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Fed Group Proposes Adjustable-Rate Mortgages Using Libor Replacement

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07/11/2019 | 02:22pm EDT

By Daniel Kruger

A financial industry group is proposing to use a new benchmark designed by the Federal Reserve for adjustable-rate mortgages, replacing the troubled London interbank offered rate.

The proposal, released Thursday in a paper written by a group overseen by the New York Fed, marks another step in efforts to replace Libor, the interest-rate benchmark that underpins trillions of dollars in financial contracts including credit cards, corporate loans and derivatives. Libor was slated for replacement in 2021 after a manipulation scandal.

The paper is the latest in a series of presentations by regulators and banks including Goldman Sachs Group Inc., Morgan Stanley and MetLife Inc. intended to push markets and companies to replace Libor. The group, known as the Alternative Reference Rates Committee, or ARRC, in 2017 designated the secured overnight financing rate, or SOFR, as its preferred benchmark.

Finding a replacement for Libor is a key challenge for banks, companies and investors because each wants a reference rate that reflects risks from short-term lending and is supported by a liquid market that behaves in a predictable manner. Properly setting the rates on such loans can determine whether the loans are affordable for borrowers and profitable for lenders.

About $1.2 trillion of U.S. mortgage debt is linked to the Libor rate, according to the New York Fed, making it the largest segment of consumer debt affected by the transition. Fannie Mae and Freddie Mac, the federal housing-finance giants, are planning to buy the new mortgages and to package them as debt securities as soon as possible before the planned cessation of Libor at the end of 2021, ARRC officials said.

Companies have sold $148 billion of shorter-term floating-rate debt linked to SOFR since the first offering by Fannie Mae last July, according to the CME Group. Almost one-quarter of that amount was issued in June, the largest monthly total to date. That is a fraction of the amount of Libor-linked debt sold during the period.

Members of the group say SOFR is more reliable than Libor because it is derived from the rate to borrow cash overnight using U.S. government securities as collateral. These trades are known as overnight repurchase agreements, or repos. Libor is set by a group of banks in London that provide estimates of the rate at which they could lend to other banks over various periods. Those estimates take into account the risk the borrowers won't repay the debt.

The push to bring the new adjustable-rate mortgages to market also could force other participants in the housing market to address the expected end of Libor, ARRC officials said. People from mortgage brokers to call-center employees will have to be educated about the mortgages, while banks, investors and servicing companies will need to revise their bookkeeping infrastructure to accommodate the new debt. Those changes could take between 12 and 18 months.

The new mortgages are the latest step by ARRC members to encourage companies to begin using SOFR as a reference rate.

In April, the Fed released a paper written by two central-bank economists describing a method to calculate longer-term SOFR rates using prices from futures contracts. Analysts have said this kind of term structure could make selling floating-rate debt linked to SOFR more attractive to companies. However, ARRC members have said that the longer-term SOFR rates won't be ready until late 2021, and are urging companies to use the overnight rate to speed the adoption of the new rate.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

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