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Residential Department: BackSpace: January 2018

 

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The death of LIBOR is imminent

The death knell has been ringing for LIBOR, the London Interbank Offered Rate, for years, but a termination date may have finally been set. This benchmark cost-of-funds rate is used by large banks throughout the world for calculating interest rates on loans, bonds, derivatives and securities.

It is estimated that $160 trillion in financial notes worldwide reference LIBOR. About $1.5 trillion of these notes are for U.S. adjustable rate mortgages (ARMs). LIBOR is used as the benchmark for making adjustments to these rates after any fixed-rate period ends. As of the end of 2021, however, LIBOR may no longer be a usable benchmark rate for financial instruments, including ARMs.

The downfall of LIBOR began during the financial crisis 10 years ago, when employees at a few banks attempted to manipulate the LIBOR rate by altering their quoted data. Although the perpetrators were caught, this manipulation brought to light several problems with LIBOR: It is based on too few transactions to be a reliable benchmark, and it often relies on expert judgment instead of actual trading data, so is easily manipulated.

Today, only 17 banks submit quotes in support of the dollar LIBOR, and these quotes are based on $1 billion or less in daily trading — for a benchmark linked to more than $100 trillion in outstanding U.S. contracts. Worse yet, many of these banks wish to discontinue submitting LIBOR quotes, but have agreed to continue supporting the benchmark until the end of 2021 to give monetary authorities a chance to find equitable replacements.

Enter SOFR

This past November, the Alternative Reference Rates Committee (ARRC), which has been tasked by the Federal Reserve with finding a U.S. dollar replacement for LIBOR, announced that a new benchmark index, called the Secured Overnight Financing Rate, or SOFR, has been chosen to replace LIBOR. The committee also set out a transition plan for implementing the new benchmark rate by the end of 2021.

SOFR is based on the overnight Treasury repo-rate (the rate at which a central bank lends money to commercial banks via securities transactions). At its foundation is data from more than $700 billion worth of daily transactions. These transactions include general collateral finance (GCF) repo-rate data and bilateral repo-rate data cleared by the Fixed Income Clearing Corp. (FICC). The data on these transactions will be trimmed to attempt to exclude special transactions (those motivated by a desire to acquire specific Treasury issues, instead of a general desire to adjust cash holdings).

You basically have a totally untested new index, and those are always dangerous because you don’t really know how they behave. 
Claus Lund, Financial services adviser
Lund Consulting 

Frank Nothaft, chief economist for CoreLogic, believes SOFR will work well as a replacement for LIBOR, although he admits the new benchmark index hasn’t been used yet. “What you want to have with an index,” says Nothaft, “is something that is market based — based on actual transactions in the marketplace — and an index that is easily accessible, widely accessed, and has some transparency behind it.”

Jason Obradovich, executive vice president of capital markets at New American Funding, also believes that SOFR will be a good proxy for LIBOR. “You are kind of backdooring into effectively what LIBOR was trying to accomplish,” says Obradovich, who likes the methodology being used. “SOFR is based on transactional data and LIBOR was a survey, so already I think the SOFR index has more meat behind it.”

SOFR concerns

Obradovich says he hasn’t seen any weaknesses in SOFR, but he believes there may need to be some “little nuances” worked out on the chosen transactions before its stability as a broad market benchmark can be determined. Claus Lund, a financial services adviser with Lund Consulting who has written about ARMs, is concerned that SOFR won’t be robust enough to be reliable by 2021 because of a lack of historical data.

“You basically have a totally untested new index, and those are always dangerous because you don’t really know how they behave,” Lund says. The infrastructure for publishing the daily SOFR rate should be in place by the middle of 2018, and ARRC anticipates that trading referencing SOFR will begin by the end of 2018. This will provide three years of data by the time LIBOR may no longer be viable.

The big issue, according to Lund, will be determining the spread between the two indices. “If you are supposed to pay LIBOR plus 2.75, you can’t just say now it’s going to be SOFR plus 2.75 if there is a fundamental difference between the two indices,” Lund says.

Another issue with SOFR is that it is a spot index — based on overnight transactions — that will need to be turned into a term index for loan contracts. The ARRC transition plan does include steps for creating this term index, but that plan requires several years of SOFR-based trading to develop a vibrant derivatives market. ARRC anticipates the term rate to be ready by the end of 2021 — the same time that LIBOR may no longer be viable.

Lund hopes that LIBOR can continue for a few years after 2021 to both give the Fed more time to collect historical data on SOFR and for mortgages that reference LIBOR to fall off the books, which will ease the transition to a new index.

Whether LIBOR continues much past the end of 2021 or not, mortgage bankers and originators will want to be proactive and transition to the new benchmark early. “I think if they were smart, they would push to use it sooner versus later,” Obradovich says.

Lund agrees, saying this about the impending 2021 deadline. “I think any mortgage banker will see that as an opportunity to go out and try to refi those mortgages,” he says.

Lund even provides a sound sales pitch based on concerns that SOFR may track higher than LIBOR: “You don’t want to live with that uncertainty. Refi now, and you will have certainty.”


 

Will McDermott is managing editor for Ask a Lender. Reach him at willm@scotsmanguide.com or (800) 297-6061.

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