Federal Reserve Committee Proposes New Index for ARMs

Written By: Joel Palmer, Op-Ed Writer

A committee of financial professionals has issued a report on replacing the London Inter-bank Offered Rate (LIBOR) in adjustable-rate mortgages.

The Alternative Reference Rates Committee (ARRC) has created a framework for using the Secured Overnight Financing Rate (SOFR) for ARMs.

LIBOR has been mired in scandal for several years. The U.K. Financial Conduct Authority has warned that LIBOR could end after 2021.

The ARRC is a group of private-market participants assembled by the Federal Reserve Board and Federal Reserve Bank of New York to identify risk-free alternative reference rates for LIBOR.

LIBOR is currently the most commonly used reference rate for consumer ARMs.

SOFR measures the cost of borrowing cash overnight collateralized by Treasury securities.

“The white paper demonstrates how SOFR can be used to benefit consumers,” said Tom Wipf, ARRC Chair and Vice Chairman of Institutional Securities at Morgan Stanley. “The paper shows that there are ways to avoid subjecting consumers to the risks inherent in LIBOR. It is possible to use SOFR now to develop products that are built on a robust reference rate that is firmly grounded in market transactions.”

The ARRC proposes that SOFR-based ARMs use many of the same conventions that exist on LIBOR-based ARMs. The new model will use the same range of fixed-rate periods available, timing of payment determinations, and structure of caps on the amount that mortgage payments can rise at the end of the fixed-rate period and over the life of the mortgage.

There will be differences, based on the AARC proposal, which include:

ARMs would be based on a 30-day or 90-day average of SOFR. This differs from the current use of the one-year average for LIBOR.

The margin for SOFR-indexed ARMs would be increased over what is currently used for LIBOR. This is being proposed because SOFR tends to be lower than one-year LIBOR. According to the report, increasing the margin would make borrowers’ overall floating-rate payments comparable to existing LIBOR-based ARMs.

The paper proposes that borrowers’ monthly floating-rate payment adjust every six months instead of annually. This is to ensure that SOFR-indexed ARMs can be offered at rates consistent with other competitive rates in the market.

The proposed models cut the periodic adjustment cap from 2 percent to 1 percent. This is to minimize unexpected payment increases to the borrower. The borrower’s payment, even in a period of rapidly rising interest rates, would not change by more than 2 percent over a 12-month period, in accord with the current market convention for LIBOR-based ARMs.

Freddie Mac and Fannie Mae issued statements supporting the transition to SOFR. Fannie said it will use the framework to develop a SOFR-indexed ARM product for new originations in advance of the possible termination of LIBOR.

Also last week the ARRC released proposed fallback contract language for new ARM contracts that reference LIBOR to mitigate the risks associated with the potential end or disruption of the index after 2021.

Current contract language in closed-end, residential ARMs typically allows lenders to select a replacement index if LIBOR is no longer available. But, according to AARC’s statement, it does not provide much clarity about when an index is no longer available or the process to select a replacement. It also does not explicitly state that it may be necessary to make an adjustment to reflect differences between the current and replacement indices in order for the replacement index to be comparable.

The proposal “lays out clear and observable triggers and uses a replacement index selected or recommended by the Federal Reserve or a body convened or endorsed by the Federal Reserve, if such rate is available.”

About the Author

As an NAMU® Opinion Editorial Contributor, Joel Palmer is a freelance writer who spent 10 years as a business and financial reporter and another 10 years in marketing for the insurance and financial services industries. He regularly writes about the mortgage industry, as well as residential and commercial real estate, investments, and retirement income planning. He has also ghostwritten books on starting a business, marketing, and retirement income planning.

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