The industry has been aware for some time now that the London Interbank Offered Rate (“LIBOR”) is due to be phased out of the United States, Britain and other markets by the end of 2021. The LIBOR is currently used in all kinds of financial transactions around the globe, including as a benchmark index for the setting of mortgage rates. If the LIBOR will no longer be available, the mortgage industry must move to a new benchmark rate to replace the large number of all new adjustable-rate mortgage loans which currently use LIBOR, as well as those already closed with interest change dates that will occur after 2021.
LIBOR is based on the reported interest rate at which banks borrow from and lend to each other in the unsecured short-term market. Every day panel banks submit their best estimate of the interest rate to LIBOR’s administrator, the Intercontinental Exchange (“ICE”). ICE uses a methodology of “trimmed means,” which means they trim off the top and bottom 25% of the submitted rates and average the remainder to come up with the LIBOR. The banks use their own judgment and models to determine the reported rates, which came under criticism after scandals in 2012-2013 broke in which several banks were accused of manipulating the rate to their own advantage.
The goal is to move to a more stable, trusted and reliable benchmark. The Federal Reserve Board and the Federal Reserve Bank of New York (“FRBNY”) convened the Alternative Reference Rates Committee (“ARRC”) to identify an alternative to LIBOR. In June 2017, ARRC selected the Secured Overnight Financing Rate (“SOFR”) as its recommended alternative reference rate for U.S. dollar-denominated loans and derivatives. Other overnight rates are being established to cover the UK (e.g., the Sterling Overnight Interbank Average Rate), Europe, Switzerland, and Japan.
SOFR differs from LIBOR in that it is calculated from actual trades, not estimates. It is based on repurchase agreement interest rates on U.S. Treasury securities. A repurchase agreement is a secured loan where one party sells a security to another party and agrees to repurchase it later at a set date and price. According to the FRBNY, the SOFR is calculated as a volume-weighted median of relevant transactions and published by the FRBNY at 8 a.m., Eastern Time, each business day.
The Federal Reserve Board has urged accelerating adoption of the alternatives to LIBOR. To that end, both Fannie Mae and Freddie Mac announced May 17, that effective immediately, they will no longer purchase LIBOR ARMs that are roughly more than six months old at time of purchase. The stated goal of this change is to facilitate movement away from the LIBOR.
