ARRC touts use of 30-day average SOFR for new-issue ABS, MBS

The Federal Reserve-backed Alternative Reference Rates Committee is promoting the use of a 30-day average Secured Overnight Financing Rate in pricing various securitizations, keeping in step with U.S. regulatory efforts to push markets away from using U.S. dollar Libor benchmarks in new floating-rate debt products.

In a 12-page white paper released Monday through the Federal Reserve Bank of New York, the industry working group outlined how 30-day average SOFR already “incorporates several beneficial attributes” that make it a “preferable alternative to U.S. dollar … Libor for certain securitized products,” including those bundling mortgages, student loans and commercial loans, the paper stated.

The paper arrives during a time when U.S. regulators are pressuring banks to cease underwriting floating-rate debt tied to Libor. While the most widely used USD Libor rates will still be published for another two years, that period is intended for issuers to pay down legacy asset-backed securities, mortgage-backed securities and structured-finance deals that lack a fallback benchmark rate.

“The ARRC has adamantly stressed that now is the time for market participants to stop issuing new Libor-based products, including securitized products,” said Tom Wipf, the rates committee's chairman and vice chairman of institutional securities at Morgan Stanley, according to an ARRC press release.

“We’ve seen strong investor demand for the SOFR issuances that have occurred so far,” Wipf added. “This paper aims to help institutions make that important transition smoother by providing clear insight and a methodology for issuing new SOFR-based securitized products.”

The rates committee has previously recommended SOFR as a "fallback" replacement benchmark rate for new and outstanding securitizations priced against a Libor spread. SOFR gained the ARRC's endorsement because it reflects interbank transactions in the Treasuries-backed repurchase market, in contrast to the method of daily quote estimates from a panel of global banks compiled by the U.K.'s Financial Conduct Authority to create Libor rates in five currencies across seven tenors.

SOFR is not currently mandated as a replacement rate by U.S. federal banking regulators although they are leaning on Congress to get involved. SOFR also does not yet exist as a forward-looking, term-based rate (similar to three-month or six-month Libor, for example) that many consider a critical step for wider SOFR adoption.

But SOFR remains the likely designated replacement rate for outstanding legacy ABS/MBS deals because of the rates body's endorsement and market trends, as well as recently passed state legislation in New York that designates an ARRC-recommended rate for legacy, Libor-based floating-rate debt that lacks an alternative backup rate. (Wall Street financial contracts are governed by New York state law.)

Most Libor rates across the globe are scheduled to end at year's end, although U.S. dollar Libor rates for the most widely used tenors (one-, three- and six-month) will continue to be published through June 2023 to smooth the transition away from the universal reference rate that was discredited after a 2012 rate-manipulation scandal.

Scott Eells/Bloomberg

The white paper noted evidence of growing support in the private ABS/MBS markets with the issuance of new deals in consumer and commercial loans (including multifamily) using the 30-day average SOFR rate, which is published by the New York Fed from the accumulation of daily transactional repo data.

The 30-day rate model touted by the rates committee was applied to ABS, MBS and commercial mortgage-backead securities products, but the rates committee excluded collateralized loan obligation transactions from its recommendation, since discussions on alternative benchmarks continue for that sector within the ARRC’s securitization work group.

The ARRC paper modeled how new-issue ABS and MBS products could use the 30-day SOFR rates with regular resets, setting benchmark rates for notes in advance of a coming interest accrual rate.

While the New York Fed also publishes compounded averages of SOFR rates over 90 days and six months, members of an ARRC securitization working group have concerns that using overnight transactional data as far back as 180 days could produce a “staler” rate unreflective of actual market trends. The 30-day average “provides a more recent reflection of the current interest rate environment,” the paper stated.

Looking forward, or behind?
The white paper also presented a “suggested” consensus among the members of a securitization working group within ARRC preferred the use of 30-day average SOFR rates in advance of the interest accrual period, to avoid operational challenges to otherwise price deals "in arrears" from the end of interest period.

While pricing in arrears would more accurately reflect the actual daily interest rates published in the interim, borrowers would be uncertain as to their final payment when taking out a loan, the paper stated. The in-arrears method also introduces the need for a lockdown, or lookback period, of up to seven days before the end of the interest-accrual period, in order to accurately calculate a timely release of funds.

The securitization working group members "viewed these structural limitations as potentially placing an undue burden on the liquidity of ABS securities," according to the paper.

The 30-day average SOFR would serve in the absence of a crucial term-SOFR rate that the ARRC has acknowledged it is unlikely to finalize by year’s end because of insufficient deal activity in derivatives to build a longer-term, forward-looking SOFR benchmark.

“While forward-looking rates may offer some attractive features to investors, the ARRC has emphasized that it is important not to wait for those rates to be available and regulators have noted that the use of term rates should be limited,” the paper noted.

The white paper was released one week after the group acknowledged there was “no guarantee when or if” a term rate would be developed prior to the planned retirement of most Libor rates at year’s end, with the exception of key dollar tenors that will remain through mid-2023.