LIBOR fallbacks in Agency loans and caps

As of late January 2021, new interest rate caps, or those amended by way of the ISDA 2020 IBOR Fallbacks Protocol, incorporate new LIBOR fallbacks, provided the caps are governed by documentation prepared by the International Swaps and Derivatives Association (ISDA). Notably, this does not include interest rate caps purchased to hedge Freddie Mac Adjustable-Rate Mortgage (ARM) loans or Fannie Mae Structured Adjustable-Rate Mortgage (SARM) loans, which are not governed by ISDA documentation. This piece summarizes caps required by Freddie Mae and Fannie Mae (the Agencies), as well as their specific LIBOR fallback mechanisms.

Agency-required caps

Both Freddie Mac and Fannie Mae require multifamily borrowers to purchase third-party interest rate caps to limit interest rate risk in connection with their ARM and SARM products, respectively, both of which are linked to the New York Fed’s Secured Overnight Financing Rate (SOFR), rather than LIBOR, and have been since the beginning of 2021. Most Agency ARMs, SARMs, and required caps that closed before the end of 2020 were indexed to LIBOR.

For more information on Agency interest rate cap requirements, see Freddie Mac Multifamily Seller/Servicer Guide (dated as of December 15, 2020), Chapter 11, Section 11.3 and Fannie Mae Multifamily Selling and Servicing Guide (dated as of January 1, 2021), Part III, Section 1205.

Agency LIBOR fallbacks: loans and caps

The Agencies typically require their multifamily borrowers’ caps to be structured to an initial maturity of three years, in the case of a Freddie Mac ARM, or four years, in the case of a Fannie Mae SARM. Meanwhile, regulators and key stakeholders have signaled that they expect LIBOR to be published only through June 30, 2023, leaving open the possibility that certain Agency ARMs and SARMs (and their required interest rate caps) may become subject to transition on or before June 30, 2023.

Fortunately, both Freddie Mac and Fannie Mae have accounted for this in their LIBOR-indexed ARMs/SARMs, and associated caps. Freddie Mac’s LIBOR ARMs contain language that gives Freddie Mac the right to convert the loan to an alternative index in the event of a LIBOR discontinuation, an announcement that LIBOR will be discontinued or is no longer representative, or if, at their discretion, an alternative index has become broadly used in commercial real estate financing. Fannie Mae’s SARMs have similar language. The interest rate caps for both have broad language that allows the cap provider, in consultation with Freddie Mac or Fannie Mae, to convert the index on the cap from LIBOR to an alternative rate at their discretion. While we typically would advise our borrowers to preserve the right to make decisions related to LIBOR fallbacks, we are confident that the Agencies will do all they can to ensure an equitable transition from LIBOR, both in their loans and associated interest rate caps.

What’s an Agency borrower to do?

With this language, Freddie Mac and Fannie Mae have the ability to transition their loans to an alternative index like SOFR at their discretion and similarly, work with cap providers to transition the associated caps from LIBOR. While we typically would view a unilateral lender right like this as less than ideal from a borrower’s perspective, our conversations with Freddie Mac and Fannie Mae leave us cautiously optimistic that the transition of Agency LIBOR loans will occur in a way that is not harmful to borrowers. Both have indicated to us that they don’t expect to be “market leaders” in the transition of pre-existing LIBOR debt and are focused on ensuring a transition approach that would not be economically detrimental to their borrowers. One Agency production team member indicated that they may not force a conversion of LIBOR caps if doing so would result in their borrowers coming out of pocket. In that case, they might prefer to leave a SOFR loan hedged with a LIBOR cap, particularly in the current market environment where rates are expected to remain low for years to come.

In the interim, it’s important to remember that you should not adhere to the ISDA Protocol for any Agency interest rate caps. The ISDA Protocol, as drafted, does not apply to Agency caps as they are not governed by an ISDA Agreement. Outside counsel for Freddie Mac and Fannie Mae have told us they do not want borrowers attempting to incorporate the ISDA Protocol language into Agency caps because the caps already have the aforementioned fallback language. Similarly, if your non-Agency lenders, JV partners, or hedge providers (in connection with non-Agency loans) approach you regarding the ISDA Protocol, be aware that adoption of the Protocol will not impact your portfolio of Agency caps.

Please reach out to your Chatham team to discuss the best way to evaluate any risk in transition and how to best approach your lending contact and/or cap provider. This could lead to trading out of a LIBOR-based position and into another position before the “safety net” of the Agencies’ fallbacks: we’ll be able to provide better direction as the market evolves and encourage you to monitor our LIBOR transition insights for updates.