A Federal Reserve committee, with the backing of Fannie Mae and Freddie Mac, on Thursday proposed a road map for lenders to shift pricing on hybrid adjustable-rate mortgages to a new index by 2021.
Put simply, SOFR is taking over for the much-maligned Libor.
The Alternative Reference Rates Committee outlined in a 13-page proposal the use of compounded 30- or 90-day averages of the Secured Overnight Funding Rate — published daily by the Federal Reserve Bank of New York — in place of the one-year London Interbank Offered Rate now used to price adjustable-rate mortgages after their initial fixed-rate periods.
The Fed plans on developing and publishing the new index rates in anticipation of the expected demise of U.S.-dollar Libor. Two years ago, the U.K.’s Financial Conduct Authority announced that Libor rates would be phased out by 2021, when it would cease requiring panel banks from submitting quotes used to calculate the rates. Libor was seen as increasingly non-relevant since it was not based on actual transactions, and had been the center of a manipulation scandal in 2012.
Both Fannie and Freddie issued statements endorsing the ARRC’s plans, and they pledged to develop SOFR-indexed ARM products for new originations before the anticipated of published Libor in less than two years.
The proposal only applies to newly originated hybrid ARMs, rather than existing contracts. And as a recommendation, it would not preclude lenders from choosing another alternative rate that develops in the market.
The proposal marks the first time ARRC has expanded its SOFR recommendations into consumer lending. Earlier this year, the committee finalized recommendations on adapting SOFR as a replacement benchmark in corporate loans and securitizations, including as a fallback rate for debt instruments with maturities extending past 2021.
SOFR still has hurdles to overcome, even with a Fed endorsement and its use in connection with $800 billion in daily repo transactions of U.S. Treasury securities. As a daily rate, it can be challenging to adapt it for use as a forward-looking term rate. And while Libor’s demise is expected, it is not a foregone conclusion that it disappears. Some legacy debt instruments may maintain Libor using the final published Libor rate through maturity. In addition, the administrator of the global Libor rates across five currencies — the ICE Benchmark Administration — has stated it plans to continue publishing Libor through voluntary bank opinions as well as some interbank transactional activity.
But SOFR is gaining traction since the New York Fed began publishing the daily rate in 2018. Beside the daily Treasury repo transactions, it has been used as a rate in $80 billion in securitization transactions, according to the Fed. That includes four four credit-risk transfer portfolios totaling $15.5 billion sponsored by Fannie.
For the hybrid ARM contracts, the new SOFR-derived index rates are being planned to mirror current Libor rates and structures, according to the proposal published by ARRC’s consumer products working group.
The plan recommended no change to the currently available fixed-rate periods for ARMs (three, five, seven and 10 years) nor to the annual rate caps on ARMs after the fixed-rate period expires (currently 2% for three- and five-year ARMs, and 5% for seven- and 10-year loans).
But because SOFR rates are usually lower than one-year Libor rates, ARRC said it anticipates a higher margin rate of 2.75% to 3% (compared to the 2.25% common for current Libor-based ARMs) that lenders will charge borrowers to keep SOFR-based floating-rate payments comparable to existing ARMS.
The most notable change for consumers would involve more frequent adjustments in monthly payments. Instead of shifting the rates annually as in a 3/1 or 5/1 ARM, the ARRC recommends lenders adjust rates every six months due to the potential greater variability in SOFR reference rates from cumulative 30-day and 90-day averages.
The six-month adjust period would “ensure that these ARMs can be offered at rates consistent with other competitive rates in the market.”
SOFR itself is calculated daily from cleared repurchase agreement, or repo, transactions of U.S. Treasury securities.
Also, to safeguard unexpected payment jumps, the proposed models will cap the periodic adjustments of SOFR ARMs at 1% — meaning the rate would not exceed the current market standard cap of 2%, given the shortened six-month period applied to the rates.
No specific timetable has been established for publishing SOFR-based ARM rates, but in a statement released concurrent with the ARRC announcement, Fannie Mae said it would “make an ARM product based on overnight SOFR available once systems and processes have been put in place to accommodate the new index.”
The SOFR-based ARM rates would be based on what the ARRC terms the “in advance” structure of calculating the daily averages of the published SOFR rates prior to the onset of a borrower’s interest period. The consumer working group’s members believed that provides more payment certainty to borrowers, as opposed to the SOFR “in arrears” calculation used in derivatives and some floating-rate debt instruments that determines the SOFR rate based on the current interest period, according to the proposal.
The ARRC’s consumer products working group was set up this year. It includes members of ARRC, Fannie, Freddie, servicers, lenders, investors and consumer advocacy groups.
Market participants were concerned that there would not be a way of using SOFR until a term SOFR rate was created. And that rate is not anticipated until 2021.
The SOFR index models were created not only to model the current Libor ARM products, but to gain acceptance from investors while meeting consumer protection requirements.
The New York Fed plans to start publishing averages of the rates early next year.