With the London interbank offered rate going away by 2021, picking a new index to serve as the benchmark for adjustable-rate mortgages is the easy part. Industrywide implementation is where things get tricky.

Origination and servicing systems will need to be updated to accommodate the new benchmark and those revisions have to be applied in a consistent manner across myriad platforms, which are often customized to meet lender and servicer specifications, said John Levonick, director of regulatory compliance at Clayton Holdings. Failure to do so could invite a new wave of legal and regulatory scrutiny to the mortgage industry, particularly if consumers are harmed.

"There is no standardization in manufacturing a mortgage today, so there is going to be some negative impact on assets that inadvertently cause Truth-in-Lending disclosure violations," he said. "That is going to be the most concerning; how to approach assets that are manufactured with defects based upon this change."

The most likely replacement for Libor comes from the Alternative Reference Rates Committee, which wants to use a benchmark based on overnight repurchase transactions collateralized by Treasury securities, Levonick said.

The government-sponsored enterprises require any replacement to be a comparable index, one that behaves in the same way as Libor.

Libor is a bank-to-bank lending rate which has seven different maturities, ranging from overnight through one year and is published for five currencies — the euro, the U.S. dollar, the pound, the yen and the Swiss franc. It is published daily at noon London time by the ICE Benchmark Administration.

Many hybrid ARMs, such as the 3/1, 5/1, 7/1 and 10/1 products, are indexed to Libor.

National Mortgage News reached out to three large originators/servicers — Wells Fargo, Quicken Loans and Chase — and the common response was that it was too early following the announcement to discuss any specific effect the decision to drop Libor would have on their business.

There are 4.2 million ARMs, or about 8.16% of all outstanding mortgages, according to Black Knight Financial Services. Of those, 2.7 million, or 65%, are indexed to Libor. And about half of those Libor-index ARMs have already reached their first adjustment date. The remaining are in the initial fixed-rate period.

Other indices the GSEs permit for ARMs include the one-year Treasury and the Eleventh Federal Home Loan District Cost of Funds Index; the latter measures what thrifts in Arizona, California and Nevada pay for mortgage funds. Both behave differently than Libor.

But those aren't the only options to replace Libor, said Stephen Hazelton, the founder and CEO of Street Diligence, which provides fixed-income analytics data. "The likely winner, or winners, may well be an upgrade from Libor and may also require geography-specific solutions."

"The crux of the matter lies in liquidity and choice of currency. Interbank lending transactions have declined since the financial crisis," said Hazelton.

"For instance, one initiative in the U.K., which is supported by a number of global banks, proposes the use of the Sterling Overnight Index Average, or SONIA, a measure of Sterling-denominated overnight funding rates from actual transactions in the wholesale money markets. While this eliminates the reliance on estimates, the frequency of transactions is an open question," he said.

In the U.S., possible alternatives derived from actual transactions include the Overnight Bank Funding Rate and the overnight lending rate in Treasury-backed repurchase agreements that Levonick mentioned. "The OBFR is based on a weighted-average, overnight federal funds rate for unsecured, dollar and Eurodollar, loans. The overnight lending rate, in contrast, is secured by Treasuries to backstop the loans," Hazelton said.

There might not be as many versions created for the Treasury repo rate versus what exists with Libor, "but there's got to be iterations to make it comparable," Levonick said; he sees the development of two or three variations.

Servicers already have "a lot of challenges getting it right on a seasoned index. Add in a whole new index and a new methodology, there might be some challenge. What happens if the servicer doesn't do it right? Do they get a second bite of the apple to redisclose to the consumer" or will they have to make refunds if the payment is not calculated correctly, Levonick asked.

Servicers are going to have to make sure that "the consumer's contractual rights aren't trumped by the creditor's right to replace the index," he said.

On the origination side, to avoid loan defects, lenders must adjust systems to calculate the fully indexed rate and maximum payment after a five-year period.

The Treasury repo rate is not yet available, although the ARRC is expected to pick a date in 2018 or 2019 for it to go live, Levonick said. The rate will be published by the Federal Reserve Bank of New York in cooperation with the Treasury Department Office of Financial Research.

Libor is used as the base rate for future, option and swap pricing. In the U.S., it is used for commercial mortgage loans as well as being a base rate for nonmortgage products like credit card and auto loans.

The index also is used by mortgage warehouse credit providers to price their lines of credit. But the typical term of a warehouse line is one year and these lenders have time to find a replacement.

In their standard ARM notes, Fannie Mae and Freddie Mac anticipate the possibility that a particular index, such as Libor, would no longer be published.

"Lenders should advise borrowers that alternative published indexes will be selected (consistent with the provisions of the mortgage note) should the original index for a specific ARM plan no longer be available or published," reads the Fannie Mae online selling guide.

The offering circular for Freddie Mac's securities contains the following language: "We make no representation as to the continuing availability of any Index or source of Index values. If an Index becomes unavailable, we will designate a new one based upon comparable information and methodology."

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