Most of the roughly $150 billion adjustable-rate mortgages (ARMs) originated in the U.S. each year are pegged to the London Inter-Bank Offered Rate (LIBOR), which is expected to be eliminated by the U.K. government in 2021.
More than seven years ago, U.K. regulators uncovered widespread manipulation of LIBOR, ultimately resulting in the recommendation to sunset the benchmark. In the U.S., approximately $1.2 trillion in ARMs is currently tied to the rate – forcing the industry to consider how it will manage legacy as well as new ARM originations after 2021.
“U.S. regulators and mortgage lenders have little time left to begin the enormous effort of transitioning systems and products to a new benchmark rate,” said Tom Cronin, Managing Director of The Collingwood Group, a SitusAMC company. “The Federal Reserve’s recent guidance around the use of the Secured Overnight Financing Rate (SOFR) provides a good blueprint for how to get started.”
In 2014, the Federal Reserve created the Alternative Refence Rates Committee (AARC) to identify a replacement and provide guidance on an appropriate transition from LIBOR. The Consumer Products Working Group of AARC was tasked specifically with looking at how the transition would impact ARMs.
The Working Group released its recommendations in a report earlier this month. The report reiterates the Federal Reserve’s endorsement of the SOFR – a rate based on overnight transactions in the Treasury repo market.
The rate, produced by the Federal Reserve Bank of New York, is based on a “well-derived market with sufficient depth to make it extraordinarily difficult to manipulate,” according to the report. “It is produced in a transparent, direct manner and is based on observable transactions, rather than being dependent on estimates, like LIBOR.”
The working group recommends the mortgage industry peg ARMs to a SOFR average – not just a single reading – to better reflect a longer period in the market. The frequency of rate changes should be increased from once a year under LIBOR to twice a year under SOFR, according to the Federal Reserve.
“Market participants should seek to transition away from LIBOR as soon as possible,” the report states, warning of the time it will take to develop new product systems.
“Fannie Mae and Freddie Mac have said they are already working on a SOFR-indexed ARM,” said Cronin. “Their ARM product will likely become the standard for the industry.”
The government-sponsored enterprises (GSEs) said they expected the effort to take roughly 18 months to complete. “We have not told Fannie and Freddie to stop buying LIBOR ARMs, but that is a day that will come,” said Mark Calabria, Federal Housing Finance Agency (FHFA) Director, in a recent interview with Reuters.
“We intend to work with the industry very closely and be ready before the end of 2021 to roll out a new ARM product based on an average of SOFR. The next agenda item is to focus on legacy products,” Calabria said.
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