NYDFS LIBOR Transition
By: Greggory B. Oberg, Esq.
Another one short in characters but long in consequences this week. Today, we discuss the New York State Department of Financial Services (NYDFS) December 23, 2019 Industry Letter to regulated entities addressing NY's expectation of financial service providers' transition plans for the pending discontinuation of the London Interbank Offered Rate (LIBOR) at the conclusion of 2021.
To echo (amplify?) the NYDFS's statement in the Industry Letter, "significant work" is required to ensure the existing commercial and residential investment portfolios of lenders are adequately prepared for the replacement of LIBOR; significant work which "should have already commenced."
What Are We Talking About?
The LIBOR, historically, as been an index used in both commercial and residential real estate secured transactions (among MANY other types) which vary, or are "pegged" to a market indicator. Due to UK legal developments--which may or many not relate to the Megxit and/or Brexit), the general consensus of industry is that LIBOR will become obsolete no later than the conclusion of the 2021 calendar year. This marks a dramatic change for an industry which has relied upon the index since at least the mid 1980's.
Currently, it is estimated that "the gross notional value of all financial products linked to the U.S. dollar LIBOR is approximately $200 trillion ... [including at least $2.5 trillion of consumer or residential debt.]" Needless to say, the impact of a shift in index used to predict the value of these products is earth shattering--but again, NOT NEW NEWS if you've followed the news.
What Do We Have to Do?
That's a complicated question that I just posed to myself; nice job. The answer depends on whether you do business in New York, to some extent. It also depends on whehter you deal in LIBOR-related securities and your overall risk tolerance.
For those of us subject to NYDFS regulation, I feel compelled to again echo the NYDFS letter to regulated industries; paraphrasing liberally--if this is the first time somebody told you LIBOR is being discontinued, you're gonna have a bad time. We'll talk in a few paragraphs.
For the rest of us, consider yourself subject to NYDFS expectations on LIBOR transition simply because it's a pretty good idea. Or don't, but I reserve "told ya so" rights when safety and soundness concerns arise.
The Issue Facing Residential Lenders
As stated in aggregate stats above, the LIBOR index is used for quite a few financial products in the United States, in addition to places like the UK. Where it most often comes into play in our environment is ARM mortgages.
Looking exclusively at the residential space, I'd wager that 99% of salable or sold loans originated in the recent past under Fannie standard Security Instruments pose very little to no compliance risk due to the inclusion of default "fallback language" in the rate calculation language which allows lenders to substitute a new index if the stated one is no longer published.
If your entire concern is consumer protection, you can probably stop reading now. This is because the majority of the LIBOR transition exposure faced by community lenders is balance sheet/safety and soundness risk. There is--although certainly subject to exceptions for poor process--little to no risk in losing the security on a LIBOR loan. But there certainly should be a consideration of the impact of the substitute rate--the Secured Overnight Financing Rate (SOFR), as declared by the FRB (among others)--on the valuation of on book assets and resulting implications. I won't pretend to be a CFO, but it's clear that nobody expects the SOFR to mirror LIBOR historical patterns. It simply isn't designed to do so.
The NY Financial Institutions' Obligation
Shockingly simply, yet deceptively complex. If NYDFS has regulatory authority over your activities, you (in addition to being WAY behind for not reading their letter) are charged with responding to a specific set of question regarding how your institution will respond to outlined LIBOR transition challenges.
NYDFS requires regulated institutions, by February 7, 2020, to submit a written response to the NYDFS addressing "the institution's plan to address LIBOR cessation and transition risk." Specifically, the written response must address:
programs that would identify, measure, monitor, and manage all financial and non-financial risks of the transition;
processes for analyzing and assessing alternative rates, and the potential associated benefits and risks of such rates both for the institution and its consumers and counterparties;
processes for communication with consumers and counterparties;
a process and plan for operational readiness, including related accounting, tax and reporting aspects of such transition, and;
the governance framework, including oversight by the board of directors, or equivalent governing authority, of the regulated institutions.
Quick Thoughts on NYDFS
First hot tip--pay a visit to your local Mortgage Bankers Association. The MBA and MMBA have both had internal (and likely external, but I won't speak for them) discussions and publications on the issue.
Second, if there are non-NYDFS Regulated Institutions still reading (thanks!), consider yourself subject to the plan requirement laid out by NYDFS. Might not be the law, but it's a good idea. The LIBOR transition will create risk--and as a natural counterparty--opportunity within the market. I'd argue that NY regulated institutions are being forced to run ahead of the curve here.
Third, and my least confident point for which I would appreciate feedback, strongly consider use of the SOFR rate as your preferred fallback rate in absence of a valid LIBOR publication. Is it perfect? I don't know, and I doubt anyone who says they do. But, a respected regulator in the form of the NY Fed (among others) have endorsed it. My position would be that any institution choosing a different index to replace LIBOR faces increased scrutiny. Keep it simple unless you KNOW you're not a simple operation,
Fourth, and finally, pay extra attention to consumer who will be impacted by this change. While I will concede the average consumer will not be sensation to the differences in index behavior, some certainly will. More likely, they will hear about the impending doom of the LIBOR transition from Stephen Colbert.
If you don't have a transition plan, how do you expect your servicing personnel to respond to such questions?
If anybody is in the process of responding to the NYDFS, or performing an analogous assessment for internal purposes, please call me!
As always, I am not permitted nor attempting to provide legal advice. This is certainly a complicated issue that requires input from multiple disciplines within the senior management of institutions. You should not rely primarily or exclusively on this blog for regulatory advice, please contact your internal or external compliance/legal department for authoritative guidance. The opinions herein are my own, I am not willing or authorized to speak on behalf of others.