The Situation
Now seems as good a time as any to take a break from virus news and economic projections, so let’s talk about LIBOR. The London Interbank Offered Rate (LIBOR) has long been the benchmark on which collateralized mortgage obligations (CMOs) are based. This benchmark rate is used for more than just CMOs. Many consumer and corporate loans are tied to the rate, including auto, home, and student loans. But, back in 2012, an international investigation revealed several large banks were manipulating LIBOR, which was calculated daily using numbers being self-reported by the banks.
In addition to this manipulation, the number of banks reporting LIBOR is shrinking, and LIBOR is fast becoming outdated. Since that time the search for a new, more reliable benchmark has been underway. Fast forward to today. December of 2021 has been targeted as the final end date for LIBOR, and a new rate – the Secured Overnight Financing Rate (SOFR) – is expected to take its place.
The Differences
From here, things only get more complex. There are several key differences between LIBOR and SOFR that mean a direct one-for-one swap out cannot happen.
- LIBOR is based on bank reporting data and market data “expert judgement,” while SOFR is based on actual transaction data.
- SOFR is only a daily overnight rate, whereas LIBOR has terms ranging from one day to one year.
- LIBOR is a bank-to-bank transaction carrying some risk, while SOFR is based on Treasuries and so represents a “risk-free” transaction.
All this means that there needs to be some adjustment to SOFR in order for it to replace LIBOR in existing formulas. Newly issued CMOs and other adjustable rate securities are beginning the transition to SOFR this month. However, there are legacy securities that were created prior to the idea that LIBOR would ever cease to exist. Many CMOs in your portfolio fall into that category. Fannie Mae and Freddie Mac have issued guidance on the transition from LIBOR to SOFR for those legacy CMOs. What it boils down to is SOFR will replace LIBOR in calculating payments and a spread adjustment will be used to accommodate the differences in the rates.
The Adjustment
What remains to be decided is exactly how that spread will be calculated. The International Swaps and Derivatives Association (ISDA), which also relies heavily on LIBOR, has decided on a spread calculation involving a 5 year median of the difference between the two relevant rates. The Alternative Reference Rates Committee (ARRC), which is tasked with the LIBOR transition for loans and securitizations, is still working on a final spread formula, though it is likely to be at least similar to the ISDA process.
The Bottom Line
The transition will continue to be clarified over the next 18 months. July marks the beginning of CMOs being issued by Fannie Mae and Freddie Mac using SOFR. After September, the government-sponsored entities expect to no longer issue new LIBOR-based CMOs. Because we don’t yet know the spread calculation to be used for the difference between the benchmark rates, there will likely be some volatility in the legacy CMO markets. The general consensus amongst bond traders, though, seems to be that the transition, though complex, will essentially be a non-issue. Realistically, all the other factors currently weighing on the world and financial markets will likely continue to have a much bigger impact than this transition, but we are, of course, keeping a close eye on the situation.
If you would like to read more about the transition from LIBOR, here are some relevant links.
LIBOR & SOFR – Spread Adjustments
Federal Reserve Bank of NY – SOFR and the Transition from LIBOR
This information is not intended to be used as the only basis for investment decisions, nor should it be construed as advice designed to meet your particular needs. You are advised to seek the advice of your financial adviser, legal or tax professional, prior to making any investment decision based on any specific information contained herein. Copyright Cooper Capital, Inc. 2020
