Freddie Mac asks borrowers to extend protection on LIBOR-indexed ARMs through June 2023

In November 2020, U.S. bank regulators issued a statement providing that, with few exceptions, banks may no longer offer new LIBOR-indexed loans or hedges (including interest rate caps and swaps) beyond the end of 2021. Freddie Mac requires floating-rate borrowers purchase interest rate caps to establish a ceiling on their interest expense for the first few years of the loan (typically 2–3 years) and then to extend the cap before it expires (typically for 1–2 years at a time). Concerned about the possibility that LIBOR protection will not be available or less liquid after the end of this year, Freddie Mac encourages borrowers to extend their existing LIBOR caps through July 1, 2023, the anticipated discontinuation date for LIBOR. Freddie provided this guidance to its network of Optigo lenders on July 21, with the following key takeaways:

• Freddie is asking servicers to encourage borrowers with existing LIBOR-indexed ARMs to extend the LIBOR caps hedging these loans through the earlier of the loan maturity date or at least July 1, 2023.
• Freddie is encouraging borrowers to execute these extensions as soon as possible — no later than the end of this year. They view this approach as a best practice given the risk that LIBOR caps won’t be available beyond this year-end.
• SOFR caps would be available on LIBOR loans only in situations where a borrower chooses not to extend a cap now, and LIBOR caps later become unavailable.
  
• While Freddie has communicated its intent to its servicers, their services have not yet communicated this to borrowers; letters from some servicers to borrowers are expected to start going out as early as this week.
  
• Borrowers will be able to use funds previously escrowed for cap extensions if they elect to extend caps now. We are awaiting guidance from Freddie on how new escrow requirements will be calculated if an early extension is purchased.
  

Considerations and recommendations

As this is a recommendation, not a mandate, Freddie Mac borrowers have a choice as to whether to extend any LIBOR protection now (potentially in advance of when a cap would need to be extended pursuant to loan requirements) or wait until the current cap maturity date. In evaluating this decision, we suggest factoring in the following considerations:

• Freddie Mac preference: While not a strict requirement, Freddie has articulated that it is their preference to see borrowers take this approach to avoid situations where a borrower is unable to extend a LIBOR cap and are forced to purchase a SOFR cap to cover a LIBOR-indexed loan. While the SOFR cap market is less liquid than the LIBOR market, SOFR caps have been readily available since Chatham executed the first Freddie Mac SOFR cap in September 2020.
• Asset plan: While plans may change, if a borrower plans to sell or refinance an asset prior to the current cap’s maturity date, they may be less inclined to extend the interest rate cap now.
  
• Additional extensions: Extending a cap early, through at least June 2023, may increase the number of cap extensions a borrower would need to complete. Consider a situation in which an existing cap expires in January 2023 and the borrower expects to refinance by January 2024. Absent this guidance, the borrower would likely extend the existing cap once in January 2023, through January 2024. Were the borrower to follow Freddie’s guidance, the borrower would extend the existing cap today through at least June 2023 and then again (with a SOFR cap) in July 2023, incurring transaction costs twice.
  
• Pricing considerations: As in any other situation where a borrower is considering extending an interest rate cap in advance, there is a trade-off between locking in a known price for the cap extension today or waiting until later when the term of the purchased cap is shorter and potentially less expensive. Consider a situation where a borrower has a $30M loan covered by a LIBOR cap with a 2.5% strike that expires on July 1, 2022, and will need to be extended for one year on that date. They could elect today to extend the cap for the additional year, purchasing the second year of a two-year cap today for a price of $19,000 based on current market conditions, locking in the cost. Alternatively, they could wait until July 1, 2022. If rate conditions don’t change and a LIBOR cap is available in the market, they will pay less for the cap — a spot-starting one-year cap with the same structure currently costs $10,000. However, if rate expectations or volatility increase, they may end up paying more than if they had extended the cap earlier. This should be a primary consideration for the typical Freddie borrower. If pricing today for an extension through July 1, 2023, is reasonable, then a borrower may prefer to extend the cap now. If the borrower is inclined to pay the minimum amount possible (and is willing to risk that pricing may move against them), they may prefer to defer the extension until closer to the required extension date.
  
• Basis risk: Freddie’s concern that LIBOR caps may be unavailable after the end of 2021 may be well founded, depending on how dealers interpret U.S. bank regulators’ guidance. In discussions with Freddie-approved cap providers, four have told us that they currently think it’s unlikely they’ll offer LIBOR-indexed caps in a meaningful way beyond end of 2021. However, the largest provider (by Freddie caps outstanding) has told us they are still evaluating whether they will continue to offer LIBOR caps beyond 2021. We expect to have clarity on this within a few weeks. Borrowers would be able to purchase SOFR caps on LIBOR loans if LIBOR caps are unavailable, but this introduces basis risk, the possibility that LIBOR will increase in a way not reflected by a commensurate increase in SOFR. In such a situation, a borrower’s interest expense on their LIBOR loan could increase while the SOFR cap may not provide the intended protection, causing the borrower to pay more net interest than if they had used a LIBOR cap. In most market conditions, this would be unusual — LIBOR and SOFR have a high degree of correlation as both tend to move in tandem with the Fed Funds target rate. However, in times of market distress when credit conditions are tightening, we do observe that LIBOR can temporarily spike relative to SOFR, as happened at the outset of COVID (see the period of March-April 2021 in the graph below). This risk is mitigated by the fact that most Freddie Mac caps have strike rates that are well out of the money compared to current rates. LIBOR would have to rise substantially (both absolutely and relative to SOFR) for this to drive a real economic impact for a borrower. Situations in which LIBOR has risen relative to SOFR by a meaningful amount, have tended to be relatively short lived. This consideration may be less significant for the typical Freddie Mac borrower.
  

Conclusion

With the possibility that LIBOR caps and cap extensions may not be available beyond the end of 2021, Freddie Mac is asking borrowers to consider extending LIBOR caps now through the anticipated LIBOR sunset date in mid-2023. Borrowers weighing this guidance should consider the import of Freddie’s stated preference, as well as underlying asset plan, the pricing of extending a cap now vs. later, and potential basis risk between LIBOR and SOFR in a situation where a borrower is forced to hedge a LIBOR loan with a SOFR cap. Please reach out to Chatham with questions as you weigh these considerations.