A smooth transition to SOFR for legacy agency CMOs
admin | June 5, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Among the highest hurdles in the path from LIBOR to SOFR is managing the switch for financial contracts that never anticipated a permanent end of LIBOR. These contracts lack adequate language for transitioning to a new benchmark interest rate. If LIBOR ends as scheduled at the end of 2021, these floating-rate securities will effectively convert to fixed-rate securities with the coupon held at the last available LIBOR setting. Fannie Mae and Freddie Mac, as trustees for their securities, have lately amended and supplemented their governing legal documents to incorporate LIBOR fallback provisions, providing a smooth mechanism for their legacy CMOs to transition to SOFR.
The silent contracts
In November 2019, Fannie and Freddie both announced they were undertaking a comprehensive review of how a LIBOR cessation would impact some cohorts of their legacy floating-rate and inverse floating-rate CMO bonds.
Freddie Mac initially highlighted agency CMOs issued between January 1992 and March 2011, where the documentation specified that the floating rate coupons are calculated by the “LIBO Method.” The LIBO method is the fallback method outlined in many older Freddie Mac contracts that specifies how to determine the floating-rate coupon in the event that the LIBOR setting is not available on the adjustment date. As was common at the time, the fallback method depends on polling at least two reference banks that normally contribute quotes to the LIBOR setting and calculating an arithmetic average. In the event two banks do not offer quotes, the rate for the next accrual period is set at the determined on the previous adjustment date. Complete details of the LIBO method can be found in the Offering Circular for Freddie Mac Multiclass Certificates (REMIC and MACR) dated June 1, 2010, Appendix V (pages 77-78 of 82).
In January 2020, Freddie Mac expanded the review to include legacy CMOs issued from March 2014 through July 2017 whose floating-rate coupons are calculated via the “ICE method”. The ICE method was the updated fallback provision for determining the floating-rate coupon when LIBOR was unavailable, so-named when ICE took over administration of LIBOR from the BBA. The ICE method bypasses polling reference banks to determine a new quote if LIBOR is unavailable on an adjustment date, and instead immediately falls back to the most recently published quote. Details of the ICE method can be found in the Offering Circular for Freddie Mac Multiclass Certificates (REMIC and MACR) dated August 1, 2014, Appendix V (page 79 of 83).
Neither the LIBO or ICE method anticipates a permanent end to LIBOR but only contemplates an interruption in LIBOR’s publication or availability. As part of their review, Fannie Mae identified all floating-rate and inverse floating-rate CMOs based on LIBOR that were issued prior to June 2014 as potentially being affected by a LIBOR cessation.
As part of the review of legacy CMOs, both agencies announced a moratorium on new re-REMICs during the evaluation period, which began on November 26, 2019.
An interesting resolution
Fannie Mae and Freddie Mac, in their corporate capacity, are the trustees for their multiclass certificates. The master trust agreements include provisions that allow for amendments or supplements without the consent of certificate holders provided that the amendments do not adversely affect or impair any of the holders’ interests or rights, including the right to receive payment of principal and interest. The guiding principle is that the amendments or supplements, which are issued under relevant state contract law applicable to the master trust agreement, cannot violate or overrule the protections for bondholders outlined in the Trust Indenture Act, which is federal law. Fannie Mae’s trust agreements, certificates and legal documents governing most of their securities, except the CAS program, are issued under the laws of the District of Columbia. Freddie Mac’s securities and trust agreements, like those of most US financial securities, are issued under the laws of the state of New York.
Fannie and Freddie have resolved this issue for legacy LIBOR-indexed CMOs by amending (Freddie Mac) and supplementing (Fannie Mae) their designated trust agreements for their REMIC and other multiclass certificates. These prospective amendments and supplements explicitly provide for a replacement benchmark index substantially similar to LIBOR be designated on the occurrence of a benchmark transition event. The ARRC-approved definitions, waterfalls and fallback language are all included, providing for LIBOR to be replaced by SOFR plus a spread adjustment in the event that LIBOR is permanently discontinued or becomes unrepresentative.
Presto. Fannie Mae and Freddie Mac’s legacy CMOs will now transition to SOFR at the same time and under the same benchmark transition rules as CMOs issued since 2014 and 2015 along with current CMOs that have equivalent fallback language in the offering circulars, offering circular supplements and other governing legal documents. As part of the posting of the amendments/supplements, Fannie and Freddie removed the moratorium on re-REMICs backed by their legacy CMOs as of June 2020.
A brief overview of Fannie and Freddie’s approach to its LIBOR-indexed legacy CMOs can be found in the recent article Leading the LIBOR Transition by lawyers at Hunton Andrews Kurth LLP.
Why this solution may not be broadly applicable to other silent contracts
Fannie Mae and Freddie Mac’s original fallback language in their legacy CMO documents is consistent with fallback language in a lot of legacy financial contracts, including those governing many corporate preferred equity issues and other non-agency structured products. However, it’s unlikely this solution to silent contracts will become more broadly applicable. Most issuers are not the trustees of their certificates and might find it difficult to amend trust agreements without coming into conflict with provisions of state law or the bondholder consent provisions of the Trust Indenture Act. The Federal Housing Finance Agency, as the regulator and conservator of Fannie and Freddie, has long put a high priority on evaluating and preparing for the LIBOR transition for the GSEs and on behalf of their bondholders. As a government agency, the FHFA possibly has more flexibility to push through this solution than a private party does. If challenged under state law, the FHFA can potentially cloak the amendment and supplement to the trust agreement within their federal powers under the Administrative Procedures Act.