Replacement of Libor mortgage index recalls memories of Y2K panic

The development of a replacement index for the London interbank offered rate brought back memories for one secondary market participant of the technology disaster worries many had at the turn of the century.

It has been "almost Y2K-ish, but hopefully that's a big overstatement," Timothy Kitt, senior vice president and head of pricing and execution for Freddie Mac, said during a panel session Tuesday at the Mortgage Bankers Association's National Secondary Market Conference in New York.

Still, he continued, there is a huge sense of urgency among secondary market sellers and servicers regarding finding a replacement, which would have to be both for new loans as well as for legacy adjustable-rate mortgages, securities and credit risk transfer instruments tied to Libor.

But what nobody wants is a "zombie Libor," one based on nonaggregated data, said Renee Schultz, senior vice president of capital markets at Fannie Mae. In addition, some loan contracts require that the rate be frozen if Libor were to stop being published.

Any replacement product would need to have a market among both secondary market sellers and mortgage borrowers, Kitt said. One alternative being discussed is the secured overnight funding rate in various iterations.

Most ARM loans are indexed to Libor. The estimate is $1.2 trillion of residential mortgages are exposed to Libor, according to the Alternative Reference Rates Committee. However, ARM originations remain muted; since the start of the year, there were only two weeks where the share of new applications for ARM loans exceeded 9%.

There is a lot that has to happen between now and 2021, when Libor data will no longer have to be submitted and aggregated, Shultz said. For potential new originations of ARM loans to a different index, both lenders and vendors "will need time to make changes to [their] systems," she said.

But the whole process to come up with an alternative will be very similar to what the GSEs did in creating the single security that will come to the market on June 3, "so we know we can do this," Schultz said.

The agencies were directed to work together to find a replacement by the Federal Housing Finance Agency, but even so, going in different directions "is not in the best interests of the industry," she continued.

Existing loans stand as a bigger challenge for lenders. If an index is eliminated, any replacement is dictated by the terms of the loan documents.

Right now, the secondary market is getting a "test run" on seeing an index go away because the 11th Federal Home Loan Cost of Funds Index will stop being calculated and published at the end of this year, she said.

So during the COFI replacement process, it will be "how quickly servicers and vendors can implement a new index," said Kitt.

Plus, the markets had replaced other obsolete ARM indices in the past, Schultz added, so making a change is not something new. But it had not involved a market the size of Libor-indexed products either, she continued.