Sherri Carr: A New Solution for Variable-Rate Loan Products

Sherri Carr is Vice President of Commercial Servicer Product Development for FICS (Financial Industry Computer Systems Inc.), a mortgage software company that provides c in-house mortgage loan origination, residential mortgage servicing and commercial mortgage servicing software to mortgage lenders, banks and credit unions.

With rates so low for conventional 30-year fixed-rate mortgages, many lenders haven’t paid much attention to adjustable-rate mortgages. They’ve been very busy satisfying the demand for fixed-rate loans. As competition heats up in the face of the anticipated slowdown in mortgage demand, adjustable-rate loans will become an important competitive tool for many loan originators.

As lenders take their ARM loan product to market, they’ll be explaining to borrowers that the interest rate will adjust according to a new index, as the old one is about to be retired. The London InterBank Offered Rate (LIBOR) has been the gauge used by lenders for decades now, but that is about to change. Created in 1968 by Minos Zombanakis, a Greek banker, the benchmark was originally developed to provide a way to lend large quantities of U.S. dollars to countries that wanted to avoid the rigors of American financial regulation.

Over the next five decades, LIBOR would help set interest rates on more than $300 trillion in financial products. However, since LIBOR is calculated from banks’ daily quotes of borrowing costs, banks were able to manipulate the rates through lying in the surveys. After long use, the benchmark fell out of favor in the 2010s when it became clear that some U.K. banks were doing just that – reporting erroneous data to manipulate the benchmark and inflate interest rates.

As a result, the Federal Reserve will replace LIBOR as the primary index for interest rates in 2022. Because LIBOR has served as a foundational interest rate product for so many decades, lenders are already beginning to prepare for their transition to new processes.

In search of a better solution for variable interest rate loans

It was clear that U.S. mortgage lenders would need a better benchmark as early as 2014. That’s when the Federal Reserve began working with the New York Fed through a new committee called the Alternative Reference Rates Committee (ARRC). The goal of the AARC was to find a better solution than LIBOR. A few years later, they settled on the Secured Overnight Financing Rate (SOFR) as the recommended replacement. That’s what’s coming next.

SOFR is a benchmark rate for dollar-denominated derivatives and loans based on transactions in the Treasury repurchase market. Instead of the estimated borrowing rates that LIBOR was based on, SOFR is based on actual data from observable transactions. The Federal Reserve Bank of New York began publishing the benchmark rate in April 2018 specifically to replace LIBOR. By October 2020, interest rate swaps on more than $80 trillion in notional debt switched to SOFR.

While LIBOR was based on anticipated borrower rates over some future period (such as the one-year LIBOR typically used on mortgage loans), SOFR is an overnight rate that is backward looking. This makes SOFR more accurate than LIBOR, which should reduce lender risk.

Change is never easy. In the short term, the switch from LIBOR to SOFR would initially result in a lower interest rate, so an adjustment spread will be needed to ensure compatibility. But that’s just one of the pieces that must fall into place for a smooth transition.

A Big Change for Mortgage Lenders

Lenders have been instructed to stop using LIBOR by the end of 2021, through a joint statement from the Federal Reserve Board, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency last November. The regulators said continuing to use the benchmark “would create safety and soundness risks” which would lead them to “examine bank practices accordingly.”

The biggest change for lenders will involve loan contracts for both new and existing mortgage loans. Any contract for a loan that is expected to extend beyond the end of 2021 and require a benchmark interest rate should not include LIBOR. Lenders should instead build SOFR into new contracts for adjustable-rate loans, because at this point it is unlikely that an adjustable-rate mortgage originated today will refinance into a new product before LIBOR sunsets.

Some lenders have waited to act until all the questions about the shift have been answered. For instance, AARC is still working on a forward-looking term rate for SOFR, which it hopes to publish by the end of the year. That may be a better tool for setting some interest rates, but regulators have made it quite clear that LIBOR is over and unanswered questions are no excuse for not preparing for the shift.

How Lenders Can Prepare for the Change

If lenders simply stop writing LIBOR into their contracts for new mortgages, they will easily meet the end-of-year deadline. However, it will not be quite as simple to deal with existing loans. Lenders may need to discuss existing contracts with counsel to determine the institution’s risk exposure when LIBOR is retired at year’s end.

Legacy contracts will only have until the end of the second quarter 2023 before regulators expect LIBOR to have disruptions. The hope is that most existing contracts will mature by then, but the term on most adjustable-rate mortgages is much longer than that on consumer loans.

Lenders could just amend their existing LIBOR loans, but that also entails cost and risk. First, there are a lot of these loans out there. According to the ARRC’s estimates, there are currently $1.3 trillion in retail mortgages (with $800 billion maturing after June 2023) and $800 billion in mortgage backed securities in outstanding exposures to USD LIBOR. Second, and potentially more troubling, is that consumers might push back against loan modifications they do not fully understand.

As with all change management, preparation is key. Lenders can take these three steps now to prepare for the coming change:

First, make sure current mortgage servicing software can support the shift to a new benchmark. The right software will facilitate this change, but only if it offers the right functionality.

Mortgage servicing software should be able to (a) seamlessly integrate the new rate codes for the various SOFR products, (b) utilize an adjustment spread if necessary, (c) easily modify legacy loans to SOFR specifications, (d) ensure that interest rate adjustments can be determined using both LIBOR and the new SOFR products and (e) modify third-party reporting with the new SOFR products.

Second, lenders should create a program to educate staff, so they have the correct answers to borrowers’ questions. If staff members answer questions incorrectly or inconsistently, borrower satisfaction may drop.  

Third, consult legal counsel about creating a plan for all existing contracts.

Because the servicing software is so important, lenders should work with their mortgage software partners as they navigate the transition from LIBOR. Most mortgage software vendors have been studying and preparing for this shift for some time now. Like it does for other changes impacting the mortgage industry, a proactive approach often yields the best results.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)