Recommendations will assist lenders in preparing adjustable-rate mortgages for the transition from LIBOR to SOFR.
December 2019 - As it continues its preparation for the expected phase-out of the London Interbank Offered Rate (LIBOR) at the end of 2021, the Alternative Reference Rates Committee (ARRC) recently released recommendations on contract fallback language to be used for new closed-end residential adjustable-rate mortgages (ARMs).
For lenders that continue to enter into LIBOR-based ARMs, the recommended language is designed to help ease the transition, for both lenders and consumers, from LIBOR to a spread-adjusted index based on the Secured Overnight Financing Rate (SOFR).
In anticipation of the expected phase-out of LIBOR, the Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York convened the ARRC to identify a replacement index for US dollar LIBOR and develop a plan for the transition. In 2018, the ARRC selected SOFR as the recommended replacement index for US dollar LIBOR and created a Paced Transition Plan to help guide market participants through this important change.
The ARRC has noted that most contracts referencing LIBOR do not appear to have envisioned a permanent cessation of LIBOR. They may allow lenders to replace LIBOR if it is no longer available, but they do not provide much guidance for how to implement such a change. To help address this issue, the ARRC consulted with market participants and recommended fallback language to use for LIBOR-based cash products. To date, the ARRC has released recommendations for bilateral business loans, floating-rate notes, securitizations, syndicated loans, and most recently, ARMs.
The recommended fallback language for each of these products is based on the following framework:
- Defining triggering events
- Selection of a replacement index
- Defining the spread adjustment between LIBOR and the replacement index to account for the differences between these two benchmarks
With respect to ARMS, the ARRC recognized that while its recommendation needed to be consistent with this framework and its recommended fallback language for the other cash products, it needed to make the language and the choices simpler and more easily understood for consumer products.
Fallback Language for Adjustable-rate Mortgages
The ARRC’s recommended fallback language for ARMs can be applied to any residential ARM, including those that reference an index other than LIBOR. As with all fallback language guidance provided by the ARRC, the adoption of ARM recommendations is voluntary for market participants. Fannie Mae and Freddie Mac have announced that they intend to use the ARRC’s recommended fallback language for newly originated ARMs and anticipate publishing updates in the first quarter of 2020 to their uniform ARM notes to incorporate the recommended language.
The fallback language for ARMs identifies clear and observable triggers for the transition to the replacement index. The ARRC sets out two triggers in its recommendations:
- Move to a replacement index in the event the administrator of the current index (ICE Benchmark Administration) has stopped providing the index to the general public. This trigger emphasizes the need for the index to be provided to the public if it is to be used in an ARM product.
- Move to a replacement index in the event the administrator of the index or the regulator with authority over the administrator (Financial Conduct Authority) announces that the index is no longer reliable or representative.
Upon the occurrence of a triggering event, the ARM fallback language provides that the note holder will select a replacement index pursuant to a defined “waterfall.”
First, the new index used to calculate interest for the ARM will be the replacement index for use in consumer products selected or recommended by the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, or a committee endorsed or convened by these two entities. As previously mentioned, the ARRC has selected SOFR as the replacement index for US dollar LIBOR.
If a replacement index has not been selected by the identified governing body, then a replacement index is determined by the note holder, with possible adjustment to the loan’s margin to account for the different between LIBOR and the chosen replacement index.
A fundamental tenet of sound fallback language is that parties to a contract should be in the same economic position once fallback provisions are triggered as they were prior to the triggering event. In other words, when an ARM transitions to using SOFR as the benchmark, the borrower should continue to pay an interest rate comparable to the LIBOR-indexed rate.
Due to the differences between LIBOR and SOFR, a spread adjustment to the SOFR index will be necessary. To minimize impact on interest rates for the borrower, the ARRC is working with stakeholders to develop and recommend a spread adjustment for cash products and corresponding spread-adjusted SOFR-based replacement that accommodates difference between LIBOR and SOFR. The ARRC has committed to making any rate and spread adjustment it recommends publicly available.
For additional information, visit the ARRC’s website and view the resources below.
The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial, and accounting advisors before entering into any transaction.