The London Interbank Offered Rate, which many short-term mortgages are tied to, will be phased out at the end of 2021, and some think the Federal Reserve Bank of New York’s Secured Overnight Finance Rate may have the best bet of becoming its replacement.
But SOFR is an overnight rate, and therefore much more volatile than LIBOR, leading experts to think a new, forward-looking SOFR would be the best replacement.
LIBOR, dubbed the world’s most important number, is a scandal-plagued benchmark that undergirds about $350 trillion in loans. LIBOR is a common benchmark for determining short-term interest rates. Adjustable rate mortgages, for example, are often linked to LIBOR.
When borrowers take out on ARM on their home, they lock in a lower interest rate for a set period of time, typically about five years. After that, the interest rate will fluctuate depending on an index like LIBOR.
HousingWire Magazine’s February cover story details the challenges with LIBOR, and what its end will mean for mortgage servicers. Click here to read more about that [subscription required].
Now, as the end of LIBOR draws near, the Alternative Reference Rates Committee, convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York, is seeking to find the best replacement.
ARRC includes several key industry players to find its replacement, including the government sponsored enterprises Fannie Mae and Freddie Mac.
In fact, the Federal Housing Finance Agency revealed that one of the targets for the GSEs in 2019 will be to find a replacement for LIBOR as its end nears. The FHFA released the information in the GSEs’ 2019 Scorecards. These Scorecards tell Fannie and Freddie what the FHFA expects of them each year, and what they will be graded on.
Freddie Mac CEO Donald Layton explained in an interview with HousingWire that find LIBOR’s replacement is a work in progress, but there is a lot work still to be done.
The Structured Finance Industry Group explained why a forward-looking term SOFR could be the best option in a response to ARRC.
“SFIG strongly supports the use of a forward-looking term SOFR in the event of a transition away from LIBOR, as modified to reflect the difference between the SOFR risk-free rate and the credit component included in LIBOR. We think that such a rate would provide for as smooth of a transition away from LIBOR as possible,” SFIG stated in a letter to AARC.
From the letter:
A forward-looking term SOFR would be based on market expectations of SOFR over an upcoming accrual period, and would be available at the beginning of the accrual period. For cash markets generally, such a rate is superior to a daily compounded SOFR either set in advance (which would reflect actual funding costs over the preceding accrual period on a lookback basis), or in arrears (which would not be known until the end of the future accrual period).
Although forward-looking term SOFR does not exist today, it is anticipated that such rates will be available ahead of LIBOR cessation, and that these rates will be based on market transactions in derivatives contracts and futures trading that will reference SOFR.