Lenders anxiously await Fed’s proposed guidance on Libor transition

The Libor replacement benchmark that regulators and much of the financial industry has focused on may not be appropriate for every type of transaction, but lenders opting for an alternative to the Secured Overnight Financing Rate had better choose carefully, or face having to refinance loans and the attendant complications.

Market participants are anxiously awaiting a rule proposal from the Federal Reserve for regulations that will interpret the Libor act that President Biden signed into law in March and could resolve pressing questions. The law calls for the rule to be approved by Sept. 9, which leaves a tight window for interested parties to submit comment letters and regulators to digest them. This reality also prompts speculation the proposal will closely echo the legislative language and leave critical issues unresolved.

One key issue centers on transitioning away from Libor — for London interbank offered rate — to a new rate that could result in lenders’ having to refinance the loan, raising a host of issues banks would prefer to avoid.

“If an institution has reason to use a different rate or has other concerns about triggering a refinance, they should really address the specific concerns with their legal counsel,” Martha-Rosalind Stainton, a partner at Potomac Point Group, said in an email.

Stainton and other industry professionals addressed the issue in detail at the Mortgage Bankers Association’s recent Secondary & Capital Markets Conference in a session titled “The Libor Transition: ARMed and Dangerous?”

The refinancing issues stem from new rules from the Consumer Financial Protection Bureau issued Dec. 7, 2021, that established requirements for how creditors must select replacement indices for existing Libor-linked consumer loans. Those requirements became effective after April 1. Creditors have until June 30, 2023, to transition all existing Libor-based loans to a replacement rate, and the rule requires transitioning consumer loans to a “substantially similar” rate.

During the MBA session, Jon David D. Langlois, a partner at the law firm Buckley, noted that the CFPB worked closely with the Alternative Reference Rates Committee (ARRC), the industry group sponsored by the Federal Reserve that developed SOFR, so it is unsurprising that it identifies SOFR as an example of a substantially similar rate. It also identifies the prime rate as substantially similar.

However, unlike Libor, SOFR does not reflect banks’ credit risk, and regional and community banks have argued that financial market volatility could result in the cost to fund their loans rising much faster than the returns on those assets priced over SOFR.

To address those concerns, several alternative LIBOR-replacement rates have emerged, including the Bloomberg Short-Term Bank Yield Index (BSBY) and the American Financial Exchange’s Ameribor, which do incorporate credit risk. Langlois said that the Libor law makes it clear that using an alternative rate besides SOFR will not be held against lenders, and the Fed’s rule interpreting the law is expected to do the same.

“Examiners can’t take supervisory action just because it isn’t SOFR,” Langlois said.

However, if alternative rates fail to meet the CFPB’s substantially similar test they will have to be refinanced rather than simply amended or modified. That means mortgage servicing rights on the refinanced loan will disappear, and borrowers will suddenly find themselves in a new loan, perhaps with a higher interest rate. Lenders can’t refinance the loan by fiat, Langlois said. He added that it remains unclear how lenders will deal with that situation, and that the CFPB’s otherwise helpful Frequently Asked Questions section accompanying its rule does not address the issue. That’s where Stainton’s advice to consult with legal counsel becomes imperative.

Langlois said SOFR meets the test for the most part, since it is specifically referenced in federal legislation and regulation. He cautioned that if lenders opt for a rate besides SOFR, then they must be sure they can prove why and how it is substantially similar, and that it is a comparable index and based on similar information.

“When cross-examined” by regulators, “you’re going to have to be able to provide it,” Langlois said.

SOFR isn’t necessarily the perfect solution, either. The ARRC has recommended one-month, three-month and six-month terms of SOFR to replace equivalent Libor terms, but it has yet to recommend one-year term SOFR, which is used to price home-equity and other consumer loans.

Stainton said that the ARRC expects to recommend SOFR as a replacement for one-year Libor by June 30, and that will apply to new cash products. She added that the Fed’s final rules due in September are expected to formalize all of the ARRC’s recommendations, including the one-year SOFR replacing the equivalent Libor term, although that’s not certain.

Lenders originating Libor-based loans before it was required to price them over a Libor-replacement rate, at the start of this year, may have used the “fallback” language the ARRC recommended in 2020. It provided guidance for which replacement rate to use after the transition. Stainton noted that the ARRC’s fallback language accounts for the possibility that the 12-month term SOFR rate will not be available, and if that’s the case directs transitioning the loan to six-moth SOFR, which the ARRC has recommended.

“So unfortunately, you get a little bit of flexibility called for there, but it is accounted for if you’re using the ARRC’s fallback language,” Stainton said. She said she expects that language to be included in the Fed’s rule.

As for which party in a securitization would be responsible for executing the change to a Libor- replacement benchmark, Langlois said that it ultimately depends on the contract, but most often it will be the noteholder. He added that the noteholder could assign that obligation to the servicer, but he suggested caution, recalling an instance a year and a half ago when parties to a mortgage-backed security asked the servicer to come up with the new rate.

“I looked at the liability and indemnification sections of the deal,” Langlois said, “and I advised my client, ‘I don’t know if you really want to be in the position of coming up with what rate everybody is supposed to use.’ ”