transaction and we’re using Libor in the loan and Libor in the swap, and it runs past 2021, and in the meantime Libor is supposed to go away – how do I know I get a perfect hedge?’ That’s their main concern. They don’t really care what we call the thing – they just want to know they’re going to end up with the same fixed rate,” says Hall.

At the moment, it’s impossible to say how those hedges will be preserved. Working groups for each product set are currently drawing up proposals that will determine how bonds, derivatives, loans and securitisations behave when Libor dies – and, in the case of swaps, drawing up a protocol that would allow signatories to convert trades to a new rate en masse, before the end of 2021, assuming the parties on both sides of the book agree.

Creeping doubts

If these plans match up across the product sets, then it may be possible to ensure that – for example – a loan and its accompanying swap switch to the same replacement rate, at the same time, and that the economics of the original trades are preserved. But differences are already creeping in – for example, US syndicated loans will switch to a forward-looking SOFR rate known at the start of a given period, while swaps will move to a backward-looking rate only known as the end of the period.

As an onlooker, Webster can only tell its clients not to fret.

“We’ll tell them there is some uncertainty, that a replacement rate has been identified but that it’s not an exact match for the rate we’re currently using – that it’s overnight instead of a one-month or three-month rate, it’s secured instead of unsecured – so there will have to be a way to preserve the spread we agreed at the time we did the original transactions. They have our commitment that we’re going to make this work for them, however it comes out,” says Hall. 

Denise Hall, Webster Bank

For banks like Webster – and their customers – huge, grey clouds of doubt hang over key elements of their business, while the debate about how to blow away those clouds takes place in New York, London, Frankfurt and Tokyo.

The bank traces its history back to 1935, when Harold Webster Smith founded the First Federal Savings and Loan in Waterbury, Connecticut using money borrowed from family and friends. Today, it has $27 billion in assets and around 3,400 employees, but still talks up its community roots and values.

Its swaps customers range from small businesses to commercial real estate developers and major corporates – Webster participates in the syndicated loan market to support the bigger borrowers in its region – and the swaps range in size from half a million dollars to $100 million or more. Maturities can go out as far as 20 years – the bank executed “four or five” such trades last year, Hall says.

In all, the bank has around $8 billion notional of customer-related swaps – counting both the client-facing leg and the dealer-facing hedges – of which about 45% will mature before the end of 2021. Webster will consider moving the rest of the book away from Libor prior to the rate’s death, Hall says – it’s keenly awaiting the release of a protocol from the International Swaps and Derivatives Association that will enable the entirety of a bilateral portfolio to be transitioned to a replacement rate if signed by both counterparties.

Loan fallbacks 

There is no equivalent solution for the loan book, however, meaning each loan would need to be renegotiated separately. 

These disparate loan contracts pose a problem for any bank that wants to understand its exposure to Libor. Each deal contains some kind of fallback rate that would be used should Libor ever stop being published, but the remedies are diverse and were typically agreed as a stopgap – envisaging a brief, technical hiatus in Libor’s publication – rather than to cover the benchmark’s death.

“It’s easy to say: ‘Here are all our Libor-based loans.’ The trick is making sure you know what’s in every loan document, too – because you could have one that says if Libor ends then we revert to the Prime rate, and you could have another that falls back to something entirely different. So you need to know what will happen in every single case,” says Hall.

On June 4, the Prime rate was around 300 basis points higher than the three-month US dollar Libor rate.

To stop digging this hole, Webster Bank’s lawyers have already drawn up uniform fallback language that is being included in all new loans. 

The first thing we wanted to do was ensure new loans include better fallbacks

Denise Hall, Webster Bank

“The first thing we wanted to do was ensure new loans include better fallbacks,” she says.

“Most Libor fallback language only contemplated the rate being unavailable for a short time period, not being eliminated altogether. New fallback language needs to address a number of key points: the discontinuation of Libor being published; Libor ceasing to be representative of our cost to make the loan; specific events that would trigger the fallback; and the identification of a specific replacement rate, including any adjustment to the spread, that will maintain the economics of the deal for the bank.”

For now, this is as far as Webster’s preparations have gone – educating clients about the change, and standardising fallbacks in new loans. In total, Hall estimates no more than two dozen of the bank’s staff have currently been involved in benchmark reform work. But that number is set to climb.

In addition to the work already being done by the bank’s in-house and external lawyers, Hall expects the transition work to fall heavily on the bank’s treasury and loan operations group, as well as a project management team. In the former, portfolio managers will have the job of working out how much Libor exposure is in Webster’s loan and securities books, while the asset/liability management team will model the effect of switching to a new reference rate. 

The loan operations group, meanwhile, will have to “make sure they are ready to modify the rates on all existing loans that reference Libor; make sure they understand the new index and how it works,” she says.

Support network

To support these efforts, Hall says Webster will have to engage in a “huge training effort” for everyone using the bank’s systems to book or manage interest rate products and risks.  

This kind of multi-pronged, multi-year project isn’t easy for a smaller bank, so Webster will draw on support where it can – from industry groups, external lawyers and bigger dealers. 

Hall also expects the bank to lean on its peers, as it did during a radical overhaul of derivatives regulation in the years that followed the financial crisis.

“With the Dodd-Frank Act, we set up what was almost a support group with around 10 other regional banks of our size. We’d get on the phone once a month and find out how the others were interpreting the text, or tackling the issues it raised. We really had to rely on each other, and I’m thinking we may need to do the same for Libor transition,” she says. 

With the Dodd-Frank Act, we set up what was almost a support group with around 10 other regional banks of our size

Denise Hall, Webster Bank

Ultimately, though, while these kinds of networks may help Webster test and amend its roadmap, the bank’s clients are its own – no-one else can help here – and Hall feels the responsibility keenly.

“Many of our clients will only have done three or four smaller-size swaps, and while the big banks may also do those trades, they don’t have a team locally who will walk the clients through it and get them comfortable. I see that as our job, and one of the benefits of working with a local regional bank” she says. 

It’s a job that puts Hall and Webster on the front line of the effort to replace Libor. Now, they’re just waiting for the information they need in that fight, including evidence they can use to reassure their customers. 

“Everyone is going to be looking at the extent to which SOFR is being utilised. We need to prove it’s really a good index to use, and be able to tell people that we’ve somehow solved the issues with the credit and term differences,” she says.