With GNMA’s recent announcement, HECM ARMs using LIBOR as their Index will soon not be viable to originate.
While LIBOR has been destined to be phased out for some time, this unexpected announcement will require a faster transition than was expected.
The framework around SOFR, the anticipated replacement to LIBOR, has not been fully developed yet, and as such adjustable-rate HECM loans will need to use CMT (Constant Maturity Treasury)– at least in the short term.
This will be a back-to-the-future for the reverse mortgage industry, as CMT based HECM products were used in the initial ARMs and were the only index available until the FHA added LIBOR in October 2007.
Background of the Indices
LIBOR, SOFR, and CMT broadly speaking are supposed to represent the cost of borrowing money to a large financial institution.
LIBOR – London Inter Bank Offer Rate
This is a measure of the cost to Banks of borrowing cash from each other for relatively short periods of time.
There are different LIBOR rates for different borrowing periods, and for different currencies.
LIBOR rates were determined by a survey of panel banks, conducted by the British Bankers Association, and not necessarily based on actual transactions.
This methodology allowed for manipulation of the LIBOR rates by large financial institutions, and as result, regulators have mandated the phase-out of LIBOR.
SOFR – Secured Overnight Financing Rate
As the name indicates, this is a measure of cost of borrowing cash overnight, secured by Treasuries as collateral.
It is derived from actual activity in the Treasuries repurchase (Repo) market, where banks and investors borrow, or loan Treasury securities – hundreds of billions of dollars are traded daily in this market.
The US Federal Reserve’s Alternative Reference Rates Committee (ARRC) selected SOFR as the replacement for LIBOR in June 2017.
By its very definition, SOFR is an overnight rate, so creating longer term SOFR rates has proved problematic.
CMT – Constant Maturity Treasury
CMT rates are designed to reflect the United States Treasury’s cost of borrowing. CMT yields are read directly from the Treasury’s daily yield curve, derived from actual yields on Treasury Securities.
Because Treasury instruments have a set maturity date, and are issued according to need, it is very rare for the maturity of Treasury security to align with an exact time period e.g. Twelve Months, so interpolation ( weighted averaging) is used to determine the Constant Maturity yields. The Federal Reserve publishes CMT yields
Why is the index changing?
The London Interbank Offered Rate, or LIBOR, reflects the average interest rate that major global banks pay to borrow money from each other.
We have known for some time that the industry was seeking to discontinue the LIBOR index after some banks provided purported interest rate figures which did not truly reflect the rate at which they could borrow.
After it was discovered that this index was subject to manipulation, trust in the LIBOR index as an indicator for the health of the global economy was lost.
What does this mean for you?
If you have a current reverse mortgage in process on the 1-year LIBOR ARM reverse mortgage, it will no longer be able to close after November 30, 2020.
If you are in the midst of processing an adjustable rate reverse mortgage at this time, if that loan does not close by November 30, 2020, the terms will change to a 1-month CMT ARM (Constant Maturity Treasury) with a life cap of 10% instead of the current 5% life cap on the 1-year LIBOR ARM.
The Good News!
The good news is that the CMT index is extremely low and that we are aware of no borrower in the history of reverse mortgages ever reaching the capped rate.
This means that the lifetime cap may be higher, but if the rates never hit the cap, the amount of the cap is a moot point.
1. Is the CMT rate like the LIBOR index (historical comparison on the indexes)?
Please see below a graph of the historical 12-Month rates for CMT and LIBOR since the beginning in 2010.
As you can see, the LIBOR rate has been consistently higher than the CMT rate over this period.
This largely reflects the fact that 12 Month LIBOR rates include a credit risk component (the bank that were to borrow the funds may not be able to pay them back), whereas the CMT rate is based on Treasury borrowing so is considered risk-free.
What will happen after you close your loan?
Even for those who do close their loan under the LIBOR, you need to realize that the LIBOR index is scheduled for elimination at the end of 2021. Once the LIBOR index disappears, the loan documents for reverse mortgages and traditional loans allow lenders to substitute a new index in the case that the index should become unavailable. The new index being discussed is the Secured Overnight Financing Rate (SOFR), but this will not be available at January 1, 2021. The CMT is available to use today so it allows for the uninterrupted closing of loans while the existing closed loans utilizing the LIBOR index will most likely switch to the SOFR before the end of 2021. But make no mistake, the closed loans will also need to change their index as well.
2. What margins will be available; will they be the same as they are now?
Broadly speaking, the available CMT margins will largely be the same as those currently available under LIBOR.
However, due to the lower pricing of CMT loans, some of the lowest margin rates may not be offered.
Also, given investor focus on loans originated with an expected rate close to the floor, there will be impetus to avoid simply adding higher margins.
3. What will this do to pricing in the short and long term if we go to the CMT or SOFR?
Ultimately it is the price that the investors are willing to pay for HMBS pools that determine the pricing available.
The inherent difference between LIBOR and CMT or SOFR i.e. LIBOR higher coupon for same margin, results in greater interest accrual to investor, reflected by higher HMBS pricing for LIBOR loans.
However, some investors have been avoiding LIBOR investments because it is due to be retired. Increased demand from these investors would improve the relative pricing of a CMT/ SOFR HECMs.
4. What will we use for the Jumbo LOC rate or will it not change for now since LIBOR is not officially going away until next year?
Jumbo LOC will continue to use LIBOR, until such time as a suitable replacement (likely SOFR) is well defined and broadly accepted.
5. What difference, if any, will this have on expected rates?
The Expected Rates used to determine PLFs are determined by the Margin of the loan + the appropriate 10yr Index.
For LIBOR this has been the 10yr LIBOR SWAP rate, for CMT this is the 10yr CMT rate, as published by the Federal Reserve Bank.
If you see the below chart, the 10yr LIBOR swap and 10yr CMT rates have been very similar over the course of the last 10 years.
6. How will CMT impact initial rates vs LIBOR rates?
Initial Rates will be lower for the same margin.
As an example, currently 12 Month LIBOR 0.37% v 12 Month CMT 0.12%, so for a loan with a 2.5% margin, the initial rate for the CMT product will be 2.62%, whereas the LIBOR would be 2.87%.
This more attractive Initial Rate should be a focus with consumers.