Fannie And Freddie Confirm Choice Of SOFR As Replacement For LIBOR In Existing Mortgage Loans – Financial Services

Although the transition from LIBOR interest rates has been
planned for quite some time now, Fannie Mae and Freddie Mac
recently provided additional details of the necessary changes to
outstanding adjustable rate mortgage loans that currently are
linked to LIBOR indices. As expected, these changes largely mirror
the changes mandated in the recently enacted LIBOR Act, described
below, as well as current practice for new Fannie Mae and Freddie
Mac loans. Consequently, loan servicers can now solidify plans for
adjustments to the rate calculations this summer, but should take
care to do so accurately.

Recent Events

By now the plan to abandon the use of LIBOR-based interest rates
is well known. The end of the life of LIBOR means that a
replacement for it is needed in existing loans that rely on it for
the calculation of interest, including adjustable rate residential
mortgage loans, among many other contracts. Fannie Mae and Freddie
Mac (“GSEs”), and federal governmental authorities,
have been planning for the transition away from LIBOR for a number
of years, providing numerous timelines, guidance, and resources,
and dedicated transition portals. Most recently, in January 2023,
the GSEs updated their
LIBOR Transition Playbook, originally published in May
2020.

In order to facilitate the benchmark replacement for all
outstanding contracts currently relying on LIBOR but containing no,
or inadequate, fallback (i.e., rate transition) provisions,
including but not limited to mortgage loans, the
Adjustable Interest Rate (LIBOR) Act (“LIBOR Act”)
was signed into law on March 15, 2022 (discussed in our Legal
Update,
A Deeper Dive Into the US Adjustable Interest Rate (LIBOR)
Act). Subsequently, on December 16, 2022, the Board of
Governors of the Federal Reserve System (“Fed Board”)
adopted the final version of the
Regulation Implementing the Adjustable Interest Rate (LIBOR)
Act (“LIBOR Act Regulations”) (discussed in our
Legal Update,
Fed Adopts Final Rule Implementing the Adjustable Interest Rate
(LIBOR) Act) to provide additional detail about
how the LIBOR Act would be applied, including confirming the
various benchmark replacements chosen by the Fed Board.

On the heels of the adoption of the LIBOR Act Regulations,
Fannie Mae and Freddie
Mac, on December 22, 2022, announced their choice of
SOFR-linked benchmark replacements for existing
“legacy” LIBOR-linked mortgage loans for which they are
the “determining person,” as defined
in the LIBOR Act. Those announcements follow multiple guidance
publications issued by the GSEs beginning in February 2020 (the
first of which is discussed in our blog post,
Fannie Mae and Freddie Mac Issue Guidance for a LIBOR-less
World).

Authority for Specification of Benchmark Replacement ARM
Indices

The LIBOR Act defines a “determining person” as the
party to a LIBOR contract, “with the authority, right, or
obligation, including on a temporary basis (as identified by the
LIBOR contract or by the governing law of the LIBOR contract, as
appropriate) to determine a [LIBOR] benchmark replacement.”
This definition and the provisions of the LIBOR Act therefore
permit the GSEs to determine the replacement index for LIBOR for
their loans, provided they have that authority under the loans.

The GSEs may or may not have that authority, however, depending
on the terms of the loan documents. Although the GSEs use
standardized loan documents, the specific terms in those documents
have changed over time, and some loans contain variations on the
standard terms or omit a discussion of replacement indices
altogether (in part because some existing legacy loans go back
decades). In anticipation of the transition away from LIBOR, the
GSEs updated the forms of LIBOR notes and riders in February 2020
to include language recommended by the
Alternative Reference Rates Committee for this purpose. But
prior to that change, most of the GSEs’ note forms contained
more general language stating that: “[i]f the Index is no
longer available, the Note Holder will choose a new index which is
based upon comparable information.” As noted by
Fannie Mae, however, some notes, particularly those used before
2009, may have non-standard language or may not have any language
specifying how a replacement index will be selected.

If the GSEs do not have the requisite authority under the
applicable loan documents, the LIBOR Act authorizes the Fed Board
to specify the benchmark replacement. More specifically, the LIBOR
Act provides that on the “LIBOR replacement date” (July
3, 2023, the first business day following the last day on which ICE
Benchmark Administration will publish LIBOR on a representative
basis, June 30, 2023), the benchmark replacement specified by the
Fed Board will become the benchmark replacement for any LIBOR
contract, (a) that contains no fallback provisions specifying a
method for determining a replacement for the LIBOR benchmark, (b)
that contains fallback provisions, but such fallback provisions
don’t identify a specific benchmark replacement or a
determining person, or (c) for which a determining person fails to
select a benchmark replacement. As noted above, the Board-selected
benchmark replacements are set forth in the LIBOR Act
Regulations.

Benchmark Replacement Rate Selections by Fannie Mae and Freddie
Mac

Despite the possibility that different loan terms may lead to
different sources of authority for determining the applicable LIBOR
replacement rate , it ultimately will not matter whether that
authority is the GSEs, as determining persons for their loans, or
the Fed Board, as the authority to designate benchmark replacements
under the LIBOR Act. That is because the GSEs adopted the Fed
Board-recommended benchmark replacements in their December
announcements. So, whether the GSEs or the Fed Board chooses the
replacement under a particular loan, the same benchmark
replacements can be expected to be used.

In keeping with the benchmark replacements selected by the Fed
Board in the LIBOR Act Regulations, the GSEs each selected the
following SOFR-linked benchmark replacement rates for the legacy
LIBOR loans (and certain related instruments and agreements) for
which they act as a determining person:

In their December 2022 announcements, the GSEs also confirmed
that the transition for these legacy contracts will occur on the
LIBOR replacement date, the same date that would apply if the Fed
Board’s selections were to be used.

Subsequently, on January 25, 2023, Fannie Mae and Freddie Mac
formalized the selections announced in December for residential
mortgage loans relying on 1-month, 6-month and 1-year LIBOR indices
via a servicing
notice and a guide
bulletin, respectively. These materials provide more granular
detail for loan servicers with respect to replacement index codes
and other details, and a mandate to use the applicable replacement
index published by Refinitiv Limited (a provider of financial
market data), as set forth in the respective tables provided in the
notice and bulletin. The notice and bulletin also provide
additional instructions for servicers, including a requirement that
they provide borrowers with written notice identifying the
replacement index and otherwise follow all regulations and policies
applicable to adjustable-rate mortgage loans.

Additional resources regarding the transition from LIBOR indices
also can be found at webpages maintained by Fannie
Mae and Freddie
Mac for that purpose.

Application to Privately Held or Securitized Loans Using Fannie
Mae and Freddie Mac Documents

Although Fannie Mae and Freddie Mac are obviously the primary
users of their forms of loan documents, many other lenders use
those forms as a “market standard” for residential
mortgage loans. The GSEs authority to designate a replacement rate
index (assuming that authority is included in the notes) arises out
of their role as holders of those notes, so their selection of
rates does not apply to the loans held by other investors. For
loans that have not been delivered to the GSEs, that authority will
rest with these other note holders, assuming the related loan
documentation so provides.

For the owners and servicers of these loans, the choice of a
replacement index is a more open question, at least technically. If
the notes use language that would be sufficient to qualify the note
holders as “determining persons” under the LIBOR Act,
the note holders could choose a benchmark replacement that is
different than those chosen by the GSEs or mandated by the LIBOR
Act Regulations (although the safe harbor provisions of the LIBOR
Act provide a powerful incentive to choose a SOFR-based replacement
rate). If notes do not specify a benchmark replacement, or the note
holders do not qualify as determining persons and therefore cannot
specify a benchmark replacement, however, the Fed Board’s
selected benchmark replacement should apply.

As a practical matter, we expect most private holders of
LIBOR-indexed residential mortgage loans to follow the lead of the
GSEs and the Fed Board. There undoubtedly is some safety in taking
the same approach as the creators of the forms and the designated
federal authority on the issue. That said, the particular
situations of different private loan owners may vary, and different
approaches may be seen in some cases in the market.

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