As changes and deadlines go, the decision to phase out the London Interbank Offered Rate (LIBOR), the primary benchmark for short-term interest rates, is significant for the global and the U.S. consumer finance and mortgage industries. According to the Bank of England, approximately $350 trillion worth of financial derivative contracts, mortgages, bonds, and retail and commercial loans have interest rates tied to the current global benchmark.
Yet, despite the logistical and technological changes it will result in, a four-year deadline for the switch over should be manageable, assuming the lending and servicing sectors can quickly agree on a replacement and get to work on implementation sooner rather than later.
For decades, LIBOR has been the key index for the consumer finance industry in making adjustable rate loans. As many know, a recent scandal demonstrated the index to be susceptible to manipulation, prompting regulators to “sunset” LIBOR. The benchmark rate will no longer receive the backing of regulators and, as a result, the global financial markets now require a new benchmark for setting interest rates.
The Financial Conduct Authority (FCA) is the regulatory agency that is responsible for overseeing LIBOR and publishing the rates. In July, FCA announced its recommendation to set an expiration date for LIBOR, effectively putting the public on notice that the FCA was stepping away from its oversight of LIBOR. It set 2021 as the deadline in an effort to give U.S. financial markets sufficient time, four and a half years, to adopt a new benchmark.
In the U.S., the Federal Reserve has identified the Alternative Reference Rate Committee (AARC) as the group responsible for the transition from the U.S. Dollar LIBOR to a new rate index. ARRC has proposed that the replacement rate in the U.S. be a new index known as the Broad Treasury Financing Rate (BTFR). BTFR is a Treasuries’ repo rate (non-currency based rate like LIBOR). It will reflect the cost of overnight loans secured against U.S. Treasuries. The Federal Reserve Bank of New York is the entity proposed to publish BTFR, along with the Treasury Department’s Office of Financial Research (OFR). ARRC expects BTFR to be ready in early 2018.
Economists may choose to debate whether the overnight rates of BTFR, or iterations of BTFR based on similar maturity expectations, will be as predictable and stable as the term structure of LIBOR that carries a similar, if not the same maturity. What isn’t debatable, however, is the impact this new benchmark rate will have upon mortgage lending and servicing and upon tech providers.
Originators presumably will determine the BTFR implementation schedule and logistics once industry standards and customs leaders, such as FHFA and the FHLBs, conclude BTFR is acceptable and has been adopted as a benchmark for rate setting. The challenge will be for the technology managers and third-party providers of the loan origination systems and loan servicing systems.
Perhaps the greatest uncertainty, and risk, will be in assessing whether a comparable replacement index can be unilaterally changed, for an existing contractual obligation, by the note holder.
In the event that the chosen comparable replacement index proves to be more volatile than LIBOR, this could open up the lender to liability. Consumers would claim that they agreed to the loan based upon a less volatile index, seeking damages based on increased costs that flow from the decision to replace LIBOR with a more volatile index.
NEW ORIGINATIONS
For new originations to be delivered to Fannie Mae and Freddie Mac, the impact will not be as overwhelming. Most product and pricing engines (PPEs) already provide for LIBOR-alternative products.
For example, the most popular ARM products (10/1, 7/1 and 5/1 ARMs) qualify as a Fannie Mae Standard ARM under either the 1-Yr Wall Street Journal LIBOR or the 1-Yr Weekly Constant Maturity Treasury (CMT) Index. Fannie Mae will likely review historical performance data, among other performance metrics, for BTFR before it adopts it as a replacement benchmark index for the 1-Yr WSJ LIBOR, and only permit the use of the 1-Yr Weekly CMT until it can affirm the new benchmark’s stability.
For LOSs that have built in PPEs, the impact will be minimal to adjust to another fully vetted index. For LOSs that only use LIBOR, there will have to be a shift to another comparable, commercially accepted index. This will require them, first, to fully test the ability to print the appropriate index onto the notes, and then to accurately pull historical values based upon the disclosed note look-back period to accurately calculate the fully indexed rate for use in the Truth in Lending Act loan estimate and closing disclosures.
EXISTING MORTGAGES
But what about ARM Loans that have been originated referencing LIBOR prior to the 2021 cut off? In the event that the mortgage uses a Fannie Mae/Freddie Mac Multistate Adjustable Rate Note WSJ One- Year LIBOR, Uniform Instrument, Section 4(B) provides that “[i]f the Index is no longer available, the Note Holder will choose a new index that is based upon comparable information” and “[t]he Note Holder will give me notice of this choice.”
This begs the question of comparability. Is BTFR comparable to LIBOR? Or is the 1-Yr WSJ LIBOR more comparable to the 1-YR CMT, or the 11th District COFI, the 6-Month Treasury Bill or the 6-Month Certificate of Deposit?
The determination of the index is ordinarily based upon the lender’s desire to match the cost of lending to its cost of funds. So, to determine a viable replacement, the Note Holder will have to determine which index is comparable to its supporting obligations. As noted above, a prudent lender should also take into consideration the lack of volatility that the consumer may have relied upon in entering into the obligation.
Servicers will have the obligation to replace LIBOR with the new comparable index for assessment of future payment adjustments, as determined by the Note Holder. Moreover, servicers will have to ensure that, if they are going to use BTFR, the payments will be calculated accurately and disclosed in a timely manner according to the contractual notice of change obligations. Presumably, notice of change of the index could occur concurrently with the notice of an interest rate change.
The shift away from LIBOR in the U.S., as it applies to consumer finance, will require attention by all interested parties in the lifecycle of the asset. The manufacturing and the servicing of these assets will require the most attention. The industry must also determine if BTFR is sufficiently comparable, or if an existing index is a more appropriate alternative replacing LIBOR as the industry standard and benchmark.
Probably the biggest risks in shifting away from LIBOR involve TILA disclosures, and errors in reset calculations by servicers. These could create new liabilities, exposure to lawsuits and result in regulatory enforcement. But the good news is, as an industry, we have four and a half years to get this right.
