GOODBYE LIBOR, HELLO SOFR!
The London Inter-bank Offered Rate (LIBOR) is an interest-rate average calculated from estimates submitted by the leading banks in London. Each of these “panel” banks estimates what it would be charged were it to borrow from other banks in the London Inter-bank market. The resulting rate is calculated and published and is usually abbreviated as Libor or LIBOR. Thus, this methodology relied on estimates, rather than actual data, made by a small number of banks.
Over many years, LIBOR has become the predominant index for U.S. adjustable-rate mortgages (ARMs). In fact, it has become the most commonly used benchmark rate in the world, covering an estimated $300 trillion in assets across the globe and over $1 trillion of U.S. mortgage debt.
THE NEED FOR A REPLACEMENT INDEX
After the financial crisis of 2008, there were reports that some banks were falsely inflating or deflating their estimates of interbank rates which allowed them to manipulate the market to increase profits. This created the “LIBOR Scandal.”
As a result of the “LIBOR Scandal”, the financial community and financial regulators saw the need to create a new benchmark interest rate to replace LIBOR. In 2014, the Federal Reserve commissioned the Alternative Reference Rate Committee (ARRC) to recommend a new benchmark interest rate to replace LIBOR.
INTRODUCING SOFR - Secured Overnight Financing Rate
In June 2017, the ARRC selected SOFR as the preferred alternative to LIBOR, noting the stability of the repurchase market (on which SOFR is based) as the main benefit. SOFR is a “near risk-free” rate because the underlying repurchase transactions are secured by U.S. Treasuries, whereas LIBOR is based on unsecured transactions. The Federal Reserve describes the Secured Overnight Financing Rate (SOFR) as a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. Additionally, SOFR is not calculated based on sample size or future forecasts by a small, elite group of banks, but rather the calculation considers actual daily transactions.
GOODBYE LIBOR AND HELLO SOFR
New language will be required for single-family uniform ARM instruments closed on or after June 1, 2020, and importantly, acquisitions of single-family and multifamily LIBOR ARMs will cease on or before December 31, 2020. Effective January 3, 2022, the mortgage industry will cease using the long-standing LIBOR index and, instead, will adopt the new Secured Overnight Funding Rate (SOFR).
SWITCHING TO SOFR WILL HELP ENSURE THAT INTEREST RATES ARE NO LONGER SUSCEPTIBLE TO MANIPULATION OR FALSIFICATION AND PROVIDE CONFIDENCE TO ALL PARTICIPANTS IN THE FINANCIAL WORLD.
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