Switch to SOFR term rate could cost RMBS investors

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The Urban Institute believes that switching to the Secured Overnight Financing Rate as a benchmark for adjustable-rate mortgages after Libor is phased out would result in savings for consumers, but this would come at the expense of mortgage bond investors.

The think tank's conclusion is based on estimates of potential one-year SOFR rates being 25 to 50 basis points lower than the current Libor equivalent.

Using the one-year Treasury rates as a proxy, and comparing to historic Libor and SOFR rates (the latter only published as an overnight rate since April 2018), “we estimate that a one-year SOFR will be 25 to 50 basis points lower than a one-year Libor,” and would lower an estimated $1 trillion in existing adjustable rate mortgages by the same range, the report stated.

This "differential would give borrowers a change in cumulative payments and investors an increased cost of $2.5 to $5 billion a year, or $15 to $30 billion on a present-value basis,” the report stated.

A one-year SOFR rate is only on the drawing board with a New York Federal Reserve working committee, which had spearheaded efforts to adopt the overnight repo funding rate that it designed to replace Libor in the $36 trillion swaps and derivatives market.

The committee has plans to develop a term-rate replacement derived from SOFR, but the Fed’s Alternative Reference Rate Committee has only announced plans to have one ready by the end of 2021 when the Libor rate-quote system overseen by U.K. regulators is expected to end.

ARM holders would not be the only beneficiaries, the Urban Institute report claimed. About $50 billion of the reverse mortgage (or home equity conversion mortgages) market is also based on floating-rate Libor. Under a similarly lower SOFR rate determined for the ARM market, the report estimated about $125 million a year, or $2 billion, would accrue to the heirs of HECM borrowers or the Federal Housing Administration under paid insurance claims – while “the investors in Ginnie Mae securities would face increased costs,” the report stated.

The report raised the potential for an “add-on” rate to a successor SOFR rate to mitigate the difference with Libor, but conceded major obstacles. Any “ex ante,” or average add-on rate would likely still be a subject to dispute since it may not cover the value-loss in rate conversion for all investors. “[E]ven 1 basis points on $1 trillion is $100 million a year,” the report stated. “We have seen litigation over smaller amounts.”

“Given the scope of the potential impact on investors and consumers, it is important that the FHFA and the GSEs continue planning for the LIBOR change in the forward market and that the FHA think about the impact in the reverse market,” the report stated. “This is a complicated issue with no easy solution.”

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