LIBOR Sunset and SOFR Rise: What You Need to Know
For years, interbank offered rates, including USD LIBOR (London Interbank Offered Rate), have been the most widely referenced benchmark interest rates in the world. However, global indexing is moving towards risk-free rates, including the Guaranteed Overnight Funding Rate (SOFR) in the United States, with critical milestones by the end of 2021.
Here’s what this transition means for the multi-family sector, when to watch out and what to do now. See the higher resolution version of the timeline above here
What is SOFR?
SOFR is based on overnight repurchase agreements, with cash borrowers depositing US Treasuries as collateral with a repurchase agreement on a specified date.
- Daily SOFR can be subject to spikes, so agency lenders will use a 30-day compound average to smooth volatility based on recommendations from the Alternative Benchmark Rates Committee (ARRC).
- SOFR does not have a credit component, so the market will likely adjust by charging an additional spread for new SOFR-based products.
Although enough futures and swap activity has taken place since 2018 to develop the shorter part of a forward curve, the longer part of the curve will be processed by the fourth quarter of 2020. , especially since the CME and LCH clearing houses are converting their discounting methodology. With this, it is expected that the terms curve will not be ready for use in trading until the first half of 2021 at the earliest.
What does the transition to SOFR mean for existing loans?
In the area of multi-family credit, Fannie Mae and Freddie Mac have already started a two-phase transition from LIBOR to SOFR and have started entering into SOFR-based loans. All existing loans maturing after 2021 are expected to move to SOFR within the next 14 months. When transitioning loans from LIBOR to SOFR, a spread adjustment will be made to reduce the transfer of value between the two indices. The spread adjustment will impact the effective loan rate and the loan’s “long trail of contracts” – all underlying loans and derivatives maturing after 2021.
Since every floating rate loan likely has an interest rate hedge, it’s important to understand what exposure looks like for these derivatives: the trigger for a pullback, the pullback rate, and how you’ll adjust. the spread for that rate. Will there be a mismatch in the methodology and timing of loan and hedge transition? Of course, we hope we don’t see a mismatch, but a lot of it depends on the alternate language in the loan and derivative documents. The upcoming revised definitions and a related supplement and protocol from the International Swaps and Derivatives Association (ISDA) are expected to be effective and easy to adopt. But borrowers will need to understand the relief language for their specific debt and derivatives, as well as how best to synchronize them if necessary.
Alternatives are just one of the many things to look for in loan language. Loan documentation may require noteholders to approve the move to a new lending index, for example, or loans may have to remain at LIBOR even beyond 2021, as some banks may continue to use that index. .
How will the transition to SOFR impact new loans?
For new SOFR loans, the big question is how we are going to price it. Will investors increase the spread to compensate for the lack of credit component of SOFR? For that early price discovery, one can check out the Freddie Mac K Certificates, the agency’s most recent variable rate certification for indicators. As of December 2019, Freddie Mac has divided certificates into a LIBOR class and a SOFR class – each with around $ 1 billion in underlying LIBOR-based loans.
Initial indications of the new loans suggest that SOFR-based loans would cost around 6-7 basis points for LIBOR-based loans, which is in line with Freddie’s LIBOR and SOFR class average base. Coincidentally, this also maintains roughly the same initial coupon at current rates. During the first month of trading, prices varied, with SOFR loan spreads ranging from 6 to 7 the width of LIBOR loans to slightly reversed at times.
Dates to watch
Despite some COVID-19-related delays on interim milestones and specific requirements, such as those related to Federal Home Loan Banks and the CARES Act Main Street Lending Program, the overall LIBOR / SOFR timeline is moving forward as expected.
Since September 30, Freddie Mac and Fannie Mae only accept applications for SOFR indexed loans.
As of October 16, the CME and LCH clearing houses have moved from LIBOR discount to SOFR discount. Additionally, in October, ISDA released its fallback protocol and definitions.
Frequently asked questions about the transition to SOFR
- How are commercial lenders reacting?
Right now, it seems commercial lenders are waiting to see how things go on the agency side before moving forward with their own SOFR loan programs.
- What will be the impact of the transition on construction loans?
Since many underlying construction loans involve smaller banks and regional banks, SOFR was not a requirement unless the lender specified it. Although these banks have not yet indexed to SOFR, all construction loans should have fallback language allowing flexible use of an alternative index.
- How will the transition affect multi-family rates in the long run?
Many long-term aspects of the LIBOR / SOFR transition are currently difficult to predict. However, with SOFR derived from repo activity and the Federal Reserve reporting rates close to zero until the end of 2022, the time may have come for that transition.
- Is LIBOR completely gone? What about other alternatives to LIBOR?
Even as some banks and loan documents continue to use LIBOR and alternative indices, such as Ameribor, gain favor with players such as regional and community banks, SOFR has been the choice of lending agencies.
– Blake Lanford, Managing Director, Walker & Dunlop