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The GSEs lead markets towards SOFR

admin | September 11, 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. This material does not constitute research.

The LIBOR-to-SOFR transition is well underway at Fannie Mae and Freddie Mac. In conjunction with their regulator, the Federal Housing Finance Agency, the GSEs have made exceptional progress crafting solutions and resolving most LIBOR-to-SOFR transition issues across their single-family and multifamily loans and securities, collateralized mortgage obligations and credit risk transfer securities.

Executive summary

Legal documentation across products has been updated with appropriate versions of ARRC recommended fallback language so that the impending transfer from LIBOR to SOFR for virtually all agency securities should occur simultaneously, based on ARRC and ISDA defined trigger events, using mostly ARRC-recommended waterfalls and spread adjustments.
These securities will transition from LIBOR to SOFR plus the ARRC / ISDA recommended spread adjustment in the event that LIBOR ceases to be published or is declared to be no longer representative.
The GSEs have designed new single-family ARMs that use 30-day average SOFR as the underlying index. The transition from a forward-looking unsecured term rate to a nearly risk-free compounded average of an overnight rate required adjustments that include shorter floating-rate reset periods, lower periodic caps and wider expected margins compared to existing LIBOR-indexed ARMs.
New multifamily borrowers have a wide range of SOFR-indexed financing options that initially use 30-day average SOFR, the same index that will be used in single-family ARMs; however there are differences between the product offerings of the two GSEs.
The biggest outstanding issue in the multifamily space is how borrowers will purchase new interest rate caps and transition existing LIBOR-based ones if the SOFR derivatives market is not fully developed by the time of the transition.
There remain transition issues underlying legacy LIBOR-indexed single-family and multifamily loans that have yet to be hammered out, which require coordinated consumer protection, regulatory and legal solutions. Fortunately, Fannie, Freddie and HUD/Ginnie Mae have the legal authority and flexibility to implement the transition for single-family and multifamily loans once the various parties have agreed upon the framework and language.
All new and recently issued LIBOR-indexed CMOs incorporate ARRC’s recommended fallback language and trigger events in their offering circulars, offering circular supplements and other governing legal documents.
Fannie and Freddie both adopted a slightly modified version of ARRC’s securitization waterfall so that CMOs will transfer to term SOFR rates, if they are available and have been approved by an “appropriate regulatory authority”. If not, CMOs will initially use 30-day average SOFR, but will transfer to term SOFR at the GSEs discretion when feasible.
The GSEs have resolved the transition for legacy LIBOR-indexed CMOs, the so-called silent contracts, by amending (Freddie Mac) and supplementing (Fannie Mae) their designated trust agreements for their REMIC and other multiclass certificates. Legacy CMOs will now transition from LIBOR to SOFR at the same time, and under the same benchmark transition rules, as recently issued CMOs.
A very small cohort of Freddie Mac CMOs could lag the transition if a zombie LIBOR–under consideration by the UK FCA—is published between the time LIBOR is expected to be declared unrepresentative, likely in Q3 2021, and when it fully ceases publication at year-end 2021.

Timeline highlights include:

Both agencies will cease accepting applications for single-family and multifamily LIBOR-indexed loans on September 30, 2020.
Fannie and Freddie will quit accepting loan applications and acquiring single-family and multifamily whole loan LIBOR ARMs by year-end 2020. Fannie Mae began accepting applications and purchasing SOFR-indexed ARM loans on August 3, 2020 and Freddie plans to do so beginning November 16, 2020.
Both agencies will cease accepting applications for single-family and multifamily LIBOR-indexed loans on September 30, 2020.
Both GSEs began offering SOFR-indexed CMOs for settlement in July 2020 and will cease offering new LIBOR-indexed CMOs for issuance in October 2020.
Issuance of most agency single-family, multifamily, CRT and CMO LIBOR-based securities will cease by year-end 2020.
Fannie Mae will complete the transition across all products by year-end 2020; Freddie Mac will do so with the exception of issuance of multifamily LIBOR-based securities which could continue through Q2 2021.

Exhibit 1: Key transition milestones

Source: LIBOR Transition Playbook, page 8 of 58, published jointly by Fannie Mae and Freddie Mac, updated August 2020.

Fannie Mae and Freddie Mac have jointly published detailed plans for the transition from LIBOR to SOFR in the following products: single-family and multifamily ARM loans and securities, single-family and multifamily CRT, and CMOs. The plans cover both new and legacy loans and securities. Timelines and transition issues for some products are not yet fully resolved; in these circumstances Fannie and Freddie assess the outstanding issues and provide some disclosures regarding progress that still needs to be made.

The following are brief synopses of the current framework for the transition from LIBOR to SOFR for single-family ARMs, multifamily ARMs and CMOs. Please see the Libor Transition Playbook for complete details.

Single-family ARMs and securities

Fannie and Freddie, under guidance from the FHFA, have coordinated their approach to the transition for single-family ARMs. Fannie and Freddie will quit accepting loan applications and acquiring single-family and multifamily whole loan LIBOR ARMs by year-end 2020 (Exhibit 2). Fannie Mae began accepting applications and purchasing SOFR-indexed ARM loans on August 3, 2020 and Freddie plans to do so beginning November 16, 2020.

Exhibit 2: Transition deadlines for phase-out of LIBOR ARMs

Source: Fannie Mae

Additional steps that the GSEs have already taken include (page 10 of 58):

Updated existing uniform ARM notes and riders to include fallback and trigger language as recommended by the ARRC
Designed new single-family ARMs that use the NY Fed’s 30-day Average SOFR as the underlying index (SOFR30A Index on Bloomberg)
Started discussing strategies for the transition of existing LIBOR-indexed ARMs

LIBOR versus SOFR ARMs

The hybrid structures of SOFR-based ARMS are like those of existing LIBOR-based ARMs, with a defined 3-, 5-, 7- or 10-year fixed rate period, after which the loan converts to floating-rate for the remaining term to maturity. The transition from a forward-looking unsecured term rate to a nearly risk-free compounded average of an overnight rate requires some adjustments. The adjustments made to SOFR-based ARMs include shorter floating-rate reset periods, lower periodic caps and wider expected margins compared to existing LIBOR-indexed ARMs (Exhibit 3).

Say goodbye to CMT-indexed ARMs

Originators and borrowers wary of SOFR will not find a safe harbor in CMT-based loans for long. The FHFA has issued guidance that Fannie and Freddie will also cease purchasing single-family CMT-indexed ARM loans sometime in 2021.

Exhibit 3: Single-family LIBOR vs SOFR-indexed ARMs

Source: LIBOR Transition Playbook, pages 11-12.

Additional details on why each adjustment was necessary and what risks it attempts to mitigate can be found in Appendix A: Structuring a single-family SOFR-based ARM.

Transitioning existing single-family LIBOR ARMs to SOFR

This is an outstanding issue that has yet to be resolved, in part because there are a lot of hats in this ring. The process involves close coordination between: the CFPB on behalf of consumers; Fannie, Freddie and the FHFA; and HUD on behalf of Ginnie Mae. There need to be legal / document updates to implement the transition, and extensive communication to consumers and borrowers to explain the changes and how it will impact their loans. The good news is that the GSEs and HUD are presumed to have all the necessary legal authority to implement the transition to a SOFR-based index for legacy ARMs, and it should occur synchronously with the broader market transition. Unfortunately, the timeline and strategy for doing so have yet to be finalized. So stay tuned.

Multifamily ARMs and securities

Fannie and Freddie have somewhat different approaches to the transition for multifamily ARMs and securities, but that’s mostly because their product offerings in the space are different and they are trying to maintain consistency for their borrowers and investors.

Fannie Mae

Fannie Mae multifamily borrowers traditionally have a wide range of variable rate financing options. The GSE is in the process of developing SOFR-indexed offerings for Structured ARMs, 7/6 ARMs and hybrid ARMs, as well as a new SOFR-indexed capped ARM option. The index will be the New York Fed’s 30-day Average SOFR, the same index that will be used in single-family ARMs and CMOs.

Interest rate payments are the same

Interest rate calculations for SOFR-indexed multifamily products will follow the same accrual process that currently exists for LIBOR-indexed ARMs (Exhibit 4).

Exhibit 4: Sample timeline for SOFR-indexed interest rate accrual process

Source: LIBOR Transition Playbook, page 36

Interest rate caps are problematic

For the capped SOFR ARM product, the interest rate caps will either be embedded or will be available from third parties. Third party SOFR interest rate caps are necessary for Fannie Mae to offer and acquire uncapped multifamily SOFR-indexed ARMs. At this time SOFR derivatives remain a nascent market, though liquidity and depth is slowly building. Interest rate cap providers may begin offering interest rate caps when Fannie Mae begins issuing SOFR-based loans, but it’s not certain. Fannie Mae’s multifamily group is actively engaged with third party interest rate cap providers to prepare for and follow developments in the market.

Fannie Mae suggests that borrowers with existing third-party caps on LIBOR consult their agreements for the specific language on a transition to an alternative reference rate (ARR). The borrowers are obligated to purchase replacement interest rate caps for existing LIBOR-indexed ARMs under the loan documents. Fannie Mae is developing a transition strategy for loans with third party LIBOR caps and maturities past January 1, 2022.

Freddie Mac

Freddie Mac also offers floating rate and hybrid loans across all segments of its multifamily business. For Conventional, Seniors Housing and Targeted Affordable Housing business lines, Freddie intends to initially index the loans to 30-day Average SOFR. However, the loans will transition to 1-month term SOFR when the rate has been approved by regulators, and Freddie Mac is operationally, administratively and technically prepared to handle the transition.

Small balance hybrid floating rate loans will be indexed to 30-day Average SOFR during the floating rate period and will not transition to Term SOFR. Otherwise the terms for the loans should be identical to those for small balance hybrid LIBOR-indexed loans.

Like Fannie Mae, the calendar month interest accrual periods for SOFR-indexed loans will be functionally the same as those for LIBOR-indexed loans.

Third party interest rate caps

Freddie does not offer embedded caps and borrowers are required to buy third party interest rate caps for SOFR-indexed loans. Since those caps are not yet available, borrowers can temporarily purchase LIBOR-based caps, but these will need to eventually be replaced by SOFR-based caps. There are several additional requirements outlined in the documentation (page 43) that apply if the borrower purchases a LIBOR-based cap.

Legacy multifamily floating rate loans

The now familiar statement from Fannie and Freddie for single-family and multifamily legacy LIBOR-indexed loans (page 53):

“The GSEs are continuing to work with the ARRC to define the timing and strategy for transitioning legacy LIBOR-indexed Floating Rate loans to an ARR. We are coordinating closely with FHFA on this important matter. Additional details will be released as the timeline and strategy are finalized.”

Collateralized Mortgage Obligations (CMOs)

Both GSEs began offering SOFR-indexed CMOs for settlement in July 2020 and will cease offering new LIBOR-indexed CMOs for issuance in October 2020. New resecuritizations (ReREMICs) of existing LIBOR-indexed CMOs can still be issued, provided that the total unpaid principal balance does not increase.

The GSEs adopted a slightly modified version of ARRC’s securitization waterfall for new-issue LIBOR-indexed CMOs. The waterfall language provides for the use of Term SOFR as the first alternative rate, assuming that is available. The next alternative rate is the New York Fed’s 30-day Average SOFR, the same index that is used in single-family SOFR ARMs.

The GSEs have structured new-issue Delay and Non-Delay SOFR-indexed CMOs so that they:

Initially use 30-day Average SOFR as the reference rate, with a determination date 2 business days prior to the beginning of the accrual period for 45-day, 55-day and 75-day Delay and Non-Delay securities (same as current LIBOR-indexed CMOs)
The CMO program will transition to Term SOFR at the GSE’s discretion at a later date if an “appropriate regulatory authority” approves term SOFR rates, and the transition is operationally and administratively feasible. The same determination date conventions would be used as those for Average SOFR.
The transition could occur prior to the time LIBOR ceases or is declared non-representative.

Once a Term SOFR rate is approved by regulators and the GSEs have transitioned to that rate, they will cease any new issuance of CMOs using 30-day Average SOFR.

The GSEs will accept the same collateral for new-issue SOFR-indexed CMOs that is currently acceptable for LIBOR-indexed structures.

Transitioning legacy CMOs

The GSEs themselves are not expansive on this topic ( LIBOR Transition Playbook, page 33 of 58):

Approach for transitioning legacy CMOs

The GSEs are continuing to work on defining the timing and strategy for transitioning legacy LIBOR-based CMOs to an ARR. The GSEs are coordinating closely with FHFA on this important matter. The Enterprises each recently announced that they intend for their respective legacy LIBOR-indexed CMOs to be treated the same as their new-issue LIBOR-indexed CMOs in the event LIBOR ceases to be published or is declared to no longer be representative, in that the legacy LIBOR-indexed CMOs would also transition to Term SOFR (depending on its availability) or Compounded SOFR. For more information, see the announcements made by Fannie Mae and Freddie Mac.

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 so-called silent 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, 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.

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.

The above discussion is excerpted from A smooth transition to SOFR for legacy agency CMOs, published 6/5/2020. Please see that piece for further information.

Appendix A: Structuring a single-family SOFR-based ARM

ARRC published a summary table of proposed models for SOFR ARMs in its whitepaper Options for Using SOFR in Adjustable Rate Mortgages, published July 2019. The recommended adjustments are designed to satisfy ARRC’s guiding principles outlined for consumer loan products. In a nutshell the new SOFR-based ARMs are designed to be attractive, easily understood and ensure transparent outcomes to both borrowers and investors; provide a product that is fair, consistent and competitive with existing LIBOR-based ARMs; and minimize disruptions, disputes and basis risk during the transition from LIBOR to SOFR. The adjustments adopted by Fannie and Freddie in its new SOFR ARMs are consistent with the ARRC recommendations.

Setting SOFR in advance of the coupon period

The 30-day SOFR average will be set in advance of the payment period, consistent with how coupons are set in current LIBOR-indexed ARMs. Using an in arrears method, where the floating-rate payments are based on averages of SOFR that occur during the current interest period, was judged inappropriate for consumer products and inconsistent with consumer regulations because it would provide very short notice of payment changes. The in advance method will use the SOFR average observed before the current interest period begins, so servicers can provide the required notice of payment changes to the borrower well ahead of the payment due date.

In this context in advance and in arrears refer only to whether the interest rate is set prior to the start of the coupon period, or just before the coupon period is over. It does not refer to whether the interest rate itself is forward-looking like 1-year LIBOR, or backward-looking like a 30-day average of overnight SOFR. ARRC acknowledges in its whitepaper that it would be more consistent to use an in arrears method with a backward-looking rate, but stakeholders agreed that it was contrary to consumer regulations to notify borrowers of a payment change only a few days before it was due.

Shortening the reset period and lowering the periodic caps

Existing agency LIBOR-based ARMs typically have a 1-year reset during the floating-rate period, while SOFR-indexed ARMS will reset every 6 months. The shorter reset period is an attempt to mitigate some of the potential mismatch when shifting from the forward-looking 12-month term LIBOR rate to a 30-day average of backward-looking overnight SOFR. Increasing the reset frequency is preferable for lenders and investors who need to manage funding and interest rate risk, so the loans will more quickly incorporate changes in market interest rates, expectations of future rates, the outlook for inflation and other macroeconomic conditions.

Borrowers still have the coupons set in advance so there is certainty regarding future payments, and the semiannual adjustment should marginally result in a lower initial rate. The more frequent reset allows the periodic adjustment cap for SOFR ARMs to drop to 1 percent, compared to the standard 2 percent periodic cap for agency LIBOR-based ARMS that reset annually. Based on historical analysis, ARRC concluded that these changes would result in SOFR ARMs having less volatility in the floating rate coupons and frequently lower payments for consumers compared to LIBOR-based ARMs.

Increasing the margin

Single-family conventional ARMs linked to 1-year LIBOR typically have a margin of 225 bp, whereas the standard margin for ARMS based on 1-year CMT is 275 bp. The difference in the margin is to account for differences in the levels of the two indices. Historical analysis showed that on average SOFR-based ARMs with margins in the range of 275 to 300 bp would have resulted in the loans resetting to a rate approximately equivalent to that of current products.

Some of the above discussion was excerpted from A farewell to LIBOR ARMs, published 2/7/2020.

Appendix B: ARRC proposes NY State legislation to ease LIBOR transition

The Alternative Reference Rates Committee (ARRC) has proposed legislation that could significantly smooth the transition to SOFR for legacy LIBOR-based contracts that are either silent regarding a discontinuation of LIBOR, or whose fallbacks prescribe an alternative method for calculating LIBOR. In particular it would nullify the fallback polling mechanism that is commonly found in many legacy securities contracts. The proposed legislation would not impact legacy contracts whose fallback provisions transition to a non-LIBOR replacement rate, such as prime. The legislation is also designed to provide a safe harbor from litigation for parties that adopt the recommended benchmark replacement. The vast majority of US dollar denominated financial securities are issued under NY law, so the legislation also intends to prevent contract disputes from burdening the state’s courts. The proposal is not unprecedented, as it is based in part on a 1998 statute enacted ahead of the discontinuation of several sovereign currencies that were being supplanted by the euro. The timing could be a confounding factor – the NY state legislature is normally only in session from January to June of each year. COVID has disturbed the normal legislative schedule, and they could be convening in the fall of 2020. It’s unclear whether there is sufficient time between now and year-end 2021 for the legislation to be considered and voted on without causing significant market disruption. Some of the key components of the draft legislation are summarized in Exhibit 5. The ARRC proposal is here.

Exhibit 5: Key components of proposed statute

Source: ARRC

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