The Coming Shift From LIBOR

Mortgage lenders are experts at dealing with change. It’s one of the few constants in the mortgage industry, and leaders here are very good at change management. This is more impressive when you consider that they don’t actually drive the vast majority of changes that impact their businesses.

The coming shift from LIBOR is a good example.

For decades, many loans in the U.S., including adjustable-rate mortgages, have been tied to the London InterBank Offered Rate (LIBOR). The benchmark was created in 1968 by a Greek banker, Minos Zombanakis, who needed a way to lend large quantities of U.S. dollars to countries that wanted to avoid the rigors of American financial regulation.

Over the next five decades, LIBOR would help set interest rates on more than $300 trillion in financial products. However, since LIBOR is calculated from banks’ daily quotes of borrowing costs, banks were able to manipulate the rates through lying in the surveys. After long use, the benchmark fell out of favor in the 2010s when it became clear that some U.K. banks were doing just that – reporting erroneous data to manipulate the benchmark and inflate interest rates.

After years of working on a better solution, the Federal Reserve will replace LIBOR as the primary index for interest rates in 2022. Since LIBOR has served as a foundational interest rate product for so many decades, lenders are already beginning to prepare for their transition to new processes.

A better solution for variable interest rate products

In 2014 the Federal Reserve, working with the New York Fed, created the Alternative Reference Rates Committee (ARRC) to find a better solution than relying on LIBOR. A few years later, they settled on the Secured Overnight Financing Rate (SOFR) as the recommended replacement.

SOFR is a benchmark rate for dollar-denominated derivatives and loans based on transactions in the Treasury repurchase market. Instead of the estimated borrowing rates that LIBOR was based on, SOFR is based on actual data from observable transactions.

The Federal Reserve Bank of New York began publishing the benchmark rate in April 2018 specifically to replace LIBOR. By October 2020, interest rate swaps on more than $80 trillion in notional debt switched to SOFR.

While LIBOR was based on anticipated borrower rates over some future period (such as the one-year LIBOR typically used on mortgage loans), SOFR is an overnight rate that is backward looking. This makes SOFR more accurate than LIBOR, which should serve to reduce lender risk.

But in the short term, it will cause some volatility because a switch directly from LIBOR to SOFR would result in a lower interest rate. An adjustment spread will be needed to ensure compatibility. But that’s just one of the pieces that must fall into place for a smooth transition.

Preparing to do business with SOFR

The biggest change for lenders will involve loan contracts, for both new and existing mortgage loans. Any contract for a loan that is expected to extend beyond the end of 2021 and require a benchmark interest rate should not include LIBOR.

Ultimately, 35 different LIBOR rates are calculated and reported each day. These will not be acceptable as benchmarks in the United States next year. At the very least, all new contracts should have fallback language in case the LIBOR no longer exists. Lenders should instead build SOFR into new contracts for adjustable-rate loans, because at this point it is unlikely that an adjustable-rate mortgage originated today will refinance into a new product before LIBOR sunsets.

Some lenders have waited to act until all the questions about the shift have been answered. For instance, AARC is still working on a forward-looking term rate for SOFR, which it hopes to publish by the end of the year. That may be a better tool for setting some interest rates, but regulators have made it quite clear that LIBOR is over and that unanswered questions are not an excuse for not preparing for the shift.

Last November officials from the Federal Reserve Board, the FDIC and the OCC told banks to stop using LIBOR by the end of 2021, stating that continuing to use the benchmark “would create safety and soundness risks” which would lead them to “examine bank practices accordingly.”

What this means for existing mortgage contracts

Lenders can simply stop writing LIBOR into their contracts for new mortgages and easily meet the end-of-year deadline. Things are somewhat more complicated for existing loans and may require lenders to discuss these contracts with counsel to determine the institution’s risk exposure when LIBOR is retired at year’s end.

Legacy contracts will only have until the end of the second quarter 2023 before regulators expect LIBOR to have disruptions. The hope is that most existing contracts will mature by then, but the term on most adjustable-rate mortgages is much longer than that on consumer loans.

Lenders could just amend their existing LIBOR loans, but that also entails cost and risk. First, there are a lot of these loans out there. It’s estimated that there are between $1.3 trillion and $5 trillion in consumer loans based on this benchmark. Not all of them are mortgages, but about half of the JUMBO mortgages written for over $1 million are based on LIBOR.

Second, and potentially more troubling, is that consumers might push back against loan modifications they do not fully understand.

As with all change management, preparation is the key. Three steps lenders can take right now are:

1.) Make sure your current mortgage servicing software can support the shift to a new benchmark. Your servicing software should be able to:

>>Seamlessly integrate the new rate codes for the various SOFR products.

>>Utilize an adjustment spread if necessary.

>>Easily modify legacy loans to SOFR specifications.

>>Ensure that interest rate adjustments can be determined using both LIBOR and the new SOFR products.

>>Modify third-party reporting with the new SOFR products.

2.) Create a program to educate your staff so they have answers to borrower questions, and

3.) Talk to your legal counsel about creating a plan for existing contracts.

Lenders should work with their mortgage software partners, since most of these companies have been studying and preparing for this shift for some time now. Now is the time to ensure that no loans are left exposed to unnecessary risk when LIBOR sunsets at the end of the year.