What Credit Unions Can Do Now to Prepare for the End of LIBOR

The Federal Reserve continues to encourage credit unions and other financial institutions to stop writing contracts using the London Interbank Offered Rate, or LIBOR, by the end of 2021. After that, the one-week and two-month LIBOR rates for short-term borrowing will no longer be published.

And, even though the LIBOR administrator announced in late November 2020 that it will publish the remaining dollar-denominated LIBOR rates through the end of June 2023 to allow legacy contracts to mature, credit unions should begin preparing now for the transition to a new benchmark.

The Secured Overnight Financing Rate (SOFR) is expected to replace the LIBOR reference rate for U.S. transactions, and LIBOR users are understandably anxious about the conversion. After all, LIBOR has been around for decades and is the most widely used short-term lending benchmark in the world.

Some common misconceptions are fueling much of the apprehension surrounding the switch to SOFR, which likely will be more manageable than credit unions may believe it will be.

Credit unions should consider these three tips for a smooth shift away from LIBOR:

1. Implement fallback language. The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar LIBOR to SOFR, a more robust reference rate it identified as the best alternative. Recommended fallback language from the ARRC for new, closed-end, residential adjustable rate mortgages (ARMs) explains in consumer-friendly terms what happens to a borrower’s interest rate if the current index ceases to exist.

The ARRC recommends including verbiage in new ARM contracts that refers to a replacement index “selected or recommended for use in consumer products, including residential adjustable-rate mortgages, by the Board of Governors of the

Federal Reserve System, the Federal Reserve Bank of New York, or a committee endorsed or convened by the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of New York.”

And while they may not be required to do so, credit unions or their mortgage CUSO should voluntarily add the ARRC-recommended fallback language to all uniform ARM notes. This language clarifies when and how a replacement index for newly originated instruments will be chosen in the event the current benchmark is no longer available or representative. In so doing, credit unions that have continued originating loans with LIBOR can replace the index with a new benchmark (such as SOFR) later.

Including such fallback language also takes the burden of searching for a replacement index off of credit unions and allows them to ultimately adopt a new, predetermined benchmark already endorsed by the industry, including GSEs (Fannie Mae and Freddie Mac).

2. Educate borrowers. Notifying members about reassigning the index is as simple as sending them a letter stating that their rate will be adjusted based on a new index, because the original benchmark is being discontinued. Credit union leaders who feel ill-equipped to answer related member questions can consult with their mortgage CUSO or reference these FAQs from the ARRC.

Credit unions may also want to take preemptive measures to avoid confusion among members whose interest rates are scheduled to adjust near the time their loans are being transitioned from LIBOR to a new benchmark. For these borrowers, credit unions may want to include an explanatory letter with the regulatory notice about the new index.

Adjustment periods trigger pre-set notices required by law that advise ARM holders their interest rate will adjust according to LIBOR – the current index assigned to the loan. When those timeframes coincide with the end of LIBOR, another notice would arrive in close proximity explaining to borrowers that their loans are being assigned a new index.

To ensure members in this situation understand how their rates are adjusting, credit unions could include a letter with the regulatory notice explaining that the notice is required by law to reflect the current index (LIBOR), but that their adjustment will actually be based on the replacement index.

3. Remember the SOFR spread-adjustment calculation is undetermined. Many credit unions are worried that SOFR will be lower than LIBOR, resulting in unwelcome losses. But, a term reference rate based on SOFR derivative markets cannot be calculated until liquidity has sufficiently developed to produce a robust benchmark.

So, we don’t know how the two rates will compare. The goal, however, is for the new index to mimic LIBOR as closely as possible.

The ARRC is working with all stakeholders in developing and recommending a spread adjustment and corresponding spread-adjusted SOFR-based replacement that reflects and adjusts for the differences between LIBOR and (ideally) SOFR, borrower interest rates – and therefore credit union balance sheets – should be minimally impacted when LIBOR is no longer available.

Andrew Duncan is SVP of compliance and mortgage technology at TruHome Solutions, a credit union-owned mortgage CUSO based in Lenexa, Kansas.