Multifamily Industry Prepares for LIBOR Transition

This article was originally published on Arbor Chatter: Multifamily Industry Prepares for LIBOR Transition, and all charts and images are from Arbor Chatter.

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• The London Interbank Offered Rate (LIBOR) has been the multifamily industry's benchmark for determining interest rates for adjustable-rate mortgages for decades.
• LIBOR's expiration in 2021 is leading multifamily lenders to prepare for a transition to an adjustable-rate alternative, which is likely to be the Secured Overnight Financing Rate (SOFR).
• The mortgage industry sees several benefits of using SOFR, which is based on actual transactions instead of self-reported data or estimates.

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For decades, the multifamily industry has used the London Interbank Offered Rate (LIBOR) as the benchmark for determining interest rates for adjustable-rate mortgages. An estimated $1.1 trillion in outstanding commercial mortgage loans are tied to LIBOR.

With LIBOR set to expire at the end of 2021, multifamily lenders are preparing to transition to an adjustable-rate alternative. Replacing such a widely used benchmark of the financial industry is a significant undertaking. Although the mortgage industry has begun to prepare, there is still work to be done.

Issues Around the Use of LIBOR

The LIBOR index is an average of interest rates submitted by major banks across the globe. At the end of the financial crisis, there was controversy regarding market manipulation by participants. Several banks misrepresented their submissions to achieve better returns and to avoid signaling financial weakness. This exposed LIBOR’s major flaw: it relied on self-reported data, which did not always reflect actual transactions, and left it vulnerable to malfeasance.

Another flaw that has since been observed is the lack of meaningful data to ensure LIBOR’s reliability. The volume of transactions contributing to LIBOR has declined; the rate is now based on only a handful of transactions.

By 2017, as it had become clear that LIBOR was no longer a reliable index, financial regulators announced that they would not support LIBOR after 2021. The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed, was established to explore reference rate alternatives as concerns grew over LIBOR. The Committee recommended the Secured Overnight Financing Rate (SOFR) as the preferred alternative to replace LIBOR.

SOFR as an Alternative to LIBOR

Several characteristics of SOFR differentiate it from LIBOR. SOFR is calculated based on actual transactions, not self-reports or speculative estimates. Additionally, the volume of transactions upon which SOFR is based is larger than that of any other U.S. money market. This ensures transparency and prevents manipulation. Furthermore, SOFR is not at risk of being discontinued, as it is derived from the U.S. Treasury market.

ARRC has recommended that the mortgage industry transition to SOFR, and Fannie Mae and Freddie Mac have started the process. However, representatives have stated that the transition could take 12 to 18 months. Additionally, several large institutions have already issued debt using SOFR, which reflects early confidence in the new benchmark. Fannie Mae issued three floating-rate notes valued at $6 billion in July 2018, which were the market’s first-ever securities priced to SOFR.

Lenders Prepare

Although it’s yet to be specifically determined how rates on existing adjustable-rate mortgages tied to LIBOR will be calculated going forward, lenders are working to insure a smooth transition. A recent Mortgage Bankers Association (MBA) survey found that 92% of commercial and multifamily mortgage lenders are already planning for the LIBOR transition. Additionally, 77% responded that all their new loan documents contain fallback language addressing LIBOR alternatives.

The LIBOR transition will be an enormous, industry-wide undertaking. Although guidance has been given, there is still significant work to be done. In the meantime, lenders and borrowers should remain aware of any changes that could impact their investments. With communication and awareness, the industry should be positioned to successfully navigate the transition with little disruption.

In Case You Missed It: Week of March 28, 2016

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“further volatility in oil prices will continue to affect stock market prices and potentially the real estate market, but largely in a macroeconomic and indirect way by creating uncertainty on the decision making of market participants. As long as job growth remains positive, the real estate market will remain positive as well. Some smaller areas that have shed jobs from drilling and ancillary oil demand will continue to decline, but these markets are isolated and generally small.”

How will an increase in the federal funds target rate affect mortgage rates?

The Federal Open Market Committee (FOMC) of the Federal Reserve announced in June that it will maintain the current 0.00% to 0.25% target range for the federal funds rate, the recommended rate at which banks lend to each other. The Federal Reserve can control the rate by buying or selling government bonds, in an effort to maximize employment and control inflation. The economy has been operating in a low interest rate environment since the recession and many fear that a rise in the federal funds rate will have a negative impact on mortgage rates.

Mortgage rates are market driven by lenders competing to attract investors, not just the federal funds target rate. Although they are affected indirectly because of the impact on borrowing costs, mortgage rates are largely affected by the direction of the economy and yields on competing financial products, such as treasuries and bonds. Mortgage rates don’t increase simply because the target rate increases, although some economists are worried a rate increase will have a direct impact on mortgage rates in the current economic environment.

The Federal Reserve has not officially announced a date to raise the target rate, although 15 of the 17 FOMC members surveyed stated that they believe the hikes will begin before the end of 2015. Some economists have predicted that the first rate increase will be announced at the fed’s September meeting. However, Chair Janet Yellen ensured this week that rate increases will be gradual and that policy will remain accommodative, indicating the target rate will likely end the year between 0.5% and 0.75%. The committee’s median target rate estimate for 2016 is 1.625% and 2.875% for 2017.

Given today’s low interest environment, even small increases could have a large impact. The federal funds rate has remained below 1% for nearly seven years, while the average rate for Freddie Mac 30-year mortgages has remained below 6% during that time. Prior to the most recent recession that started in late 2007, the effective federal funds rate held steady at 5.3%, while mortgage rates averaged just over 6%. In the early 1980s, mortgage rates peaked at over 18% and the fed rate climbed over 19%.

The FOMC’s economic projections also play an important role in the direction of mortgage rates, since a strong economy usually means higher rates, while a weaker economy leads to lower rates. The committee’s June projections estimate that the economy will grow at a 1.8% to 2.0% pace during 2015, which was revised down from the 2.3% to 2.7% projection published during March. Growth for 2016 is projected at 2.4% to 2.7%.

The federal funds target rate plays an indirect role in the direction of mortgage rates, with the marketplace and other key indicators of the economy playing larger roles. Given the Federal Reserve’s statements regarding accommodating policy and that the economy has still not recovered to full strength, any increase in mortgage rates driven by an increase in the federal funds target rate are expected be gradual.