Joseph Dinolfo, a Director with Treliant, has nearly 20 years of financial services experience. His areas of expertise include regulatory compliance, risk management, audit, and banking, with an emphasis on consumer credit, mortgage origination, and mortgage servicing. His specialties include regulatory exam management, regulatory risk management, audit program development and…
Ever since the London Interbank Offer Rate (LIBOR) had its name muddied in the waters in 2014, banks with adjustable-rate mortgages (ARMs) tied to LIBOR have wondered about what comes next. In 2017, banks received a bit of a reprieve with the announcement that the index can be used through 2021, with a firm cessation date of June 30, 2023. However, during that time period, certain milestones related to the sunsetting of LIBOR have come to pass, including:
- On November 9, 2020, Freddie Mac started accepting whole loan and Mortgage-Backed Security (MBS) deliveries of single-family adjustable-rate mortgage (ARM) loans indexed to the Secured Overnight Financing Rate (SOFR).
- On December 31, 2020, Fannie Mae and Freddie Mac ceased purchasing LIBOR-based ARMs.
In 2018, the Federal Reserve started publishing the SOFR as a replacement to LIBOR, and the government-sponsored enterprises (GSEs), meaning Fannie Mae and Freddie Mac, that purchase these loans have been releasing guidance on the transition. However, with rates being historically low in the last decade, as well as the popularity of adjustable-rate mortgages, the risk of most of these ARM loans adjusting was small. Therefore, banks did not see a lot of risk in waiting out the transition.
In early 2021, Federal Reserve Vice Chair for Supervision Randal K. Quarles made quite a few comments on the LIBOR transition at the “The SOFR Symposium” that caused a lot of angst. He noted that “after 2021, we believe that continued use of LIBOR in new contracts would create safety and soundness risks, and we will examine bank practices accordingly.” This was reiterated in Federal Reserve Board’s supervisory letter SR 21-7, which noted that “if supervised firms are not making adequate progress in transitioning away from Libor, examiners should consider issuing supervisory findings or taking other supervisory actions.” Quarles in his remarks made it clear that “there is no scenario in which a panel-based USD Libor will continue past June 2023, and nobody should expect it to.”
From this it is clear we cannot use LIBOR as the index for any new adjustable-rate mortgage loan products, and we must take steps to transition away from LIBOR (by substituting a replacement index) in any existing loans that use it. We are well into 2022 and just a year away from the rule’s implementation date, and banks have known about this required transition for a half decade. What should banks be doing right now to ensure these things are happening?
Steps to Ensure the Transition Goes Smoothly
First, determine the role your bank plays in the LIBOR Transition. Is your bank a loan servicer and/or a note holder? Depending on your bank’s role, the focus may have different priorities. For each of these roles, the bank should have already performed the following (and if not, the bank should get on it soon):
- Inventory the bank’s LIBOR ARM-related exposure (e., does the bank make or hold any ARMs based on LIBOR);
- Assess contracts with third parties and determine responsibilities;
- Assess impacts of transitioning away from LIBOR and to a replacement index;
- Develop LIBOR transition plans;
- Manage the transitions; and
- Manage communications with affected parties.
The bank must also choose a replacement index if it is a note holder. The industry has generally adopted SOFR as the replacement for LIBOR, so this would seem to be the easiest transition for banks but it is worth doing some homework. For example, Credit-Sensitive Rates (CSRs) are another type of benchmark that is being considered in the transition from LIBOR. CSRs are rates that are forward-looking term rates sensitive to creditworthiness, which is similar to LIBOR, and like LIBOR, the rates are published daily. However, there are a variety of CSRs that are published, such as the AMERIBOR, BSBY, and the Bank Yield Index and the IHS Markit Credit Rate. These rates are credit-sensitive and respond to changes in market conditions, for example, by rising in times of economic stress, which SOFR generally does not. There is more risk for the bank in using CSRs; however, the bank’s returns can also be higher.
Even so, these CSRs are not as widely adopted, although this doesn’t mean they might not be a good option for your bank’s portfolio loans. For banks that may only keep ARMs in their portfolio, this transition should be done sooner rather than later, especially considering increased demand.
But what about compliance aspects of the LIBOR transition? The GSEs (e.g., Fannie Mae and Freddie Mac) have already stopped purchasing LIBOR-indexed ARMs, so if your bank were selling to the GSEs, a change would have already been made. However, if your bank hasn’t been selling ARM loans to the GSEs, it will have to choose an index other than LIBOR for these.
From a compliance perspective, there are required notices for rate adjustments with a corresponding change in payment under Regulation Z, and for initial rate adjustments. While Regulation Z is silent on whether a notification must be sent for the change in the ARM index, be sure that the appropriate rate adjustment notices are sent if the borrower’s rate changes with the change in index. There are no regulations directly impacted by the transition; however, there are a few things to keep in mind.
Managing the Transition
As noted above, regulators will be looking to see how your bank is managing the transition as part of the safety and soundness examination process. If your bank hasn’t yet developed a plan and addressed each management component noted above, you may not get high marks from your regulator. Not having a detailed plan increases risk to your organization, and the regulators will recognize this.
If your bank is servicing mortgages for other note holders, you may want to start communicating with the note holders now about the transition, if you haven’t done so already. Work with them to ensure they have chosen a suitable replacement index, and updated the affected consumer products in advance of LIBOR cessation.
If your bank sells mortgage loans on the secondary market, you should tie the bank’s mortgage products to the indices utilized by its investors. Consider using indices, such as SOFR, that are used by more than one investor to limit risk.
Managing Customer Communications
Whether you are acting as a servicer and/or note holder, borrowers will have changes to their payments, and these must be communicated promptly and effectively. Consider communicating with borrowers outside of required notifications. Since we are more than midway through 2022, plan start in the third quarter, communicating in phases until the execution date of June 30, 2023, especially if the number of communications is large.
These communications should detail for the borrower:
- Information about the end of LIBOR,
- Information about the replacement index, and
- What they should expect from the transition.
Additional considerations regarding these communications:
- Document the plan for the communication, especially if done in phases;
- Ensure there are enough resources to manage communications; and
- Anticipate potential responses and follow-ups.
How about the communications themselves? Are they sufficient? If you were a borrower impacted by this change, would you understand what is going on? If you think you would not understand, then your borrowers likely won’t, either.
Communication with borrowers may also create the potential for increased numbers of complaints, notices of error, and direct disputes. Make sure your Compliance Management System (CMS) is up to date and processes are ready and capable of handling the potential uptick in volume. In order to handle this, make sure staff is informed and trained on the transition and how to speak with borrowers, including how to communicate information on how the bank managed the change from LIBOR and what borrowers should know about the change, especially as to how it will impact their payments. Anticipate a common question: will my payment go up? Feedback from customers is key to determining what may be going wrong, and how to improve.
Does your bank have a plan? Have you been planning since day one of the transition, day one of 2022, or not yet? No matter what your answer, there is still time before the cessation, but not much time to get your transition game in order. Hopefully this type of transition will be rare, but if and when it happens again, you will have a tested and effective action plan in your back pocket.
As previously seen in the July / August 2022 issue of ABA Bank Compliance Magazine.