LIBOR Transition


Release Date: 8/18/2021
Participants: Scott Carrithers, Brian Schaff
Topic: LIBOR Transition

Listen now, or read the transcript below:


Scott Carrithers:

Welcome to the latest installment of the Leaderboard Report. I’m Scott Carrithers, managing director for Country Club Bank’s Capital Markets Group.

In today’s Leaderboard Report, Brian Schaff will provide us with an update on the pending transition from U.S. dollar LIBOR to a more robust reference rate.

Brian Schaff:

Thank you, Scott.

As you have probably heard by now, we’re gearing up for a huge transition in fixed income markets. The London Inter-Bank Offering Rate, commonly referred to as LIBOR, is phasing out. The leading candidate for replacement is the Secured Overnight Financing Rate, or SOFR.

This is a change that has been long in the making, but it will still be an abrupt shift for everyone involved. I will give a little bit of background and then discuss what this means for you, the investor.

LIBOR has been a crucial element in our markets for many years. It is the most widely used benchmark in the world, underlying trillions of dollars worth of debt. The Financial Conduct Authority, which regulates LIBOR, announced it would begin phasing out LIBOR starting December 31 of this year, creating the need for an alternative.

Here in the United States, the Federal Reserve established the Alternative Reference Rates Committee, or ARRC, to select a suitable substitute for LIBOR. They formally recommended SOFR for a variety of reasons.

First, it’s based on secured loans in the repo market, while LIBOR is not.

Second, it’s based entirely on observable transactions and cannot be easily manipulated, whereas LIBOR is simply a self-reported estimation from banks.

Third, it’s based on a deep, liquid market involving trillions of dollars of daily transaction volume, ensuring it won’t dry up in times of market stress.

Fourth, it’s resilient even as markets evolve over time.

SOFR is published daily by the Federal Reserve Bank of New York and has been since 2018. Because the basis of SOFR is U.S. Treasury repos, it is seen as a much more reliable and accurate solution when compared to the old system.

So how will this affect us going forward?

The Federal Housing Finance Agency, or FHFA, which presides over Fannie Mae and Freddie Mac, is currently issuing SOFR-based debt—and has been for some time now. They’ve ceased purchasing seasoned LIBOR-based Adjustable Rate Mortgages maturing after 2021.  Additionally, effective January of 2020, the FHFA has also prohibited the FHL Banks from investing in products with maturities beyond December 31, 2021.

Adoption of SOFR has gradually increased over the past couple years, and the ARRC sees “significant momentum” in their efforts to facilitate the change. Meanwhile, newer issue LIBOR securities have included fallback language in anticipation of the upcoming changes.

As it pertains to your bank’s investment portfolio, the end of LIBOR will primarily concern your Adjustable Rate Mortgages as well as floating rate CMOs, SARMS and Floating K deals to a lesser extent.

The biggest outstanding question mark lies with the legacy LIBOR products, many of which were issued years ago. The FHFA is working to replace LIBOR in deals that contain poor fallback language and provide guidance for legacy securities currently using LIBOR as a benchmark. Keep an eye out for an announcement on this as we approach the end of the year.

We can reasonably predict, but can’t be certain, that the change to SOFR will cause liquidity in legacy products to decrease. Therefore, price volatility is a real risk and should be monitored. Again, the specific fallback language will be important in these cases.

One last important note, we are all going through this change for the first time, at the same time. There will be a learning curve to figuring out how all of this will impact our market. With that said, please reach out to your Country Club Bank representative with any questions or comments. We’re more than happy to help guide you through this uncharted transition.