Tag Archives: SOFR

Bond Illiquidity, LIBOR and You

Summary
  • A letter to the Alternative Reference Rates Committee (ARRC) from the Secured Finance Industry Group (SFIG) put an end to the fiction that major financial institutions support SOFR.
  • Financial institutions are justly concerned that SOFR could fatally squeeze bank margins in a crisis.
  • Nevertheless, other proposed alternatives, such as the changes to LIBOR proposed by Intercontinental Exchange (ICE), do not fit the regulators’ requirement that the replacement be determined by liquid market transactions prices.
  • Regulators cannot introduce a new financial instrument. LIBOR’s replacement must be the result of private sector innovation.

(Kurt Dew) A recent Secured Finance Industry Group (SFIG) comment letter is SFIG’s response to a request for comment by the Alternative Reference Rates Committee (ARRC) – a Fed-appointed committee of bankers tasked to solve the LIBOR problem. The Fed’s ARRC creation was an embarrassingly transparent attempt by the regulators to co-opt industry objections to their LIBOR replacement. ARRC proposes to replace LIBOR by the Secured Overnight Financing Rate (SOFR) – a Fed-created version of the overnight repurchase agreement rate. The SFIG comment details the objections of financial institutions to SOFR. Importantly, SFIG serves as chair of ARRC. The critical comment letter is thus the final blow to the regulators’ failed effort to gain the appearance of financial institution support for SOFR.

However, more importantly, neither financial institutions nor their regulators have a clear plan to resolve the need to replace LIBOR. If replacing LIBOR were not such a critical matter, the Byzantine machinations of the bank regulators and financial institutions around SOFR would be amusing. However, the pricing of tens of trillions in debt instruments and hundreds of trillions in derivative instruments depends on a smooth transition to some reference rate other than LIBOR. I contend that this enormous magnitude is a low estimate of the financial market assets at risk due to poorly governed debt markets.

Financial markets’ failure to solve the LIBOR replacement problem is the result of a misunderstanding of the reasons for the LIBOR problem. Understanding of LIBOR suffers from journalistic misdirection, on one hand, and a misunderstanding of the root problem that the LIBOR brouhaha exemplifies, on the other.

The failure of LIBOR is a market structure failure. However, the financial press bills LIBOR’s failure mistakenly as a failure of ethics among bankers. Recorded transcripts of telephone, email, and chat room conversations of small groups of traders provided the evidence of ethical weaknesses leading to attempted market manipulation that drove the post-Financial Crisis LIBOR embarrassment.

However, markets themselves typically are the best antidote to attempted market manipulation. The market solution to trader cabals formed to alter prices has always been a simple one. In a liquid market, larger market forces inevitably swamp organized efforts to manipulate prices. Cabals don’t work in a liquid market because the manipulators lose money.

The split over a LIBOR is an enormous opportunity.

Financial institutions have quite reasonably insisted on two key properties that SOFR lacks.

  • The LIBOR replacement should be forward-looking. That is, the rate should reflect the market’s opinion of overnight interest costs on average in the coming three months.
  • The LIBOR replacement should reflect the interest cost of private unsecured borrowers, instead of the lower interest costs of the Treasury.

Thus, coupled with the TBTF banks’ endorsement of the Intercontinental Exchange Inc. (ICE) candidate for a LIBOR replacement, the SFIG letter shows that ARRC’s SOFR proposal does not represent the banks and other financial institutions that are ARRC members. Worse, it raises a serious threat. If regulators seize on an index that might potentially bankrupt one or more major financial institutions during a financial crisis, those institutions do not plan to allow the Fed to pass the blame for this disastrous decision to them.

However, the banks (or a third party) will, I believe, have to do more than provide another bank-calculated index. The self-acknowledged problem with the ICE (TBTF endorsed) LIBOR replacement is that any index the procedure produces is the result of a transaction selection process by banks themselves. Thus, the ICE fix remains vulnerable to the same ethical vulnerabilities that LIBOR itself faced.

In short, any satisfactory LIBOR replacement must be a form of debt that doesn’t exist now. We could throw up our hands and use the hazardous SOFR, but this seems to be a negative way of looking at the situation.

This is an obvious opportunity to seize an enormous chunk of the financial markets in one fell swoop by addressing bond market illiquidity more generally. Moreover, it is an opportunity that anybody with the courage and the capital could pursue. The problem is one of creating a new debt market with a different structure. Such a new market would have no incumbent oligopolies and no reactionary regulators. Capital, a few hotshot IT professionals, and some people with skills of persuasion would be enough ammunition to get the job done. Island overwhelmed the incumbent stock exchanges with less.

Interestingly, in all likelihood, TBTF banks, incumbent exchanges, and regulators are at a disadvantage in the pursuit of a debt market innovation since they are married to old ways of generating revenues. An incumbent TBTF bank pursuing a new market structure, for example, would not find management friendly to ideas such as putting an end to collateral hypothecation in the repo market.

Why are we getting LIBOR wrong?

SFIG and the TBTF banks also concede that there is no existing instrument that meets the minimal standards required of a LIBOR replacement – the replacement should be a term (probably three-month, or six-month) unsecured debt instrument, traded in a liquid marketplace where recorded transaction prices are the result of the combined forces of supply and demand. SFIG’s comment letter to ARRC’s request to comment on SOFR points to a central quandary that neither SOFR nor its detractors have addressed. No financial instrument meets these criteria today.

Don’t blame the Fed. The Fed did everything imaginable to get industry support for repurchase agreements, the only existing liquid instrument where an honest broker (the Fed) records market transactions. Blame the markets themselves. Organized market participants are adopting the time-honored “See no evil; hear no evil; speak no evil.” approach. Once ARRC had endorsed SOFR, CME Group (CME) helpfully created a futures contract based on SOFR.

All that remained was for the markets to begin trading the SOFR-based instruments. However, that didn’t happen. CME volume in SOFR futures remains a small fraction of Eurodollar (LIBOR) futures volume. In itself, this is not a failing of the marketplace. It’s simply the market’s recognition that SOFR futures don’t provide adequate protection for their existing risks.

How big is the LIBOR problem?

No matter how dire you believe the LIBOR problem to be, the underlying problem of debt market illiquidity that the LIBOR problem reveals is many times bigger. A LIBOR fix only resolves the issue of illiquidity in the short-term end of the market for unsecured debt.

LIBOR became important to society when it began to appear as a factor in the cost of mortgages, municipal debt, and credit card debt. In other words, LIBOR is different from the interest cost of a corporate bond because of LIBOR’s visibility. However, of course, all bank debt, no matter how obscure, is a factor in the cost of consumer borrowing.

An exchange trading liquid tailor-made debt issues that capture the primary price risks associated with debt issuance at all maturities would have a massive beneficial effect on the cost of financing. This market would generate transactions comparable to the combined volume of the stock exchanges, assuming turnover in the two markets to be comparable.

What flaw in market structure creates the LIBOR/debt market liquidity problem? In the markets for corporate liabilities, the issuer is concerned about the market appeal of the terms upon which debt is sold only once – the issue date. After that, any action the corporation might take that benefits its stockholders at the expense of its debtholders faces a single low hurdle – is it legal? Investors are wise to devote more time and attention to debt acquisition than to share acquisition.

If bondholders could devise an instrument that liberates its holder from the negative effects on debt valuation of the decision-making power of a single issuer, it would be interesting to see what effect that would have on the position within corporate politics of debtholders relative to stockholders. One could imagine the popularity of this buyer-friendly instrument growing relative to the popularity of the current issuer-centric debt issues. As this form of debt grows as a share of the market for debt, the management of this debt would become gatekeepers for bond market liquidity. They might gradually induce issuers to write more buyer-friendly forms of debt.

The legal obligation of corporate management to consider the interest of stockholders when these interests conflict with the interests of debtholders is writ in stone. Nevertheless, there is no legal barrier to investors – the final constituency for all corporate obligations – using their influence to discriminate among debt issues. If debtholders confront stockholders with a positive payoff to pleasing debtholders, there might be multiple systemic improvements. The value of buyer-friendly debt would rise relative to issuer-friendly issues, driving down its interest cost and resulting in capital gains to both debt and shareholders. The result would be an altogether safer financial system as a whole.

Source: by Kurt Dew, Think Twice Finance | Seeking Alpha

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LIBOR’s Phase Out Poses Massive Uncertainty for Adjustable Rate Mortgage Stakeholders

LIBOR, the London Interbank Offered Rate, which sets the rate for 2.8 million adjustable-rate mortgages (ARMs) and most reverse mortgages, is set to expire in three years. The index that appears to be LIBOR’s most likely successor, the Secured Overnight Financing Rate (SOFR), could potentially create a $2.5 to $5.0 billion annual windfall for forward mortgage holders and an equivalent loss for investors.  

Fannie Mae, Freddie Mac (the government-sponsored enterprises, or GSEs), and their regulator, the Federal Housing Finance Agency (FHFA), have the greatest influence on the transition from LIBOR to a new index. Given the scope of the potential impact on investors and consumers, it’s important that the FHFA and the GSEs continue planning for the LIBOR change.

The LIBOR, dubbed “the world’s most important number,” is the rate at which banks report that they lend money to each other. It is a reference index, setting interest rates on mortgages and millions of other financial contracts totaling $200 trillion. Because of the “LIBOR fixing” scandal, in which certain banks deliberately misrepresented their lending rates (which are used to create the LIBOR), LIBOR is expected to be replaced by an alternative index by the end of 2021.

There are about $1 trillion in LIBOR-based adjustable-rate forward mortgages, or 2.8 million mortgages which represent close to 10 percent of the outstanding mortgage market. The greatest concentration is in loans held in bank portfolios and in private-label securities.

https://edit.urban.org/sites/default/files/liborpie.jpg

Approximately 57 percent of these 2.8 million LIBOR-based mortgages were originated pre-crisis. In terms of credit characteristics, LIBOR ARMs tend to look similar to fixed-rate loans originated at the same time, except in the private label securities market, where the characteristics of the pre-crisis LIBOR product were weaker. LIBOR ARMs tend to be larger loans than their fixed rate counterparts. This is particularly pronounced in the bank portfolio space, where the average ARM loan is $582,400 versus $306,200 for all portfolio loans.

https://edit.urban.org/sites/default/files/libortable.jpg

We also need to consider the possibility of a “zombie” LIBOR

LIBOR is apt to disappear at the end of 2021. Regulatory bodies are encouraging banks to continue to submit the numbers used to create the LIBOR through the end of 2021, at which point they are likely to stop. At that point, a substitute index will need to be used.

The legal documents on most adjustable-rate mortgages allow for the substitution of a new index based on comparable information if the original index is no longer available. But contract language for most mortgages is largely silent on how to define a reasonable substitute and what it means for LIBOR to be unavailable. 

On the latter issue, there is also the possibility that the LIBOR will become increasingly unreliable before it expires. As banks begin to pull back from providing information, they may create what has been nicknamed a “Zombie LIBOR,” which would be an unreliable LIBOR index and a real risk.

We believe that Fannie Mae and Freddie Mac, while they play a small role in the LIBOR market for adjustable-rate mortgages (20 percent by loan count), will decide under FHFA guidance how they want to handle GSE adjustable-rate mortgages, and the rest of the market will follow suit.  

What will the SOFR do to mortgage rates?

A group convened by the Federal Reserve has recommended that the SOFR be the successor to the LIBOR, but the SOFR differs from the LIBOR in two important ways:

  1. The SOFR is a secured rate, while the LIBOR is unsecured and, therefore, includes a risk premium. Historically, this has meant that the SOFR has been both lower than the LIBOR and less volatile.
  2. The SOFR is an overnight rate, while the LIBOR is quoted for a variety of terms.

Efforts have been made to encourage the development of a longer-term SOFR, but this market has not yet matured, so it’s not clear how the longer-term SOFR will be priced. But by comparing the historic LIBOR and SOFR rates and comparing one-year LIBORs with one-year Treasuries (as a proxy for the still-emerging longer-term SOFR), we estimate that a one-year SOFR will be 25 to 50 basis points lower than a one-year LIBOR. If this is accurate, substituting the SOFR for the LIBOR could decrease the mortgage rate on the outstanding LIBOR-indexed ARMs by 25 to 50 basis points.

https://edit.urban.org/sites/default/files/liborline.jpg

If SOFR was substituted for LIBOR, we estimate that, over the entire $1 trillion forward ARM market, this differential would give borrowers a change in cumulative payments and investors an increased cost of $2.5 to $5.0 billion a year, or $15 to $30 billion on a present-value basis.

Close to 90 percent of the recent reverse mortgage market originations (home equity conversion mortgages, or HECMs) and 60 percent, or $50 billion, of the overall HECM market is also LIBOR based. In the $50 billion LIBOR HECM market, the likely beneficiary would be the heirs or the Federal Housing Administration (FHA) for any paid insurance claims, and the investors in Ginnie Mae securities would face increased costs. We estimate this transfer could be about $125 million a year, or a present value of $2 billion.

Why not align the SOFR more closely with the LIBOR?

Conceptually, the SOFR rate could be more closely aligned with the LIBOR rate by defining the new index as term SOFR + x basis points. This would leave borrowers, on average, in the same position as they are now. But even here, there are potential issues.

Any add-on may work on average or “ex ante,” but it is subject to dispute. Reasonable people may come up with different estimates of the add-on, and even 1 basis point on $1 trillion is $100 million a year. We have seen litigation over smaller amounts. It may also be difficult for the mortgage market to use an add-on if the larger $200 trillion LIBOR market does not make this adjustment. 

Historically, the GSEs have tried to be considerate of borrowers when reference rates are discontinued, and we would indeed see a benefit to consumers if the GSEs move to the SOFR index without an add-on. 

Given the scope of the potential impact on investors and consumers, it is important that the FHFA and the GSEs continue planning for the LIBOR change in the forward market and that the FHA think about the impact in the reverse market. This is a complicated issue with no easy solution.

Source: by Edward Golding and Laurie Goodman | Urban Institute

NY Fed Launches LIBOR Replacement; Publishes First SOFR Rate At 1.80%

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This morning at 8am, the New York Fed, in cooperation with the Treasury Department’s Office of Financial Research, launched a much-anticipated, if largely worthless (for now) benchmark interest rate to replace Libor, together with two other reference rates, which traders and market participants hope will prove more reliable than the infamously rigged and manipulated index after a long and complex switch over.

The so-called Secured Overnight Financing Rate (SOFR), was set at 1.80 percent, roughly 17bp below the GC repo rate and 12bp above the fed effective.

Here is the full breakdown of today’s rates:

  • Secured Overnight Financing Rate (SOFR) set at 1.80%
  • Broad General Collateral Rate (BGCR) set at 1.77%
  • Tri-party General Collateral Rate (TGCR) set at 1.77%

SOFR – which unlike Libor is secured – is based on the overnight Treasury repurchase agreement market, which trades around $800 billion in volume daily. As Reuters notes, publishing the rate is the first step in a multi-year plan to transition more derivatives away from the London interbank offered rate (Libor), which regulators say poses systemic risks if it ceases publication; ironically it also poses systemic risks if it keeps rising as it references a total of $300 trillion in financial (swaps, futs and derivatives) and non-financial (loans, mortgages) debt.

Some are delighted by the new rate: “It’s going to be based on a very, very robust set of transactions. I don’t think a lot of the issues and unknown volatility around Libor is going to exist,” said Blake Gwinn, an interest rate strategist at NatWest Markets in Stamford, Connecticut.

To be sure, the relentless ramp higher in both LIBOR and L-OIS has confused many: “Instances like what we’ve been going through this past month where it’s not even a clear cut bank credit issue or a dollar funding issue per se. It’s kind of got everybody scratching their heads trying to figure out why it’s doing what it’s doing,” Gwinn said.

And speaking of 3M USD Libor, today’s fixing rose yet again, up from 2.3118% to 2.3208%, the highest since November 2008 and up for their 38th straight session, longest streak since November 2005.

 

https://www.zerohedge.com/sites/default/files/inline-images/3M%20USD%20LIbor%204.2.jpg?itok=rytIA4QV

Still, a move away from Libor is expected to be gradual and complicated: the most pragmatic reason is that there is not yet a market for term loans such as one and three months, as in Libor. And there may never be one, unless floating debt creators are incented to shift the reference benchmark from Libor to SOFR.

“It’s hard to imagine a way they could come up with a similar calculation for a term rate and that’s the big difference between whether or not people would be comfortable adopting SOFR as a straight replacement for Libor,” said Thomas Simons, a money market economist at Jefferies in New York.

To be sure, it will take a long time to develop liquidity in derivatives based on the rate; it will take even longer to transplant existing Libor-linked securities to SOFR. The CME Group will launch futures trades based on SOFR on May 7, while major dealers will enable swaps trading on the rate this year.

Investors will also need to adjust to the day to day volatility of the repurchase market, where rates typically increase ahead of monthly and quarterly closings.

“A lot of folks have not really followed the repo market and some of the intramonth variations particularly closely,” said Mark Cabana, head of STIR at Bank BofA. “On a day to day basis it will be more volatile, but smoothing out over a three month time horizon it should be similarly volatile.”

Now, the only question is whether it will ever be adopted.

Source: ZeroHedge