Last Friday, the Alternative Reference Rates Committee ("ARRC") published its recommended language to address LIBOR's probable cessation after 2021 in newly issued residential adjustable rate mortgages ("ARMs"). Minutes later, the ARRC announced that Fannie Mae and Freddie Mac plan to include the ARRC language in their residential mortgage note templates in the first quarter of 2020.
Mortgage documentation in use today typically provides for the lender or holder to designate a new index "based upon comparable information" upon LIBOR cessation. Given the likelihood of LIBOR's demise and in order to promote industry-wide "best practices," the ARRC's recommended language would establish a simplified set of "triggers" (actual cessation and a (pre-cessation) "unrepresentativeness" trigger) and a simplified set of "fallbacks" consisting of (i) the replacement index, if any, specific to consumer products (including ARMs) selected or recommended for use by the Federal Reserve, the New York Fed, or the ARRC or similar committee; and (ii) in the absence of such an index, the rate (composed of a "Replacement Index" plus a "Replacement Margin") selected by the "Note Holder." The "Note Holder" is undefined but in any event is to use "reasonable, good faith effort[s]" to select a rate that it "reasonably expects will minimize any change in the cost of the loan, taking into account the historical performance of the Index and the Replacement Index."
The recommended language is agnostic as to the contours of the rate that will be selected or recommended for consumer products by the ARRC, but the commentary makes clear that the ARRC is continuing to pursue the approach outlined in a July 2019 "white paper." This approach utilizes a "synthetic term" averaging of Secured Overnight Financing Rates ("SOFR") in advance for each accrual period, which differs sharply from the "in arrears" approach adopted for "institutional" cash products by the ARRC and for derivatives by ISDA.
It is becoming increasingly clear that market participants (and securitization market participants in particular) will need to reconcile and risk manage a variety of SOFR-based rates being proposed for the consumer, derivatives, and institutional cash product market segments.
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