Will borrowers accept SOFR? In the 15th episode of our LIBORcast series, Dechert’s Matthew Hays and guests from multifamily market leader Freddie Mac discuss the latest on SOFR and the broader LIBOR transition from a legal, origination, servicing and investing perspective, including Freddie Mac’s background in originating SOFR loans and securitizing them with SOFR-based bonds. Other topics include operational and outreach challenges, market preparedness, credit-sensitive rates, the availability of LIBOR caps and more.
Will borrowers accept SOFR? In the 15th episode of our LIBORcast series, Dechert’s Matthew Hays and guests from multifamily market leader Freddie Mac discuss the latest on SOFR and the broader LIBOR transition from a legal, origination, servicing and investing perspective, including Freddie Mac’s background in originating SOFR loans and securitizing them with SOFR-based bonds. Other topics include operational and outreach challenges, market preparedness, credit-sensitive rates, the availability of LIBOR caps and more.
Intro 0:05
Welcome to Dechert's LIBORcast, where industry leaders come to talk LIBOR transition.
Matt Hays 0:12
Hello, and welcome to today's edition of the Dechert LIBORcast. This is the 15th in our series. I'm Matt Hays, your host. I'm a partner in the global finance group, and I lead the asset finance and securitization team here at Dechert and our LIBOR Task Force. Today, I'm pleased to be joined by our guests from Freddie Mac: Geraldine Hayhurst, the Vice President and Deputy General Counsel, Mortgage Securities and Strategic Corporate Initiatives; Ameez Nanjee, Vice President Asset and Liability Management and Assistant Treasurer; and finally, Cindy Schwartz, the Director of Multifamily Capital Markets, Securitization; all at Freddie Mac. And I should note that the views expressed by Ameez, Cindy and Geraldine are their own views and not the views of Freddie Mac, and that they reserve the right to change their minds as new developments unfold. Welcome the program.
Geraldine Hayhurst 0:58
Thank you. Pleasure to be here.
Cindy Schwartz 0:59
Thanks for having us.
Matt Hays 1:00
So let's dive right in. I'll ask the question that I asked in most of our podcasts: on a scale of Y2K to the end of the world, where does the LIBOR transition rank?
Ameez Nanjee 1:10
I'll take that. Good afternoon, Matt, and thank you for having us. Look, it isn't the end of the world. Having said that, it does require steady, thoughtful planning and process. It's not just simply as, as some market participants have indicated, that, "what's the big deal, you're pointing to one index, just stop pointing to that and go point to another one." It does require a thought process.
Matt Hays 1:35
So with that process, do you expect the transition to become more chaotic over the next year, or less?
Ameez Nanjee 1:41
It's going to be different for every firm, you know, those that have started the process. And I've spent some resources thinking about these things. It should not be chaotic, it's doable. There's enough resources made available in the industry. There's fine folks at Dechert who can help you with the legal resources. There's, there's other folks at other firms that can help you with operational resources. And certainly the ARRC has put out a lot of information. So really, if you're a firm that's started this process, and you're going to engage in guidelines put out by the Fed, no new LIBOR issuances at the end of this year, you should be able to get that. And again, we'll get into the nuances of how we can get that. But, but it's possible.
Matt Hays 2:22
It's great advice. With the recent announcement of an extension, do you think the end of LIBOR will be pushed back even more? Or is this timeline set?
Ameez Nanjee 2:31
Well, we hope not. You know, we have no reason to think that it will be as you know, the ISDA spreads have been set. So in some sense, a pre-cessation event has already been declared. And for most LIBOR, US dollar LIBOR tenors, that's going to be June 30, 2023. So it's, it feels unlikely that it's going to get postponed even more.
Matt Hays 2:53
So you've been a pioneer in originating SOFR based loans. What challenges have you had in doing that? Are you seeing widespread acceptance?
Cindy Schwartz 2:59
I can jump in here. From the multifamily side of things, you know, we had a very smooth rollout of our SOFR-based loan product late last year, and we stopped purchasing loans indexed to LIBOR at the end of 2020. Our floating rate loan volume is at record levels, we've definitely not had any trouble with demand. And honestly, you know, as far as challenges, I would say, you know, it was all about readiness. We spent a lot of time and effort preparing and making sure optigo lenders and servicers were prepared. And that work really paid off.
Ameez Nanjee 3:31
And I can, I can speak to other products. Look, the GSE is one of the first few institutions that came out with SOFR debt offerings. Fannie Mae was the first to market and we followed closely, you know, so it took a little while at that time to figure out what does an overnight index mean, you know, there's different conventions that can be used. But we decided to go with that in arrears concept. And, you know, we'll talk more about this as we deep dive into it. But what we quickly found was, was there's no answers. And just like when you're, when you're doing something new, there's a lot of outreach that has to be done. We have to work with our investors, we have to make sure that the vendor systems, we're already on the system's point, what did you have to do to be ready? You know, you would think compounding your interest is something you could do in Excel, but you'd be shocked how many different results you can get, depending on what conventions you use, you know, how do you compound weekends, you know, so there's a lot of nuances associated with these, these things.
Matt Hays 4:31
So did you learn by being first to market
Ameez Nanjee 4:34
Because we were first to market, there was a learning curve. But I do think the industry has come along a long way. Cindy talked about our multifamily experience. Certainly they were leaders in the securitization space, and they have now transitioned over to the loan space as well. And they've made it work. So your challenges are going to be, one, what convention of SOFR to use, and then depending on what you pick, the operational and outreach elements of it. So everyone's going to have a different experience. Like I said, we were first to market. So we probably had more pain than other people. But we got it done. And if we can get it done, everyone else can do.
Matt Hays 5:16
So now that you've done it, do you think the market will more broadly adopt SOFR before the end of LIBOR?
Ameez Nanjee 5:21
We hope so. As you know, there's a lot of competing indices that are coming up in the marketplace, most of them claim to be IOSCO compliant. So it's really going to depend on what every institution picks. SOFR is robust. In its overnight nature, it has a lot of underlying transactions, it checks all the boxes for a reference rate. But it does have limitations, right. Today, there is no term SOFR and today, there is no credit component to it. We don't think we need either. But different institutions may have different expectations on what they want their reference data look like. So we think SOFR is the right index to go to, but it's hard to speculate on, on whether or not the entire industry will adopt it as an as a reference rate.
Matt Hays 6:05
So having gone through some of the transition process yourself, what concerns you most about the transition process and what remains?
Ameez Nanjee 6:12
Yeah, and like I said, like the biggest challenge we had pretty early on is deciding what convention of SOFR to use. Today, at a broad level, we have two different conventions: we have SOFR averages and and they are in arrears or in advance. Now within in arrears and in advance, you can have simpler compounded averages. But let's just say these two big conventions exist, the advantage of an in arrears is, it's more forward-looking in nature. So from that standpoint, to the extent that you're using SOFR to finance the purchases of your securities, it matches perfectly, but in arrears comes at its own price. And that price is you don't know the rate, you don't know the interest until the end of the period. So it requires a lot of system enhancements, it requires a lot of system changes. And in some instances, it may not be possible to do so. For one of our products, we found out that our payment systems needed to know at least 15 days in advance what the coupon payment was going to be in a true in arrears format, which the derivative market uses, you don't know what the payment is, until two days after the coupon payment is due. So in those instances, you don't have a choice, you don't have the ability to use in arrears. So then the question becomes, are you able to use the in advance format. And the beauty about in advance is the Fed publishes 30, 60, 90 day averages on their website. So it's a simple point and click, you get the rate. You can know the rate just like LIBOR today in advance, but it is backward-looking in there. I think the market is still struggling with what convention of SOFR to use. That concerns us, you know, those questions should have been answered at least a year ago, if not two.
Matt Hays 7:55
Do you think the market will follow your lead in the convention game? Or do you think there's, you know, likelihood that it may adopt other conventions?
Unknown Speaker 8:03
Look, it depends on who you are. To be fair, what we use at Freddie Mac mostly is the one-month index and the lag between an in arrears and in advance, the economic cost of the lag using the one-month index is minimal. It's almost negligible to a point where it's not worth making the system changes to go to an in arrears. But if you're an institution that uses a six-month or a three-month index, or even a 12-month index, an in advance may not work for you. So you will have to build you an in arrears in those situations, if you don't want to give up significant economic slippages. So we do hope that the market follows our lead, at least as far as the one-month index is concerned, because we have shown there's robust investor demand, we have shown that it can work for both the loans as well as securities. But you know, for those other institutions that use longer index resets, you have different questions to answer.
Cindy Schwartz 8:57
Yeah, and from the commercial side, right. So we've received very positive feedback from the CMBS market on the model that we have determined. And since floating rate, loans, which is really what we're passing through, right, is interest on floating rate loans, you know, we have to be able to build for that, we have to be able to build the borrowers. And for that we need in advance rate. And we don't want to have a basis mismatch. So to avoid a basis mismatch, we really need the securities and the loans to operate off of the same in advance rate. And you know, to me is the point, we've chosen the 30-day super average. And that's really working well for us at this point.
Matt Hays 9:35
Talk a little bit about operational challenges, which has been most significant for you? Have you gotten all these back-end mechanics working now? And do you feel pretty confident that you've got the systems in place to make it work well?
Ameez Nanjee 9:47
Yeah, I can answer that. I think the answer is yes, quite simply, yes. For those products, especially where we've used the in advance approach, it's been seamless. We've had to make minimal changes just because, like I said before, today the way LIBOR works, LIBORs and in advance rate. So people are just used to everything. Now we also have our experiences as investors, and we bought some unsecured debt that use an engineer's concept. In those situations, what we found is there are significant challenges. And it comes down to it is no standard in the interior space. You know, some market participants use a shifted one-day look back two-day look backs, some people use lockout concepts and lock outs, you, you basically lose out on the SOFR sets for a few days. And you see different people use different weekend compounding conventions. So so what we found there is depending on the issuer name that we buy, our interest payments that our systems calculate may not tie out to the interest payment that the issuer calculates. So that requires manual intervention. So to answer your question, as an issuer, we have faced almost no issues, setting these things up operationally, doing outreach - investors understand it. There's a robust market for it. But in the in arrears space as an investor, we've had different experience.
Matt Hays 11:11
Do you have any concerns about the broader market moving to another rate? And did the extension have any effect on that decision?
Unknown Speaker 11:18
Yeah, Freddie Mac right now, we don't anticipate looking at another index. You know, if there's demand for another index, that becomes the standard sometime down the road, you know, we will evaluate that index. But we're not looking at another rate now.
Ameez Nanjee 11:32
At this point, we don't know what the broader markets will do. But we don't have any intention to move to a different rate.
Matt Hays 11:38
One thing we've heard is concerns around SOFR not being a credit-sensitive rate. Do you share that view? Or do you think that's not as much of an issue as some may think?
Ameez Nanjee 11:50
Look, I've made this argument in the past, which is, I understand that there's a need in the market for a credit-sensitive rate. But it's more of a want than a need. You know, today, the credit-sensitive indices that are being brought up or even LIBOR for that matter, what it represents is the bank credit. And as an issue of not just us, someone else who's a non-bank issuer, our products will always trade at a spread to those bank credits, right. So it will be a plus or a minus to that spread. So from that standpoint, our investors, in theory, already have the ability to model what that spread is. And once you can model the relative spread between us and some other institution, it's easy to model that spread between us and the reference rate. And everyone who buys and sells securities that are not directly bank securities has that ability. So some institutions need a credit component. I can't answer that. I can tell you from our standpoint, we don't need it. And certainly we don't think our investors need it. Everyone wants it, but we don't know if we need it.
Unknown Speaker 13:02
So we saw yesterday an announcement from the ARRC on term SOFR, its use cases, how it will be developed. Do you have a view on that announcement?
Ameez Nanjee 13:11
Sure. I mean, there's been several different announcements. But I think what you're referencing to is the announcement that followed up the March 10 announcement, where the ARRC laid out key principles that it's going to look at in whether or not it recommends a return rate. And we think, you know, we agree with those, you know. One, of the things that ARRC has said, I think this is key principle; number two, is they want to be able to endorse a rate that will exist over time. And that over-time component is critical. And then, you know, the other principles call for making sure that the term rate has the robustness of the over, meets the principles of the overnight rate. And the third, and the most important one is the limited scope of use, I think the ARRC has been very clear. from the get go that the term rate is going to have limited scope of use. So the ARRC is working through these criterias, that they're working to determine what parameters need to be achieved based on these guiding principles for them to endorse a term rate. And we're fully supportive of that. And we'll wait and see what happens. I think they've come out and said, they're not going to endorse the term rate by June 30. But that doesn't mean they're not going to endorse a term rate at all. You know, we could see something maybe later this year, or maybe next year.
Matt Hays 14:23
So I guess that's the prognostication question, do you expect it to be available? And you know, when it becomes available, are you planning to use it? And what do you think the timeline for availability is?
Ameez Nanjee 14:33
So I'll start with the comment on timeline for availability. Like I said, I think the ARRC was very clear in its announcement that it's not going to be June. But then as the criteria is met, it could happen at any point. So like I said, it could happen by end of this year, or it could happen sometime next year. It doesn't mean it's not going to happen. There have been some news publications out there saying, oh, the ARRC doesn't plan to endorse a term rate at all. And we don't believe that to be the case. We do, all that stuff is to be determined. Now, whether or not we will use it, you know, I'll turn it over to our chief legal expert here.
Geraldine Hayhurst 15:06
Generally, well, I think it'll hinge on what the ARRC endorses. And for what use case, if the ARRC endorses the term rate for only legacy products, then we're limited in what we can do with our SOFR index book, because we have retest language in those documents, for the most part that would have looked up to us to jump to term, if that was endorsed by the ARRC. So our legacy book would have the benefit of the term rate, but not the, you know, new product book. And we'd have to look at that in terms of what our investors were expecting and whether their securities would end up orphaned. And further legacy is comprised of both LIBOR index contracts that have the ARRC fallback language, and those that do not. So if the ARRC endorses term for legacy products, you could have a situation where you have a legacy LIBOR index contract that has the ARRC fallback language in it, which would require retesting and a jump to a term rate. So once again, you could have a book that some of the contracts have the benefit of a term rate, others do not. And so as a business, you have to look at all that and say, you know, what is best for our customers, ultimately.
Unknown Speaker 16:23
So some seem to be waiting for term SOFR to be available before moving away from LIBOR. Since you've already moved, maybe it's your view is that it's not as wise to do that. But I wonder what you think of those in the market that may be waiting for that?
Ameez Nanjee 16:37
Look, I think the regulators have been really clear. They have cited safety and soundness concerns for any new LIBOR issuances past the end of this year. So from that standpoint, if you're waiting for them to come about, you're really playing a dangerous game, because like I said, right at the onset of this conversation, it's not as simple as just saying, "Oh, look at that rate has popped up. Let me just point my systems to it." You know, you need some lead time, you need to know where to point, you need to know where to look, you need to educate your investors in to make sure vendors know. So I hope people are not waiting. I'll even take it a step further, Matt, we don't think we need to terminate at all, at least our side where we use the one-month index, we generally don't know why we need a term rate. The market is sophisticated, the market knows how to price the one-month lag that exists between in arrears and in advance. And really, in an ideal world, we have a term rate and the term rate is used for every product, just like LIBOR is, legacy, new whatever. But I think the second best outcome is is we don't use term for anything.
Matt Hays 17:48
We've obviously seen some more developments in the legislative front, the New York legislation was passed by the New York State Legislature signed by Governor Cuomo. It allows for instruments that only have a LIBOR base rate and no fallback language otherwise to effectively transition to SOFR automatically by operation of law. What's your view of that legislation? And is it a good development?
Geraldine Hayhurst 18:12
I'll take that one. We at Freddie Mac, like the market, think this was a very positive development, we obviously have a significant number of contracts that are tied to New York law. So in our view, that was positive for this transition. And it can only help. Obviously, it doesn't get us the whole way there. And so we're looking to see what happens on the federal front.
Matt Hays 18:34
Since you raised the Federal front, I'm curious, what you think. Is the legislation we've seen working with Representative Sherman's office? I think the industry and some trade associations have been working on that legislation and at least providing sort of functional market views on it. Do you think we need that with the New York legislation in place? Or does that just confuse the question?
Geraldine Hayhurst 18:56
Logically, yes, not every contract or loan is governed by New York State law. So you run the risk of having a patchwork solution if the states started enacting their own legislation. Chairman Powell in February said that federal legislation is the best answer. And recently, last week, our regulator and conservator the FHFA expressed a similar opinion in front of the House Financial Services Committee. So we are just as curious as the rest of the market on where the federal legislation goes.
Matt Hays 19:26
Is there any other sort of concerns you have about the the transition process in the market that that listeners should be thinking about?
Ameez Nanjee 19:34
It's important that people start working on this. You know, we're in April. And if you really believe that, that there's going to be enforcement's from the regulators at the end of this year. You know, you have give or take seven or eight months to deal with this. And based on our experience, it takes that long, you know, sometimes what you find in an organization, and we certainly had our share of those experiences is, is you find dependencies and systems that you've been not anticipate in the planning stage, right. So you need some time, as you're doing your testing to fix these downstream impacts. You know, you, depending on on what convention or software you use, you have to think about your impacts, your tax and accounting systems. Like, let me give you an example, if you bake them in arrears concept, where you don't know the coupon until the coupon payment, just you imagine that coupon payment was due on March 31. And you won't know what that payment was until April 2, now you've closed your financials, you know, so you have to think about potentially going in updating some of that. So there's a lot of these nuances and the devils in the detail. And that's why as an organization, what helped us we can share our experience, what we did is we created a whole steering committee, that was an enterprise-wide steering committee, we had product owners, that represented each product that knew their investor base, but they still did their own outreach. At a corporate level, we had program management office, we had a chief legal counsel appointed to it, Geraldine here. And you know, it had to be an enterprise-wide effort. Because one of the things we were conscious of is, we did not want to create piecemeal solutions for every different product that we had, you know, we wanted some sort of consistency across our products to leverage the operational systems, otherwise, you just double your work triple your work for a marginal benefit, right? So it's about getting these product heads together, getting the legal counsels together, getting the operations technology folks in one space, and it just takes time. Back to your earlier question between Y2K and end of the world. Look, if you plan well, this can be done. But if you don't plan, you're gonna find a lot of surprises along the way. And, you know, the challenge here has been there is no one convention, right? It's not, it's not a plug and play solution. And depending on what product you have, depending on who your investors are, you may find that you may want to do different things. And some of them may require creation of systems that don't exist. And those just take time and money by the way, which you need to budget for so and that you you will know, you know from from your experience, just reviewing all legacy legal docs takes a ton of effort. So you know, it takes time,
Geraldine Hayhurst 22:15
I was gonna say that. I mean, it's one of the first things we did was catalog, all of the various contracts that were in existence over time, which was a monumental task, because legal language changed over time. And we had to make sure that it wasn't the LIBOR or transition provisions that were changing. And so we created a database, put every type of contract in there for every product: ARMs, multifamily floating rate notes, who had the discretion to transition, the index, I mean, we spent a significant amount of pregame time, making sure we understood our landscape in order to even begin the discussion of what the transition plan would actually be. And so if folks are waiting to do that, they're going to find that they're sort of behind because they don't actually know their own landscape. And so I would recommend that if folks or companies haven't started that pre-work, to at least get started with that, and understand where their limitations may be, in terms of contract language in transitioning.
Matt Hays 23:20
That's an excellent point. We've certainly worked on plenty of those projects here at Dechert and it is a monumental task. And each additional data point requires, you know, potentially a lot of work to determine, and there's some solutions that can help but it there's a lot of nuance to it.
Geraldine Hayhurst 23:38
That's right. Is there some issues that we need to worry about in terms of caps?
Cindy Schwartz 23:44
Yeah, so you know, the question you originally asked was, you know, things that were concerning us, and on the multifamily side, at least, we are concerned and trying to work through right now what to do about the possibility of not being able to get replacement LIBOR caps for our existing LIBOR contracts that won't convert until later. Right. So the caps all have terms that expire, and when they expire, they have to be replaced. And you know, if the LIBOR-based loans haven't converted to SOFR yet, we're going to need LIBOR base caps. And you know, the information we're getting or what we're hearing from the market is that they may not be available.
Ameez Nanjee 24:21
And I'd like to point out that in the regulatory guidance that's come out, I think the regulators have said that it's okay to continue to engage in LIBOR and, this is not the what they said, they said it more eloquently and more in a more sophisticated way, but I'm just using more layman's terms. That as long as they're risk reducing in nature, they're okay to engage in. So, so we don't think, you know, these LIBOR caps are bought for protection, they're bought for hedging reasons, we think it's exempt. But that's not what we're hearing from the market. So that's something that we're working through.
Cindy Schwartz 24:57
We've also heard from from some of our folks that regardless of whether or not it's exempt, they may not offer them. So it's definitely a concern that we have to work through. And you know, it's all in lab right now. But it's something that multifamily for sure is concerned about.
Ameez Nanjee 25:12
And that this, this goes back to your earlier point, what should the market be concerned about this, right, that liquidity in LIBOR will go away? So to the extent that even if you are an unregulated entity, and if if your expectation is, "look, I'll just continue trading LIBOR through end of 2023, what you may find is liquidity in LIBOR just goes away after the end of this year. So that's something else you've got to be concerned about.
Matt Hays 25:36
All great points. Thank you. And thank you to the Freddie team for joining.
Ameez Nanjee 25:39
Thank you.
Geraldine Hayhurst 25:40
Thank you.
Cindy Schwartz 25:41
Thank you.
Matt Hays 25:42
We hope you enjoyed listening. Please check out our LIBORcast channel to hear other insightful discussions with market industry leaders, including regulators, trade associations and market participants about the work ahead in the LIBOR transition process. Thanks again and have a great day.