Transition away from LIBOR

It’s official: Regulators are retiring LIBOR by the end of 2021. Though the transition away from LIBOR to Secured Overnight Financing Rate (SOFR) is trudging along, government agencies are digging in their spurs to encourage the commercial real estate industry to pick up the pace for updating contract language involving interest and fallback rates.

The complete transition away from LIBOR is still more than 18-months out. But recent moves by government agencies are aimed at getting industry players to stop procrastinating when it comes to executing plans to transition to the Secured Overnight Financing Rate (SOFR) as the new benchmark rate on short-term floating rate debt. 

LIBOR has been the standard across global financial markets in pricing variable-rate loans, derivatives and other financial instruments for more than three decades. It’s estimated that more than $300 trillion in financial contracts worldwide, including commercial and residential mortgages, are supported by LIBOR. The benchmark came under fire after a massive rate manipulation scheme was uncovered in 2012 involving some of the top banks in Britain. The U.K.’s Financial Conduct Authority announced in 2017 that it would phase out LIBOR and plan for a transition to “alternative benchmarks” by the end of 2021.  

In the U.S., the Federal Reserve and the Alternative Reference Rates Committee (ARRC) have been working to develop SOFR and implement an orderly transition to US Dollar LIBOR’s successor rate. Although affected firms and financial institutions are putting plans in place, many are also keeping a close eye on what action regulatory agencies and other industry groups take before moving forward. Some of the latest developments to emerge in February include key moves by the Federal Reserve Bank of New York and the Federal Housing Finance Agency (FHFA). 

New York Fed to Publish SOFR Data 

The Federal Reserve Bank of New York, the official administrator of SOFR, has announced that it will begin publishing 30-, 90- and 180-day SOFR Averages, as well as a new SOFR Index on March 2nd. The published data, which will be released in cooperation with the Treasury Department’s Office of Financial Research, is aimed at supporting the transition away from LIBOR.

The decision to publish SOFR Averages is partly due to a response from public comments that showed a desire to be able to quickly access a set of averages that can be referenced by the public. The SOFR Averages and Index will employ daily compounding on business days. Simple interest will apply to any day that is not a business day. At a rate of interest equal to the SOFR value for the preceding business day. Shortly after the March 2 initial launch, the New York Fed also plans to publish an update to the indicative series of data of the SOFR Averages and Index from April 2, 2018 through March 2, 2020.  

GSEs Set End Date on Purchasing LIBOR-backed Loans 

The Federal Housing Finance Agency (FHFA) announced in February that Fannie Mae and Freddie Mac will stop purchasing adjustable-rate mortgages (ARMs) tied to LIBOR at the end of 2020.

According to a statement from Moody’s, Fannie & Freddie’s move away from LIBOR-based ARMs in the short term is a positive for the broader securitization market, because it will encourage market participants across various asset classes to speed up their transition away from LIBOR.

However, Moody’s also noted that Fannie and Freddie have a limited direct effect as the rated securitizations issued by the GSEs in recent years rarely include floating-rate loans. But the two companies indirectly influence floating-rate loans in other ways, such as guaranteeing unrated pass-through agency mortgage securities. So, moving away from LIBOR will help deals avoid certain cash flow risks.

More Work Ahead 

Players across capital markets will continue to prepare for the transition to LIBOR in 2020 and 2021.

The Mortgage Bankers Association (MBA) noted in its June 2019 survey on LIBOR preparedness that the industry is beginning the transition. But the “devil is in the details”. Key results from the survey showed some forward progress.  

  • 92% have begun planning
  • 77% have adjusted fallback language in new loan documents
  • 56% think they are “right on track”

However, it’s clear some heavy lifting still needs to be done before LIBOR goes away.

  • Although 41% say they anticipate using SOFR, 44% said they didn’t know
  • Less than one-third (32%) said they will use an alternative prior to the cessation of LIBOR
  • 85% anticipate making adjustments to fallback language in the future, and yet only one-third said they have a formal plan for making those adjustments

Some industry experts have pointed out obstacles in the past regarding a smooth transition, mainly differences in how LIBOR and SOFR are calculated.

Effectively, LIBOR is quoted at several forward-looking maturities, e.g. 1-month and 3-month terms, while SOFR is an overnight rate. In order to allow SOFR to be applied for periods longer than one day, ARRC is planning to produce “forward-looking” SOFR term rates that are comparable to existing US Dollar LIBOR rates. It remains unclear whether SOFR will behave differently from LIBOR in periods of severe credit stress or market fluctuations.

The main focus for the commercial real estate industry is to continue to review and revise contract language related to interest rate provisions and acceptable fallback rates.