This article is part of our guide on fannie mae and non-recourse loans in multifamily, available here.
A significant change is coming, and you need to know about it. We are transitioning from LIBOR to SOFR occurring to determine adjustable rate loans to the SOFR.
In the 1970s, LIBOR was created by a panel of banks. Boards of banks based their policies and rates for adjustable rate loans on their predictions and guesses as to what the actual costs of lending and borrowing will be anywhere from one day to one year out. Prognosticating caused many problems during the financial crisis of 2007. There was a major scandal in 2012 with many member banks. Hence, the need to switch to SOFR.
What is SOFR Replacing?
The SOFR (Secured Overnight Financing Rate) replaces LIBOR’s benchmark interest rate (London Interbank Offered Rate). LIBOR was a safe and reliable interest rate benchmark to base adjustments and trades in the banking and lending community. However, in 2007, many lenders resorted to lending practices that ultimately harmed the consumer. In 2012, a banking scandal involved Barclays Bank and other panel banks in the UK and other European banks.
This scandal included manipulating the costs of lending and borrowing and not completing transactions that, on paper, had been signed off on as being completed. In 2017, it was determined by the United States Treasury Department and the Controller of the Currency that a change and transition were needed to protect the consumer as well as other investors.
So What is the Transition from LIBOR to SOFR?
The LIBOR transition to SOFR is a slow and methodical change. The growth is being made not only for the reasons above but also because of the nature of both rates. The old benchmark rate, LIBOR, is based on the conjecture and predictions of member banks as to where the costs of borrowing and lending money might be from one day up to one year. SOFR is based on transactions that have already occurred.
This does not mean that the SOFR isn’t volatile. There is a lag between the transaction and the reflection of the true cost with the maturities. This eliminates the possibility of manipulation and price fixing by member and panel banks.
The borrowing public deserves stability and security in their financial institutions. Risk exposure is problematic because it can deteriorate banks’ bottom line and erode confidence in the borrowing public.
LIBOR to SOFR Transition Timeline: What is the Timeline for the Change of LIBOR?
The LIBOR to SOFR transition timeline is for the financial system to determine:
- Which average of the SOFR to use? This will allow market participants to decide which market average to utilize to keep daily fluctuations at a minimum.
- Whether market participants want to use simple or compound interest will determine how longer-maturity rates are calculated.
- What will the period be when smoothed or long-term SOFR is calculated? Will the rates be based on trailing averages or the pre-agreement?
- How payment is due. Because there may be parties in the pre-arrangement period, it must be determined how long the parties have to make the contracted payments because rates could be volatile at the end of the reference period. If so, these parties may need a more extended payment notice.
All interested parties need to know when the transition began and the completion date for the shift.
When did SOFR Replace LIBOR?
The replacement of LIBOR with the overnight financing rate SOFR began in June of 2017 and is continuing. Many member and panel banks are somewhat concerned about the new risk levels this transition may result in. Derivative contracts are over $200 trillion in the notional value of derivatives and cash contracts.
It has been in select areas of the financial markets, like futures and floating rate notes, including adjustable rate mortgages on homes and treasury securities. The switch has impacted every part of the banking sector. There are challenges to be faced and overcome by this switchover. Because the CME SOFR Term Rates are a broad measure of the cost of borrowing cash and are collateralized by the US Treasury.
What are the Two Challenges that SOFR Faces?
Two challenges that the switch from USD LIBOR to SOFR faces is a lack of consensus and agreement. The standards that affect lending and borrowing are the lack of harmony and understanding. Another challenge is volatility.
Volatility is inherent when discussing market risk. However, the effects of this volatility are not as material as one might think. The market and panel bank participants use compounding or averaging to determine the rates.
Good Read: CLO vs. CMBS – What’s the Difference?
What is the SOFR Lookback Period?
The lookback period is called a timing convention, two days. This means that the rate is locked two days before the start of the interest period. The rate is then sealed for all the interest periods, and borrowers should give notice of borrowing three days before the borrowing date. The ARRC (Alternative Reference Rates Committee) regulates the changes and the transition from LIBOR to the SOFR.
What Agency is Pushing for the Switch to SOFR?
The ARRC (Alternative Reference Rates Committee) has been charged with pushing for and implementing the switchover from LIBOR to alternative benchmark rates. This committee is comprised of private-sector entities.
These entities include the banking and financial sector and regulators. The goal is to identify those reference rates determined to be risk-free, establish best practices, create and implement the plans and metrics and a timeline for an orderly transition and adoption of the change. The first set of objectives was met in 2017. In 2018, a Paced Transition Plan was put into effect, and the completion date for the switch was June 2017.
On December 31, 2021, the ICE Benchmark Administration stopped publishing USD LIBOR and LIBOR rates. LIBOR exposures are linked to derivative markets, yet another reason there is a transition away from LIBOR. With the SOFR, borrowing cash overnight collateralized with transactions that have already occurred prevents manipulation and fraud. Other issues are being addressed due to the currency locations.
Because of the scandal and the reforms underway, complimentary and parallel issues must be addressed. These reforms are international. Interest rate benchmarks must be changed, and most currency jurisdictions know the changes are necessary to protect consumers, investors, and bankers.
The problems caused by LIBOR Index caused issues in global financial markets because the panel bank submissions were highly unreliable. The cessation of LIBOR is a much-needed change because the financial contracts exerted caused the International Swaps and Derivatives Association to push for a replacement rate.
Frequently Asked Questions About The Transition from LIBOR to SOFR
The time fixed by SOFR is the speed at which repo trades are accomplished. The maturity for these trades is overnight, so there is little room for error or miscalculation.
The switch from LIBOR to SOFR is taking place because a banking scandal in 2012 harmed every finance and banking sector worldwide. SOFR is not subject to guesses by panel banks or individual investors.
SOFR is a risk-free rate because the transaction has already occurred and cannot be changed, manipulated, over-valued or under-valued.
Timeline for the Change to LIBOR - Conclusion
LIBOR has outlived its usefulness as a viable measurement of the costs of borrowing or lending. It is not a reliable index to change or adjust lending rates. Multifamily property investors need stability and safety when buying into or investing in these properties.
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