Preparing for the Transition from LIBOR to SOFR
The London Interbank Offered Rate (LIBOR) has been a staple as an interest rate benchmark for debt instruments like mortgages for decades. However, regulators plan to phase out the widely used benchmark rate by the end of 2021. Everyone who has relied on the LIBOR index in the past, including mortgage lenders and servicers, must now transition to a replacement index by year’s end.
While the debate continues to rage on about this replacement, the Secured Overnight Funding Rate (SOFR) is particularly being recognized and targeted for adoption by many financial institutions within the U.S. Mortgage Market.
This is a transition that would be a complex undertaking in any year. However, this year, it’s a transition that must take place alongside record mortgage volumes and the coming expiration of millions of pandemic-driven forbearances under the CARES Act.
The transition is undoubtedly going to be a challenging one. Fortunately, there are steps you can take to prepare for it and make it as smooth as possible for your organization.
Understand the Difference Between LIBOR and SOFR
In order to ensure a smooth transition, you first need to understand the difference between the current index and its replacement. For discussion purposes and based on the current leanings of most financial institutions in the U.S. Mortgage Market, this article will focus on the replacement of LIBOR with SOFR.
LIBOR rates are calculated on a daily basis by averaging funding rates obtained from large global banks. However, after the financial crisis of 2008, the number of large global banks that report on their funding rates has declined. This has forced the Intercontinental Exchange Benchmark Administration (IBA), which is the company tasked with calculating LIBOR, to rely on “data-based expert judgement” rather than actual numbers. SOFR rates, on the other hand, are calculated using only transaction data supplied by the United States Treasury. Many argue that this key difference indicates that SOFR provides a more accurate index, relying on past performance metrics rather than forward-looking projections.
The differences don’t end with calculation methods. While LIBOR has multiple term rates, SOFR is only measured daily. While LIBOR possesses credit risk due to its averaging of costs, SOFR is known as the “risk-free” rate. These are all key distinctions that mortgage professionals must be aware of prior to the transition.
Consider the Challenges at Play
Once you understand the differences between the two indexes, you must consider the challenges the mortgage industry will face when it comes to the LIBOR transition to SOFR.
Servicers with large portfolios of adjustable-rate mortgage (ARM) loans pegged to LIBOR will face many challenges. These challenges include identifying the affected loans and ensuring that the changes are communicated to borrowers in an accurate and timely manner.
Lenders have obstacles ahead of them as well. In addition to identifying the loans in their portfolios that will be affected by the shift, lenders will be tasked with using a new method for estimating interest rates. Since SOFR is solely a daily rate, unlike LIBOR, lenders will need to begin utilizing prior compounding periods to estimate interest rates for borrowers. The switch to the new SOFR index could result in unanticipated interest rate movement for borrowers, which could lead to dissatisfaction and threatened relationships.
Take Advantage of Resources for a Manageable Transition
No matter the replacement choice used for LIBOR into the future, the fact remains: there are plenty of challenges ahead. With this said, there is also help available for navigating those challenges. Resources for communicating with borrowers include a variety of customizable templates and other documents available through organizations like the Mortgage Bankers Association and the Federal Housing Finance Agency.
Additionally, technology can also play a large part in preparing for the LIBOR transition. If ever there was a time for you to recoup your investment in document management technology, 2021 is the year.
And no matter where you are in the process, MetaSource can provide the tools and expertise you need to overcome your obstacles. We can help you turn an extraordinary year into a year of extraordinary efficiency.
It starts with ensuring that your technology is up to the task, with automated search and retrieval of documents, precisely filtered by the data you need to determine which loans require your attention. High-quality document management solutions tailored for the mortgage industry are a business edge in any market, but in 2021, you can think of them as a hedge against the chaos.
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