New Fed Rate Pulls Ahead in Race to Replace Libor

Federal agencies, banks and investment firms are pushing Wall Street to install their preferred replacement for the London interbank offered rate, the interest-rate benchmark underpinning trillions of dollars in financial contracts.

The Treasury Department Wednesday said it was considering floating-rate notes linked to a new rate created by the Fed—known as the secured overnight financing rate, or SOFR. That came after a Federal Reserve Bank of New York working group in July endorsed using SOFR in adjustable-rate mortgages. The Securities and Exchange Commission has also raised concerns about the risks of firms dragging their feet through the transition, or adopting a hodge-podge of competing short-term benchmarks.

At stake is the timely replacement of Libor, which underpins $200 trillion of financial contracts ranging from home mortgages to corporate loans. That rate was slated for replacement in 2021 after a manipulation scandal.

Finding a substitute is a key challenge for banks, companies and investors. Each wants a reference rate that reflects the risks from short-term lending and is supported by a liquid market that behaves in a predictable manner. Properly setting the rates on business and consumer loans can determine whether they are affordable for borrowers and profitable for lenders.

While Libor is based on estimates of what it costs banks to borrow over different short-term periods, SOFR is based on the cost of borrowing overnight using U.S. government debt as collateral. Most companies have been slow to make the switch, so the new push from the Fed’s working group of banks and investment firms—known as the Alternative Reference Rate Committee— signals gathering momentum.

“The ARRC is trying to strike a balance between letting markets develop organically and facilitating their growth,” said Brian Grabenstein, who heads

Wells Fargo

’s Libor transition office, and sits on the ARRC’s committee on consumer products.

While companies have sold more than $150 billion of SOFR-linked notes, a government bond would catch the attention of “a lot of investors who don’t have [SOFR] floaters on their radar,” said Thomas Simons, a money-market economist at Jefferies Financial Group.

Mortgage companies Fannie Mae and Freddie Mac, both ARRC members, have said they will buy adjustable-rate mortgages linked to SOFR and repackage the loans as bonds. About $1.2 trillion of similar bonds are currently linked to Libor. Investors and banks will need to prepare for the new home-loan securities, which could be offered in the next 12 to 18 months, officials said.

Because the mortgage companies have said they will buy home loans linked to SOFR, lenders will begin underwriting them, said Timothy Kitt, who oversees Freddie Mac’s mortgage pricing and execution.

JPMorgan Chase

& Co.,

Honeywell International
Inc.

and Mood Media Corp. have used ARRC-approved language in securities offering documents that addresses the replacement of Libor as a reference rate in certain financial contracts. Some analysts said that marks an important step because regulators are pushing companies to be ready for Libor’s cessation and to disclose details of those preparations.

Some companies and investors said they would prefer a reference that accounts for the risk of not getting paid back, a feature of Libor that is absent from SOFR. The Intercontinental Exchange, which owns the rights to Libor, has created a credit-sensitive rate called the bank yield index, which is calculated using trades of bank debt and which is intended to behave like Libor. In early July, the company revised the index to link it to SOFR while maintaining its use of bank debt yields.

Yet ARRC officials have expressed skepticism about the relatively small amount of trading activity that would underpin Intercontinental’s rate. Regulators have also signaled they have concerns about alternatives to SOFR.

SEC staff “is monitoring whether the adoption of a variety of replacement rates for [U.S. dollar] Libor instead of the emergence of a dominant successor could limit the effectiveness of all replacement benchmarks,” the commission said in a July statement.

The ARRC and the Fed have urged companies to find ways to use SOFR rather than sticking with Libor. Differences between the two rates have made that difficult.

One problem is that Libor sets interest costs into the future, making payment streams predictable, while SOFR is calculated by averaging or compounding the overnight rate over a period of as many as several months, which can produce unpredictable results. ARRC officials expect to establish longer-term forward-looking maturities for the new rate by the end of 2021.

The use of futures to derive a forward-looking rate from overnight SOFR, which the ARRC suggested in May, could produce predictable payments, according to analysts at JPMorgan. Making the new rates predictable is important for reducing surprises that could cause investors or lenders to lose money or for borrowers’ payments to unexpectedly rise.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

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