By the Numbers
A LIBOR transition resource guide
Mary Beth Fisher, PhD | August 5, 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.
Although almost every debt investor knows about the scheduled end to LIBOR next year, many are finally taking it seriously and gauging the implications for their portfolio. This guide provides summary information on the federal legislation governing the LIBOR transition and how it affects legacy LIBOR securities. It also includes links to Ginnie Mae, Fannie Mae and Freddie Mac’s LIBOR transition playbooks, and the current and historical legal documentation—base offering circulars, base prospectuses and master trust agreements—for their single-family and multifamily securities.
Federal legislation mandates a transition from LIBOR to SOFR
The Adjustable Interest Rate (LIBOR) Act of 2021 was signed into law on March 15, 2022 as part of the Consolidated Appropriations Act. The bill provides a mechanism for certain financial contracts based on LIBOR to transition to a replacement benchmark rate when LIBOR terminates on June 30, 2023.
The legislation, principally authored and supported by the Federal Reserve’s Alternative Reference Rate Committee (ARRC), was primarily designed to provide a transition mechanism for so-called tough, legacy LIBOR contracts which lacked viable fallback language in the event LIBOR was no longer available. Most tough, legacy LIBOR contracts will now automatically transition to use SOFR as a benchmark when LIBOR ceases publication.
There are a lot of nuances, carve outs, and safe harbors detailed in the legislation. An excellent, deep dive summary from legal superstar firm Sullivan & Cromwell, Federal LIBOR Transition Legislation. Salient excerpts (from page 1-4 of 9, formatting and emphasis added, edited for brevity):
The LIBOR Act provides a uniform national approach for replacing U.S. dollar LIBOR as a reference interest rate in so-called “tough legacy” contracts (contracts that do not include effective fallback provisions, for example, because they have no provisions for a replacement benchmark or their fallback provisions would require the use of a LIBOR-based rate or a poll to determine a rate) for a time when LIBOR is no longer published or is no longer representative. Under the LIBOR Act, references to the most common tenors of LIBOR (the overnight, one-month, three-month, six-month and 12-month tenors) in these contracts will be replaced as a matter of law, without the need to be amended, to instead reference a benchmark interest rate that will be identified in regulations of the Federal Reserve. The Federal Reserve must promulgate these regulations by September 11, 2022, the date that is 180 days after the statute’s enactment. Any Federal Reserve-identified replacement benchmark will be based on the Secured Overnight Financing Rate (SOFR), a rate published by the Federal Reserve Bank of New York, and will include an appropriate “tenor spread adjustment” to reflect historical spreads between LIBOR and SOFR. The statute also provides a “safe harbor,” under which a party that has discretion to select a replacement for LIBOR may choose to adopt the replacement benchmark identified by the Federal Reserve.
Among other things, the LIBOR Act
(i) Provides for the mandatory, automatic replacement of LIBOR references with a Federal Reserve-identified replacement benchmark in LIBOR contracts that include certain ineffective fallback provisions;
(ii) Authorizes persons that may exercise discretionary authority to select a LIBOR replacement to opt into a statutory safe harbor by selecting the Federal Reserve-identified benchmark;
(iii) Provides that parties may opt out of the LIBOR Act; and
(iv) Provides that the legislation has no effect on LIBOR contracts that include effective fallback provisions identifying an appropriate replacement benchmark.
The LIBOR Act also includes a provision limiting supervisory criticism of banks that use benchmark interest rates that are not based on SOFR.
The automatic replacement of LIBOR with the identified replacement benchmark plus a tenor spread adjustment, as well as the integration of the conforming changes specified by the Federal Reserve, will occur on the applicable “LIBOR replacement date”—the first London banking day after June 30, 2023, unless the Federal Reserve determines the relevant LIBOR tenor will cease to be published or cease to be representative on a different day.19 As of the LIBOR replacement date, for non-consumer loans, the tenor spread adjustment added to the relevant replacement benchmark will be an adjustment specified in the LIBOR Act.20 The LIBOR Act’s adjustments are the same as the spread adjustments recommended by the Alternative Rates Reference Committee and the International Swaps and Derivatives Association.
For consumer loans, there will be a one-year transition period in applying the tenor spread adjustment specified in the LIBOR Act. That is, for these loans—which generally include lending transactions to a natural person that are primarily for personal, family or household purposes—the adjustment to the Federal Reserve-identified replacement benchmark will transition linearly over a year from the actual spread between the applicable LIBOR tenor and the replacement benchmark, as of immediately before the LIBOR replacement date, to the tenor spread adjustment specified in the LIBOR Act.
For those who prefer a short, high-level summary, there is one from Norton Rose Fulbright, US federal LIBOR legislation summary. Here is a brief excerpt that specifically mentions the safe harbor provisions from legal liability:
The federal legislation targets the estimated US$15 trillion worth of existing “tough legacy” LIBOR contracts. A “tough legacy” contract is a contract that does not:
(a) specify a replacement for LIBOR or
(b) contain an adequate LIBOR replacement mechanism.
These contracts create the specter of substantial litigation as they rely on a rate that will cease to be in existence after June 30, 2023. The federal legislation addresses this issue by permitting the Board of Governors of the Federal Reserve System to select a SOFR-based replacement for LIBOR in tough legacy contracts, which will replace LIBOR by operation of law. In doing so, the federal legislation ensures that these tough legacy contracts will continue to have an applicable active rate.
In addition, the federal legislation also creates a “safe harbor” for eligible persons (with the ability to select a benchmark replacement under the terms of a contract) who select a SOFR-based LIBOR replacement. The bill’s “safe harbor” states that no eligible person will be subject to legal liability arising out of their selection of a SOFR-based replacement for LIBOR. Likewise, the bill also insulates from legal liability eligible persons who implement contract “conforming changes” that are necessary to effectuate the transition away from LIBOR. An example of a protected “conforming change” would be replacing a contract’s references to LIBOR with SOFR.
A late change to the federal legislation also created a narrow safe harbor for banks that had previously selected a non-SOFR-based LIBOR replacement. The legislation specifies that no supervisory agency may take action against a bank solely because of its selection of a non-SOFR LIBOR replacement.
As required by the Act, the Federal Reserve published a proposed rule Implementing the Adjustable Interest Rate (LIBOR) Act on 7/28/2022, that implements the federal legislation. There is a 30-day comment period, after which the revised rule will be published and the regulations become effective.
LIBOR = SOFR + Spread adjustment
The LIBOR benchmark rate will be replaced by SOFR + spread adjustment. These spread adjustments have already been set by ISDA. They will apply regardless of whether the replacement uses daily compounded (backward-looking) SOFR, or forward-looking term SOFR rates derived from SOFR futures contracts.
The spread adjustments are:
- Overnight LIBOR = Overnight SOFR + 0.00644%
- 1 week LIBOR = 1 week SOFR + 0.03839%
- 1 month LIBOR = 1 month SOFR + 0.11448%
- 2 month LIBOR = 2 month SOFR + 0.18456%
- 3 month LIBOR = 3 month SOFR + 0.26161%
- 6 month LIBOR = 6 month SOFR + 0.42826%
- 12 month LIBOR = 12 month SOFR + 0.71513%
“This spread adjustment is an important part of the overall fallback rate, and reflects a portion of the structural differences between interbank offered rates (IBORs) and the RFRs used as a basis for the fallbacks – IBORs incorporate a credit risk premium and other factors, while RFRs are risk free or nearly risk free. Following multiple industry consultations by ISDA, it was determined that the fallback for each IBOR setting will be based on the relevant RFR compounded in arrears to address differences in tenor, plus a spread adjustment to account for the credit risk premium and other factors, calculated using a historical median approach over a five-year lookback period from the date of an announcement on cessation or non-representativeness.” — ISDA
Indices for SOFR rates and spread adjustments for all tenors are available on Bloomberg.
Evaluating legacy LIBOR products
The Alternative Reference Rates Committee (ARRC) released the LIBOR Legacy Playbook, a guide describing the existing broad frameworks to support the transition of legacy LIBOR cash products. While not intended to provide legal advice, the guide aims to provide tools and resources, including a compilation of best practice recommendations and reference materials, to assist market participants in ensuring that the transition from LIBOR is operationally successful.
Agency LIBOR transition resources and legal documentation
Fannie Mae and Freddie Mac jointly published the LIBOR Transition Playbook, which reviews LIBOR transition plans for all single-family and multifamily LIBOR products, including the underlying collateral, ARMs, CMOs, CRT, floating-rate CMBS and legacy LIBOR loans and securities.
The playbook contains numerous links to to reference documentation from the Federal Reserve’s Alternative Reference Rates Committee (ARRC), the Consumer Finance Protection Bureau (CFPB), the IRS and others that govern the LIBOR to SOFR transition across various products.
The LIBOR transition language for current securities is in legal documentation on Fannie and Freddie’s website. Each class of securities has its own documentation. The LIBOR transition language is usually found in the base prospectus or offering circular for the product, but it can also be in the trust agreement.
To find the LIBOR language for legacy securities you have to go to the historical documentation that applied when the security was issued. It’s all there, but it requires some scrolling to find the correct document and then downloading it.
Fannie Mae’s current and historical legal documentation for securities is available on Fannie Mae’s MBS Prospectuses page. This includes single-family and multifamily trust agreements and base prospectuses that have LIBOR transition language.
Freddie Mac’s legal documentation for mortgage securities has current trust agreements and base offering circulars for all of their products. There is typically LIBOR transition language in the both the trust agreement and offering circular supplements.
There is a link on the right hand side of the page above to Freddie Mac’s historical legal documentation.
Ginnie Mae has also published a complete LIBOR Index Transition Reference Guide. This comprehensive guide covers their transition timeline and process for all of their loans and securities, including ARMs and HECMs for single-family and multifamily products.
The LIBOR transition language appears in Ginnie Mae base offering circulars.