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ARRC’s Fifth Set of Recommended Fallback Language: Residential Adjustable-Rate Mortgages
By Joyce Sophia Xu, Michael Spafford, Jonathan Ko, Holly Snow, Nicole Skalla, Diona Park, Daren Stanaway & Matthew Smith
On November 15, 2019, the Alternative Reference Rates Committee (the “ARRC”) released its recommended contractual fallback language for U.S. dollar LIBOR denominated closed-end, residential adjustable-rate mortgages (“ARMs”) in anticipation of the phasing-out of LIBOR and the transition to a spread-adjusted index based on the Secured Overnight Financing Rate (“SOFR”).
In making its recommendation with respect to residential ARMs, the ARRC sought to provide greater clarity and specificity with respect to a LIBOR cessation and implementation of a replacement index, because current contractual language in the Fannie Mae/Freddie Mac uniform residential ARM notes does not adequately describe the process for making any such adjustment.
Triggers
A trigger is intended to capture an objective, observable event that will cause the replacement of the relevant benchmark rate or “Index” (e.g., LIBOR) with a new reference rate. The ARRC’s recommended fallback language for residential ARMs includes two triggers: (1) when the administrator has permanently or indefinitely stopped providing the Index to the general public, and (2) when the administrator or its regulator issues an official public statement that the Index is no longer reliable or representative. Both triggers are consistent with the ARRC’s recommended fallback language with respect to other cash products. However, only the first trigger is consistent with ISDA’s anticipated fallback language for derivative products, given that ISDA currently is contemplating whether to include pre-cessation triggers in its fallback provisions and has not yet indicated whether it will do so.
Replacement Index and Margin
Upon the occurrence of a trigger, the ARRC’s recommended fallback provisions contain a waterfall for the parties to use for determining the replacement rate for the relevant Index. The waterfall runs as follows:
Step 1: Replacement index selected or recommended by 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 (e.g., the ARRC).
Step 2: Replacement index determined by the note holder, with possible adjustments to the loan’s margin to account for differences between LIBOR and the chosen replacement index.
With respect to Step 1, the ARRC’s successor rate for residential ARMs will not match ISDA’s successor rate, a compounded average of SOFR in arrears, since the latter would be incompatible with current consumer regulations, which require advance notice of any payment change. Instead, the ARRC anticipates recommending a forward-looking SOFR-based rate as the successor rate for residential ARMs and the corresponding spread adjustment to account for the economic differences between LIBOR and SOFR that it will develop and publish after consulting with market participants. The ARRC has committed to make publicly available any such successor rate and spread adjustment it recommends for residential ARMs in order to minimize impact to the borrowers of such consumer products.
Conclusion
As recently stated by Tom Wipf, the ARRC’s Chair: “There’s no question about it: in a mere 778 days, we cannot rely on LIBOR still being available for use. That’s why it is mission critical that all institutions prepare for this inevitability.”
Fallback Contract Language for New Closed-End, Residential Adjustable Rate Mortgages (2019),
Language for Residential Adjustable-Rate Mortgages (November 15, 2019),
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