By the Numbers
A bumpy migration to SOFR
Mary Beth Fisher, PhD | May 6, 2022
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.
Parts of the agency MBS and CMBS markets are showing the effects of the agencies’ early transition to SOFR. The agencies took some of the first steps to transition from LIBOR, but the only SOFR benchmark available and endorsed by regulators at the time was compound SOFR, the average of daily overnight SOFR over a backward-looking period. Regulators have since endorsed forward-looking term SOFR and most new non-agency floating-rate loans and securitized products have adopted that index, while agency loans and securities have not yet transitioned to term SOFR. The Fed’s aggressive hiking cycle has opened a significant yield gap between backward- and forward-looking SOFR rates. The lack of a consistent SOFR convention across structured products is creating pockets of illiquidity—including parts of the agency market—as investors prefer products and deals benchmarked to term SOFR. The GSEs meanwhile appear to have the laid the groundwork to shift to term SOFR but perhaps lack the regulatory mandate to do so.
Early adopters used backward-looking SOFR
Fannie and Freddie both stopped underwriting new single-family and multifamily floating-rate loans indexed to LIBOR by the end of 2020, and stopped issuing new LIBOR-based securities by the end of the second quarter of 2021. An overview of timelines and LIBOR transition plans and milestones for Fannie Mae and Freddie Mac appears in their jointly published LIBOR Transition Playbook. Ginnie Mae followed a bit later, and published their own Libor Transition Reference Guide.
Forward-looking SOFR term rates, derived from the still nascent SOFR futures market, were not yet approved for use as LIBOR replacements when the GSEs conducted their migration. They consequently structured all of their floating-rate benchmark replacements around backward-looking, compound average SOFR. The GSEs clearly stated a preference for an eventual transfer to term SOFR rates, pending approval of the term rates by regulators.
Legal provisions in place for migration to term SOFR
Freddie Mac’s multifamily loans and securities currently indexed to compound average SOFR as a floating rate, for example, include provisions for a transition to term SOFR. The transition from compounded to term SOFR is at Freddie Mac’s sole discretion and does not appear to require either borrower or investor approval.
The following are excerpts from one of Freddie Mac’s offering circular supplements from a recent floating-rate K-deal (edited for brevity, formatting added):
Changes to, or the Elimination of, SOFR, or the Conversion of SOFR to an Alternate Index, Could Adversely Affect the Market Value or Liquidity of the Offered Certificates. The mortgage interest rates for the underlying mortgage loans will be based on the SOFR Rate. The SOFR Rate will be based on Compounded SOFR unless and until those certain conditions described in the definition of “SOFR Rate” under “Description of the Underlying Mortgage Loans—Certain Terms and Conditions of the Underlying Mortgage Loans—Mortgage Interest Rates; Calculations of Interest” in this information circular are satisfied, in which case the SOFR Rate will then be based on Term SOFR.
Freddie Mac may, from time to time, at its sole discretion, make SOFR Adjustment Conforming Changes without the consent of holders of the offered certificates or any other party, which could change the methodology used to determine the SOFR Rate. Holders of the offered certificates will be deemed to have agreed to waive and release any and all claims relating to any such adjustments. There is no assurance that the methodology to calculate Compounded SOFR, or, if later adopted, Term SOFR, will not be adjusted as described in the prior sentence and, if so adjusted, that the resulting interest rates for the underlying mortgage loans will yield the same or similar economic results over the lives of such underlying mortgage loans relative to the results that would have occurred had the related interest rate been based on Compounded SOFR or Term SOFR, as applicable, without such adjustment or that the market value will not decrease due to any such adjustment in methodology. Freddie Mac will have significant discretion in making SOFR Adjustment Conforming Changes.
Freddie Mac’s single-family agency CMOs currently indexed to compound average SOFR also allow transition to term SOFR. In a similar vein, Ginnie Mae has incorporated language into their single-family and multifamily securities documentation in the base offering circulars that gives them discretion to convert from compounded to term SOFR without the consent of security holders.
Despite the endorsement of term SOFR rates by ARRC in July 2021, none of the GSEs have yet migrated to term SOFR. The GSEs could be waiting for regulations implementing the LIBOR Act, passed in March 2022, to be finalized before migrating from backward-looking to term SOFR. The LIBOR Act requires the Federal Reserve to promulgate regulations by September 2022 that identify replacement benchmarks based on SOFR for the tough, legacy LIBOR contracts.
ARRC focus remains backwards, but some securitized products move forwards
The Alternative Reference Rate Committee (ARRC), organized by the New York Fed, endorsed the use of forward-looking term SOFR rates as a replacement for US dollar LIBOR on July 29, 2021. However, ARRC’s formal announcement recommended using the term rates in relatively narrow circumstances:
- ARRC supports the use of term SOFR rates for business loan activity, where adapting to an overnight rate could be more difficult;
- Does not support the use of term SOFR rates for derivatives markets except when end users are hedging cash products;
- Continues to recommend using the overnight and backward-looking compound averages of SOFR where possible.
Despite ARRC’s suggestion for narrow use of term SOFR, many financial products, hedging and investment strategies incorporate market expectations, which are most clearly priced into forward-looking rates. Non-agency, non-bank issuers, which don’t fall under the direct regulatory supervision of the Federal Reserve, also have more flexibility to pick the version of SOFR that best suits their borrowers and investors.
The majority of non-agency loans and structured product securities did not fully transition from LIBOR to SOFR until the beginning of 2022. So far, the convention for using backward- or forward-looking SOFR as a replacement for LIBOR has not been consistent across securitized products. For example, most new CRE CLOs are predominantly using 30-day compound average SOFR; while floating rate single-asset, single-borrower (SASB) deals have adopted 1-month term SOFR. Two recent CRE CLO deals from Rialto and Arbor have also used term SOFR, as opposed to average SOFR, as a benchmark.
Now that the Fed is in a hiking cycle, the difference between backward- and forward-looking rates can be large. Currently, there is a greater than 50 bp gap between backward-looking 30-day compound average SOFR (29 bp) and forward-looking 1-month term SOFR (81 bp). Assuming the Fed raises rates 50 bp, that gap will narrow as 30-day average SOFR slowly rises. Obviously the reverse would be true during an easing cycle. Over long periods of time that cover both hiking and easing cycles, the median difference between backward and forward-looking rates should be effectively zero. But for short- to mid-term borrowers and investors, the difference in costs or returns between backward- and forward-looking rates can be meaningful. Some investors have already begun migrating from agency CMBS and CRE CLOs linked to backward-looking SOFR, to floating-rate SASB for the additional yield provided by term SOFR.
An accidental driver of relative value
The repercussions of the multiple SOFR benchmark conventions across and within securitized products could lead to pockets of illiquidity developing when backward- and forward-looking SOFR are gapping apart. Investors could move between products, or between deals within products, based on preferences for the underlying SOFR rate.
Entities that issue and invest in floating-rate debt, like the Federal Home Loan Banks and most commercial banks, could exhibit a strong preference to have both their assets and liabilities indexed off the same SOFR rate. This would most likely be term SOFR, which could put more pressure on the GSEs to migrate from compound average to term SOFR in a timely manner.