​LIBOR/SOFR Transition Update

LIBOR/SOFR Transition Update
June 17, 2020

0:05
Welcome, everyone. Hope everyone is doing well and are safe. Thank you for joining us here today, for our webinar, the LIBOR SOFR transition update. My name is Andrew Paolillo. I am the director of Member Strategies and Solutions here at the Bank and with me today will be Dan Redmond, our Money Desk Manager.
0:23
So, what we'd like to do is go over three areas related to the transition. And before we jump in, I just want to say we are looking at the registrations and very pleased to see a good showing across all our members of varying shapes and sizes and folks from different areas within their organization, whether it be Treasury, accounting, and finance, or lending, or senior management. So, I think this is a testament and speaks to the interest in this topic that's only going to continue to grow as we get closer to the cessation date of LIBOR. So the three main areas that we're going to look to cover today: First, we're going to do an overview and introduction to SOFR, as well as look at some of the recent developments that are occurring in the LIBOR transition. Secondly, we'll look at one of the solutions at the Federal Home Loan Bank of Boston [that]
1:17
is contributing to the LIBOR transition process with the development of the SOFR-Index Advance. And then lastly we'll wrap things up. I'm looking at some balance sheet strategies, and applications for using that SOFR-Indexed Advance in the day-to-day balance sheet management of your organization. So let's jump right in and talk about the introduction to SOFR and some of the things that are going on with the transition. So what is SOFR first and foremost? It is the secured overnight financing rate and that essentially refers to repurchase agreements or commonly known as repo. So there's three main characteristics of what goes into SOFR. And the first is that it is an index that is based off of an overnight term.

2:04
The second is that it is a repo transaction [and] is a secured lending transaction and it's collateralized by Treasury bonds. And then the last part of SOFR is that the calculation of the index is derived from actual transactions occurring in the marketplace. So repo is often referred to as the plumbing of the financial system. And as you can see on this chart, this is the single day volumes since SOFR has been calculated by the New York Fed, going back to 2018. And the average daily volume since then is just slightly under $1 trillion worth of activity. And one thing to note is that while SOFR,  the index and the acronym are relatively new, going back to 2018, what is based off of repo transactions go back much, much further. So there is data pointing towards, you know, what drives these rates.
3:03
So in terms of how is SOFR calculated, essentially it is a volume weighted median of actual transactions that occur. So qualified repo transactions are tracked by the New York Fed. And as we can see here in this visual, this is an example of where SOFR has been, since the beginning of May into June. And the darker blue line is the actual SOFR index rate.
3:30
But on each side ... of the actual SOFR rate, we see the percentiles for the transaction is the first, and the 99th, the 25th, and 75th. So, for example, on the last day that we, before we pulled this chart, back on June 5th, the SOFR Index was at seven basis points. But we saw that the bands for the transactions as part of that trillion dollars’ worth of daily volume were five basis points and 18 basis points on the very, very high and low ends. But narrowing that range saw six basis points and 12 basis points for the 25th and 75th. So, based on actual transactions and very transparent in terms of, you know, the data that is being used.
4:14
So, why are we talking about a LIBOR SOFR transition?
4:19
So, ultimately, it boils down to the fact that there was a LIBOR manipulation scandal about 7 or 8 years ago, and that involved dealer banks who were charged with submitting their estimates for LIBOR. So, that's basically how LIBOR was calculated, where there was a panel of large money center banks who would provide estimates at various terms where they thought they could borrow in the inter-bank lending market. So, the issue occurred because they were submitting prices that serve their benefits -- depending on what exposures that their particular bank had, and whether the higher, or LIBOR which would suit their needs, that's where their submissions
5:02
drifted towards. So that is what has led to this massive movement towards a new benchmark, replacement for LIBOR, and what is going on is that after December 31, 2021, the regulators will are not requiring the panel banks to submit prices for LIBOR. So ultimately, a new replacement index will be required. And when you think about the size and scale of the LIBOR market, it's one of the most important, if not the most important interest rate in the world. And underlying hundreds of trillions of dollars of transactions and exposures across the globe.
5:43
And there's a lot of fallback provision for existing contracts and securities and loans, and things like that, that there's a lot of work and resources going into creating amendments and ways to adjust existing exposures. But ultimately, for any go-forward business, there needs to be a more permanent solution, and fix, than just relying upon fallbacks.
6:10
So, looking at some of the recent things that have been going on, and, you know, as we look back over the last year or two, you know, we've said that the LIBOR transition developments have gone kind of in a step, staircase fashion, where nothing happens for a period of time. And then, all of a sudden, a lot of things happen, and then it kind of levels off, and then, all of a sudden, there's a jump of activity. And the last month or two has been one of those jumps and activity, where there's been a number of high profile things and news items that have come to the forefront. So, as you can see here, these main buckets the benchmark reform impacts a lot of different areas, and then a lot of different types of organizations. So if you look at what's occurring in the residential lending side, Fannie Mae
6:59
and Freddie Mac recently released a transition playbook, where they offer up some timelines and updates to their product suite. So, certainly, if you're involved in dealing with the GSEs on the secondary marketing side of things, then certainly you want to know what is going on there. And specifically one thing of note is that they have, both Fannie and Freddie have, ceased purchasing any LIBOR-related loans
7:26
and will be starting to purchase SOFR loans. So if you think about the residential, excuse me, depositories offering and expanding their menu of loan options, it's difficult to take that first step into offering a SOFR-based loan without knowing that there is potentially a secondary market for that loan. So now that, that will be there, much like it is for the fixed rate and has historically been for LIBOR, that offers an outlet for institutions. They also will also be beginning to issue SOFR-based CMOs so that offers a floating rate alternative for the investment portfolio. Also of note, is the CFPB has issued guidance on adjustable-rate mortgages and HELOCs and, you know, with the CFPB, obviously, you know, they're focused more on the consumer side of things.
8:21
So that offers organizations guidance in, not just how to, operationally, do the things that you, as a banking or insurance organization need to do, but how do you communicate that downstream to your customers? Certainly, retail focused where they may not be seeing and hearing as much about the LIBOR SOFR transition as you may be. On the debt issuance side, every month that passes, we continue to see growth and expansion of bonds being issued into the market, exceeding now, $600 billion in terms of, SOFR-linked debt. The GSEs, including the Federal Home Loan Bank System, comprises a large portion of that close to $200 million to $200 billion.
9:06
And, in fact, the last couple of months has continued to see growth not just in the private market issuance, but also in the longer terms, which is a welcome sight to see. So you have your …  large global banks, like the mortgage families of the world, who are issuing SOFR-linked debt. But you also have the community banks who are issuing subordinated debt in a typical fixed to floating structure where the floating leg of that transaction will be referenced off of SOFR. So, it is becoming more prominent and part of the issuance playbook. The derivatives market, again, continued to see growth, regularly and expansion of the product lineup, in terms of futures options and all different kinds of derivatives.
9:57
And, you know, it's interesting to note that while your organization may not necessarily explicitly be engaged in those types of instruments, it does benefit you. Because the folks who are involved in providing more straightforward instruments in order to properly fund and hedge and efficiently price, those types of instruments, whether they be cash or other types of derivatives, the more liquidity and access and opportunity that you have in varying pockets of the market, it all supports liquidity and transparency, all along the way.
10:36
In terms of the benchmark transition, in 2014, there's a group called the Alternative Reference Rates Committee, who was convened by the Federal Reserve, to aid and ensure a smooth transition away from LIBOR into an alternative benchmark environment. And they really have been on the front lines in providing information, guidelines for organizations of all shapes and sizes, how to manage this huge, multi-year transition project. And within the last month or so, they released a best practices document, which we are going to take a look at in a slide or two,
11:17
which has some really helpful tips about finding out where you are in relation to where you should be in terms of the transition and, you know. And the last piece there is that, you know, what we're doing with the SOFR-Indexed Advance and we'll get to that in a little bit as well.
11:35
So, here's a snapshot of something from the ARRC Best Practices document. And this is an example where you're looking at the recommended transition milestones. So, depending on the particular type of product where, their recommendation for where you should be in the process in terms of having fallbacks in place, so, you have the LIBOR-linked instrument.
11:58
Well, are you going to move to an alternative replacement index like SOFR or something else? And is it going to be a 1 for 1 transition or is it going to be the new index plus some kind of an adjustment spread? So, you know, that understanding of what those fallbacks are going to be are important. And they vary according to the product.
12:19
Then there's also some guidelines for the operational and technological readiness but also the ceasing of using LIBOR going forward. And, you know, one thing that's interesting to point out is that a couple of weeks, or a little more than a month ago, actually, the Main Street Lending Program, one of the stimulus programs that the Fed had put forth to support the economy. Initially, those loans that were going to be indexed versus SOFR, but, after some commentary and some feedback, they decided to switch those loans to be LIBOR-based. And ultimately, what they heard was that depositories weren't equipped to handle a new index. You know, they had their systems in place where they can handle LIBOR, but given all the challenges going on in the world and in the banking landscape right now, they weren't ready to just flip that switch.
13:15
So, I think this is a good example of how, even for the long-range planning, and this transition did not sneak up on anybody, but, know, it is a lot of work. It takes a long time, and when you get such unprecedented catalyst, like we've seen, certainly in the last three months, that even though the cessation date is still a year and a half away, that it's better to be prepared and be 1 or 2 or 3 steps ahead of the game.
13:49
And, you know, one thing I will point out, is that in the wake of that transition, to LIBOR from SOFR in the Main Street Lending Program, the Fed in multiple channels and communications,  has re-affirmed their commitment to transitioning away from LIBOR. So certainly they are continuing to put all the pieces in place to make sure that ultimately LIBOR will be going away.
14:16
So the last thing for this section is to give you some transition resources. And this presentation will be up on our website so you'll be able to click on these links and find them.
14:28
So the first one is just simply the page on the Federal Reserve Bank of New York that has the access to SOFR and the historical data, those charts that we pulled about the bands and the volume and things like that. So, you know, if you feel the need to understand and educate, and see where those rates are, that's easily accessible. The link for the AARC there is as well. And, like I said, that is a fantastic resource. It's a, there's a lot of information, and a lot of different areas. But, that is intended to be the central command for this transition process. And then, lastly, I'll point out something that we're doing. You know, we have a transition update document that we’ll be regularly updating and putting in, as new things develop, and, you know, we don't have to be as broad based as the AARC is, necessarily, we want to know, it's our goal to focus on the things that are most relevant to our members, and their businesses.
15:26
So, that document, hopefully, will ... focus and direct you into the things that may be most relevant to you.
15:35
So at this point, I'm going to pass it over to Dan, and he's going to talk a little bit about one of the things that we here at the Bank are doing in regards to the transition.
15:44
Thank you, Andrew. Good day all. Thank you for your time, as always. I always appreciate it, and hope all are well. So the reason we're here obviously as Andrew highlighted is the SOFR LIBOR transition, and we're dealing with a situation where the publication of LIBOR is not guaranteed beyond December 31, 2021. Depending on who you talk to, there's different degrees as far as who believes than not. It seems like most of those in the know have LIBOR expiry falling into the Death and Taxes category. So safe to assume that we're in a situation where we lose this index by the end of 2021. There's some concern out there that we may even see it fade. It's important to stay prepared prior to then. So, preparation becomes all the more important because panel banks stop publishing LIBOR rates, it may become a zombie index, and it may not be effective.
16:37
So our regulator, the Federal Housing Finance Agency, wanted to be way out front of this topic.
16:45
And the goal of the agency was really to establish a depth of knowledge regarding this change regarding the new SOFR index, regarding the products, new products in the market, as a whole, and, you know, building up an expertise that, we can in turn, share with our membership and help, you know, at the member level with the transition. So that's what we've done. This has been a hot topic at the Home Loan Bank of Boston for a couple of years now. We've had a, you know, based on initiative from our regulator, we've had a cross functional group working together since about 2018, focusing on identifying the exposure or our exposure to LIBOR on our balance sheet, and preparing from a member standpoint. Our advance products, you know, taking a look, see what products are indexed or dependent upon LIBOR. And we have put a maturity restriction on a basket of products out to December 31, 2021.
17:43
And what we've been doing is, we've tried to rework some of the more popular products to get them back out and available to members, which we have done in a few cases. And one of the other things, too, was to get members access to the index, the SOFR ndex, and we did that with the SOFR-Indexed Advance.
17:58
On this slide, you can see back in October of 2019, we introduced this adjustable rate index, Excuse me, adjustable rate advance that’s indexed directly to SOFR, has a very flexible maturity scheduled, rate terms out to 20 years. The advance rate adjusts on a daily basis at SOFR plus a pre-determined, static spread that’s determinant trade date, and it's dependent upon the final maturity of the advance. Interest is suggested and calculated daily.
18:26
And the interesting stuff, it's a zero day look back on the SOFR index. So, interest charged for, say, March 10th, would be based on the SOFR rate set of March 10. So, technically, you don't see that till March 11. But that is how it would calculate, and it's a simple interest calculation based on an actual 360-day year. Interest is paid annually. So, principal would be due at maturity, but interest is paid annually, and if you have an advance that matures inside of a year, so a SOFR advance that’s either 2 to 3 months, or six months and term. That is all interest is paid at maturity at that point. And the advance is also prepayable, subject to a fee, depending upon the market conditions at the time.
19:09
So what I did from here is, I developed just a hypothetical advance to include in this presentation, dating back with shorter-term advance. If you've paid attention or you've seen any of the activity that we've done recently, we've done a lot of three-month offerings, so a three-month SOFR advance offering as specials on a weekly or biweekly basis.
19:30
And that seems to be where the interest has been recently, especially with the uncertainty in the market. And so what  I did is I went back to end of February, technically beginning of March by the time this hypothetical advance settled, and priced out and created a three-month SOFR Advance back on February 27. So the advance would typically settle two days out. We do have some flexibility on the front end there if you need it sooner. So in this case, to date, two business days forward would have been March 2 and you have a three-month advance. And I'm using a notional dollar amount of 10 million. As you can see on the right, I listed in that chart SOFR advance rates from March 2 out through August 2, excuse me, June 2. And as you can see, on there average SOFR advance rate during that period of time, 23 basis points. Of course, it's an interesting period that we chose here, or just timing wise, because you see that where really short-term rates fell off the cliff.
20:21
So, as far as the advance, in this example, at the time, we're looking at a three- month SOFR advance priced at SOFR plus 30 basis points. So, at that time, I would assume SOFR was set at six basis points, higher than the date. So, you probably would have been somewhere around 190 out of the gate, but that index dropped off significantly after that point. And you looked at a situation where you were talking about an average advance rate of 53 basis points for that 90-day period. So, great timing, utilizing that advance, and
20:56
when that advance comes to maturity, as I said before in the prior slide, principal is due at maturity.
21:01
You're looking at a 92-day count, so you’re just going to get a simple average of those SOFR sets, for that period of time. So the interest due on 10 million over that 92-day period based on a 53 basis points advance rate, 13,544 spot 44. So ... although principal is paid at maturity on the maturity date, the interest on the advance is paid two business day thereafter. Just takes time [there] was a delay in the rate, so, SOFR rates set for that last business day, and allows time to calculate move forward.
21:32
So, just as an example, you know, using this three month, if one was to initiate a three-month fixed advance rate back on March 2, it would have been a 155. So this example, obviously, a big win, if members had utilized that, SOFR advance rate and took advantage of the front end of the curve, and the LIBOR rates have gone. So, we have had, as I had mentioned before, a few SOFR offerings recently, and most recently was back on June 11. Last Thursday, June 11, we had a three-month SOFR advance that went off SOFR plus 29 basis points. The SOFR index set at seven basis points on that settlement date. So the initial rate set would have been 36. I think we've bumped around that 7 to 9 basis points since then. So just comparatively if you go back to the trade date, June 11, our overnight one-month and three-month advances were all at the same level at 45 basis points. So, again, nice savings out of the gate, and always a positive. When you can see lower cost liabilities in the end. A nice saving, excuse me, a nice funding alternative.
22:37
So, as I mentioned in the first slide, a lot of flexibility with the product. There's a lot of opportunity there now. We've been rolling out these three-month specials, but that doesn't mean we can't do other terms. If it's something that you have any interest in, be at a different term, or you'd like [to] have, you might have some questions regarding the product, how it functions, give us a call on the Money Desk, or kick us an email. Either way, we're more than happy to discuss. And, like I said, I think it's a very flexible and feasible option at this point. So please reach out to us and let's have that conversation.
23:10
And at this point, kicked back over to you. Andrew.
23:13
Thanks, Dan.
23:15
So lastly, we'll wrap up. And I think that's a good segue from Dan's example there, in terms of looking at the pricing advantage to looking at three ways that we can take this SOFR-Indexed Advance and apply it to the average everyday balance sheet strategies that you're probably already using. And that creates an opportunity where you can save a little bit on interest expense and, or improve some of the correlation and matching with the types of assets that you're putting on the books. So, we'll jump right into the first example, as simply a short-term funding alternative. So a lot of members, whether it's because they're just simply plugging the fluctuation in there, the liability side of their balance sheet and looking to borrow short-term or they're asset sensitive. So, they structurally have a preference to have liabilities on the front end and have some static level of wholesale funding.
24:11
Well, here's an example where you're going to compare where one-month classic rates were versus the three-month SOFR-Indexed Advance.
24:22
So this is looking back at the last five weeks here, where we've seen where the one-month classic was priced, and we've also seen where the three-month SOFR-Indexed Advance was priced. So you can see all the way circled on the left-hand side, the one-month classic was between 41 and 45 basis points. The SOFR-Indexed Advance, all the way to the right, was between 26 and 36 basis points on those days. So pretty significant day one savings in terms of the SOFR-Indexed Advance. And you can see that the two sets of bars in the middle are simply how we reach the all-in rate for the SOFR-Indexed Advance. It's simply the base index plus the pre-determined static spread.
25:10
So pretty significant when we're considering that we're in a 0% world here to see 5 to 15 basis points of potential savings.
25:17
So, you know, one of the things that is interesting in terms of having this variable rate, short-term, exposure, is the fluctuation in Treasury bill rates. So here's an example where we looked at what went on with SOFR as well as the one month T bill rate through the end of May into the beginning of January, excuse me, June.
25:43
So on, at quarter end, both SOFR and one-month T bills were right at one basis point.
25:51
But as issuance started to ramp up, largely related to the funding of all the stimulus measures that are are now coming into the market T-bill rates,
26:02
classic supply demand mismatch, moved up pretty considerably in a pretty short period of time. So you can see those red dots mark that about 1.5 week mark, where Treasury, T-bill rates, went from one basis point, all the way up to 20 basis points. Whereas SOFR stayed flat at one basis points. So when you think about that strategy of rolling one-month advances, when your advance comes due for maturity, you're subject to the timing of wherever rates are at that particular day, when it's time to replace that advance. So if you are unfortunate to have an advance maturing in that April 7th, 8th, 9th, 10th range, you're going to see a likely elevated advance rate
26:46
because one-month Classic Advance rates are based off of where T-bill rates are. So, you can see in the call out box there in the middle, where one-month advance rate were around 34 basis points at the end of March, while, on April 9th, they had elevated all the way up to 50 basis points. So, if you are fortunate to have a SOFR-Indexed Advance leading into that period, you would have not seen a rise in interest expense, like you would have seen in that rolling one-month strategy. So, we saw on the prior slide where there's the day one savings.
27:24
But this is that path afterwards where the savings can accelerate. And that gap can widen in your favor because your liability costs remain low and stable.
27:39
The second balance sheet strategic use for the SOFR-Indexed Advance could be paired with interest-rate swap. So a lot of our members use swaps in a strategy of paying the fixed rate on the swap, often LIBOR-linked swap, and they receive the floating rate and they fund it by rolling short-term Classic Advances, either one month or three month. So there's two ways that the SOFR-Indexed Advance can be used a little more efficiently here, so
28:13
as the transition from LIBOR progresses, the market, the swaps market is gravitating to non LIBOR-related alternatives, that includes the OIS market – that’s the overnight index swap, and we'll get into exactly what that is in a minute. So if you look at the first column and the third column there, we won't go into all the details here, but here is a situation where you're doing largely identical things with two different types of instruments. You're doing a two-year swap, and you're funding it with a three-month advance.
28:45
So in the left-hand side, you're doing an OIS swap funded by SOFR, in the right LIBOR swap funded with Classic Advances. And if you go all the way down to the bottom, you can see the differential in the price there is 34 basis points versus 42 basis points. So, again, eight basis points of savings. In a time period where every basis point matters that much more, and, you know, one of the advantages, excuse me, and a second application would be, rather than just transitioning new activity to these OIS-based swaps, your organization may have LIBOR-based swaps that they have on the books already and that you're funding with
29:31
rolling Classic Advances. Well, you know, in the last couple of weeks, I've had a number of conversations with the swap dealers and ALCO advisors who are very prominent with community banks and credit unions and many of them who worked with organizations like yourselves, and they saw some things about the SOFR-Indexed Advance and they were intrigued in the different types of applications. And some of the feedback that we've gotten is that certainly the OIS and the SOFR relationship would allow for a much, much cleaner hedge accounting relationship. But even the relationship between LIBOR and SOFR is strong enough that the, you know, the correlation is there, so, you can check off that box. But, you can also, as we saw on the bottom of the screen, produce some interest expense savings, which is, which is always a good thing,
30:24
and most, especially, in this climate that we're in right now. So, I mentioned OIS and essentially OIS is just a fancy way for saying, Fed Funds the same way that SOFR is a fancy way for saying repo, so but you know, we want to look at what is the relationship between SOFR and OIS, and I mentioned the very tight correlation. So if you look at this set of charts here, you kind of have to squint to see that there's actually two lines on the chart and that's intentional because that shows how tight the correlation actually is between OIS and SOFR, between Fed Funds and repo. So on the left-hand side, we see the year-to-date daily readings for SOFR and Fed Funds. And you can see right on top of them, both in those first two months of the year, where it was kind of a normal environment. But also through March, when we're in a pretty chaotic and volatile environment, and, in fact, SOFR actually fell faster and closer towards zero than Fed Funds did.
31:27
And then they've been right on top of each other ever since.
31:30
Looking at the right-hand side, this is a rolling one-month average of SOFR and Fed Funds, goes all the way back to 2018. And I think this is an interesting dynamic because, you know, back in September of 2019, you may have seen that the repo market had a little bit of a disturbance where rates spiked up exceptionally high, as there were some short-term funding pressures in the markets.
31:54
And you know, when you look at a daily rate, it only contributes
32:00
one 30th to a monthly average, 190th of a three-month average. So it's a little bit of apples to oranges to comparing an overnight index versus a one-month or a three-month index like LIBOR. So when you look at the impact of that temporary dislocation in the repo market in September of 2019, well, that only contributed about a 16 basis point dislocation between SOFR and Fed Funds if you look towards the right-hand side of that chart there. Well compare that 16 basis points
32:35
versus what you saw in LIBOR in March and April, which was an excess of 100 basis points. So, you know, you have to use that rolling one-month average to really give you a clear perspective.
32:49
So, that leads us into the last part here in terms of funding floating-rate assets.
32:55
So, you know, if you're originating variable-rate loans tied to LIBOR still or investing in LIBOR-linked investments, well the SOFR advance can be a wise way to fund these assets to align not just the integrate exposure but also the liquidity profile. So, as we mentioned before, the correlation tends to be strong over long periods of time. But when it does diverge and as pointed out by some of those arrows on the screen, you can see it happens because the credit component of LIBOR leads to a widening and, or SOFR falling faster while LIBOR is flat, or even going higher. So, what does that mean? If you have a LIBOR asset and a SOFR liability, you want your asset index to go higher and you want your liability index to go lower because your margin is going to expand. And, in fact, that's what we saw in March and April and, you know, one good example of, that would be our insurance company members who invest in, things like CMOs.
34:02
And they saw, they're linked to LIBOR,
34:05
and they saw the yield that they were receiving on those assets go much, much higher. And even for our depository members, any LIBOR-linked loans that they had that were due to reset in March benefited.  And it was a kind of one of the glass half full aspects of what was going on in March. That income did remain relatively high because of the dislocation. So, you can see SOFR tends to trade at any level well below that of LIBOR and in periods of stress, that margin can expand.
34:39
​So, long story short, there's a number of different applications that Dan mentioned. The advance is very flexible and malleable, and certainly in this environment, it can contribute to interest expense, which is something that is on everybody's radar at the present time. So, I want to thank everybody for being with us here today. As Dan mentioned, we are here as a resource. We've committed a lot of time effort and energy to putting these pieces in place, to be a resource for members. So, if there's anything here, and like I mentioned earlier, this presentation will be up on our website, the slides, as well as the, the entire webinar. And we are here to be of help. So do not be shy in reaching out. Thank you very much, and we'll speak to you soon.