Reena Pally of MetLife on the Transition from LIBOR to SOFR
By MBA Insights Staff
March 11, 2019
MBA Insights posed questions to Reena Pally, Managing Director of Real Estate Debt Strategies with MetLife Investment Management, about the transition away from LIBOR to a successor index for floating-rate loans.
MBA INSIGHTS: Can you start by telling us about the potential LIBOR transition and why it matters to MBA's membership?
REENA PALLY, METLIFE:A majority of floating-rate mortgages have their interest rates based off of LIBOR, the London Interbank Offered Rate. The availability of LIBOR beyond 2021 is unclear. The regulator of LIBOR, the UK Financial Conduct Authority, announced in 2017 that it will no longer require LIBOR panel banks to make LIBOR submissions beyond 2021. Therefore, floating-rate lenders need to prepare for the eventual transition from LIBOR to a successor index rate.
With hundreds of trillions of dollars of global derivatives and cash products (such as mortgages and syndicated loans) tied to LIBOR, it's important that investors understand the potential timing and implications of a transition from LIBOR to a replacement index. This transition has the potential to impact the economics of all MBA members and their clients.
The Alternative Reference Rates Committee, formed by the Federal Reserve, identified the Secured Overnight Financing Rate as its recommended alternative rate to U.S. LIBOR. The Federal Reserve began publishing SOFR in April 2018. Since then, we have seen significant issuance of SOFR-linked notes by the agencies and major financial institutions totaling $48.8 billion as of February 5 (Source: CME Group). This is a positive signal, as investor appetite continues to grow for SOFR linked notes.
INSIGHTS: "Real" transactions based on actual trades underlie SOFR, while LIBOR is a more subjective estimate. What advantages does this offer?
PALLY: SOFR is based on short-term loans known as repurchase agreements or "repo" trades, backed by U.S. Treasury securities as collateral. SOFR consists of transaction data from across the repo markets. SOFR reflects the cost of borrowing cash overnight secured by U.S. government debt. The secured rate is based on actual transactions and published by the Federal Reserve Bank of New York.
In contrast, LIBOR is a benchmark designed to be representative of the unsecured borrowing costs of banks when lending cash to each other. Due to declining interbank transactions, LIBOR panel banks have increasingly relied on ‘expert judgment' to determine LIBOR, causing LIBOR to be subjective in nature. Going forward, there is concern there may be insufficient data to sustain LIBOR as an objective benchmark.
SOFR is a more robust, transparent and dependable rate given it is entirely transaction based.
INSIGHTS: Do you think SOFR will ever completely replace LIBOR or do you expect there to be a variety of alternatives?
PALLY: We still have a ways to go, as the SOFR market is evolving. Today SOFR is an overnight rate and over time we expect that a term structure will be developed to reflect different future maturities such as one-month SOFR and three-month SOFR. SOFR futures and SOFR swaps have begun to trade with adoption accelerating in recent months.
Open interest in SOFR futures increased 42 percent in January and cumulative volume in nine months exceeds 1.5 million contracts. SOFR swap activity has increased as well. In January there were 43 fixed-rate SOFR swaps reported to data repositories and long-dated SOFR swaps are being actively quoted and 30-year SOFR swaps have been executed. (Source: Bloomberg). As SOFR futures and swaps continue to trade and increase in volume and liquidity, we will begin to see a term structure develop for forward looking SOFR. The ARRC has published a phased transition plan and anticipates a SOFR term rate will be available by 2021. Although, it is feasible the forward SOFR curve may be available sooner. Cash products can then begin to utilize SOFR.
I am aware of a few ‘competing' U.S. alternatives, such as AFX's Ameribor or ICE's proposed Bank Yield Index, but none would appear to satisfy a key International Organization of Security Commissions's principle for financial benchmarks, namely that they be based on robust underlying market transactions. It would be helpful for market participants to coalesce around a single reference rate in order to ease market functionality.
Lastly, we should not assume that LIBOR will just go away after 2021. There is a possibility that it will remain and Intercontinental Exchange, which calculates LIBOR, may make the case that it should continue to be used as an index for floating-rate loans and securities.
INSIGHTS: Commercial mortgage lenders have meaningful exposure to LIBOR. How can institutions get in front of the potential issues associated with transition away from LIBOR?
PALLY: While 2021 may seem like a far horizon, there are many things that lenders can do to prepare today from an overall education perspective and from a practical perspective. Lenders should consider following updates from a number of industry groups--for example, ARRC periodically publishes updates on SOFR and the transition.
The ARRC recently announced that David Bowman, Senior Advisor at the Board of Governors of the Federal Reserve, will hold weekly open office hours to offer market participants an opportunity to ask questions on transitions issues. The International Swaps and Derivatives Association also provides webinars for its members.
From a practical standpoint, understanding the amount of LIBOR-based exposure you have that matures after 2021 is important. Lenders should also have appropriate fallback language in legal documents to allow for a smooth transition from LIBOR to a replacement index. Fallback language will be beneficial even if LIBOR continues to exist, but is no longer the market standard. Ensuring technology systems can support a portfolio based on LIBOR and other replacement indices is also an essential step.
In addition, lenders with international portfolios can track advancements of other key replacement indices, such as Sterling Overnight Interbank Average Rate, or SONIA, which will replace LIBOR in the UK. Lastly, many institutions have formed cross-functional working groups consisting of key partners such as Legal, Portfolio Managers and Technology to assess and navigate the transition.
INSIGHTS: Your firm is involved in a variety of industry initiatives. Can you tell us a little about your participation in LIBOR Outreach Committee in particular and anything else you think would be helpful for MBA members to be aware of?
PALLY: It's exciting to see a new benchmark develop. While we anticipate LIBOR will remain viable through 2021, over the next few years, progress will need to be made on a number of evolving issues. ISDA is anticipated to publish key protocols regarding conversion of existing LIBOR-hedging agreements to a replacement index. In addition, because LIBOR is an unsecured rate and SOFR is a secured rate, we anticipate ISDA will publish protocols for spread adjustments to account for rate differences.
It's been a great opportunity to contribute as a member of the MBA LIBOR Outreach Committee. Under the leadership of the MBA, the committee brings together institutions from different pockets of the mortgage market to share how each institution is handling the transition from LIBOR to a replacement index. Through sharing best practices, we aim to make the transition smoother for each MBA member.
With market participants focused on the matter, we remain optimistic of a successful market transition.
(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 Insights welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at email@example.com; or Michael Tucker, editorial manager, at firstname.lastname@example.org.)