It’s Time for The Industry to Engage on SOFR’s Voldemort Problem

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It’s a rule around here that I don’t write on the same topic twice in a row because if you don’t get bored, I will.  I am making an exception this week to revisit last week’s blog about the industry’s failure to take on, or at least discuss, the considerable negative externalities of transferring our entire business from LIBOR to SOFR while we have time.  The problem, of course, and I recommend last week’s commentary for a more fulsome discussion (or screed), is that we are barreling toward a world in which trillions of dollars of floating rate debt will be based on an index that is not credit-sensitive and which may (and likely will) cause a transfer of value from the providers of capital to the users of capital.

After last week’s commentary, I got a lot of responses from folks saying thanks for raising this issue yet again.  It’s a big one, but the industry doesn’t seem to have any appetite (or might even be bottom, as the English like to say) to take it on.  A Voldemort sort of thing?

A problem, of course, is the Tragedy of the Commons.  An economic actor (homo economicus) acting in accordance with his or her own self-interest will shy away from expending resources in pursuit of the common good.  The notion originated in an essay written in 1833 by William Forster Lloyd (I looked it up).  Notwithstanding my exemplary attention to useless minutia while pursuing a degree in economics, I had never heard of him.  But his theory and the examples he provided are well-known.  The estimable Mr. Lloyd used the concept of unregulated grazing on common land around small villages in Great Britain.  While it was broadly understood that the commons could only support a certain number of grazing sheep, if no one was prepared to regulate their number of sheep, the commons would become exhausted which would lead to dead sheep and starving peasants.  And apparently, it regularly did.

Mr. Lloyd was talking about depleting resources, but the same applies in this instance.  Who will pay to address a problem resulting from ill-conceived regulation, when everyone else will be a free rider on the work?  Let’s be clear here—there are real costs to taking this up.  Of course, there are not immaterial out-of-pocket costs for staff resources, external consultants and (God help us) lawyers, but the real cost is the political price.  It’s the price of contesting the consensus of the governmental elites; pushing back on the concordat amongst the great powers that it must be SOFR all the time.

Nonetheless, I would urge my friends and colleagues in the industry to do something now.  I fully recognize the concerns about doing something and the risk of standing out, the risk of annoying the regulators, the risk of not appearing “onside” with the Fed.  I also acknowledge a certain ennui resulting from the thinking, championed by the ARRC and others, that the train has left the station, and that there is really nothing that can be done except to go all boiled frog (and I’ve used this metaphor too many times before to go through it again here).

But I don’t think that’s true.  Here’s the plan: We all belong to a host of trade organizations representing banks, securitization industry participants and the broader mortgage finance marketplace.  They can and should help (that’s, of course, their job).  We need to task them to do so.

To date, all our major trade organizations have active LIBOR transition committees or task forces, but none that I’m aware of have specifically, and with particularity, addressed the question of whether there should be a space for credit-sensitive rates in the marketplace.  Some institutions have tested the waters on credit-sensitive rates or indeed embraced BSBY or Ameribor, but absent an industrywide effort driven by the trade organizations, this is not going to be enough to provide real choices to the market and avoid the disorderly extirpation of LIBOR.

This past week I spoke to both the MBA and CREFC and we plan to touch base with some of the other principal trade organizations to raise the issue of whether a forum, task force or even a simple meeting convened to focus on alternate rates is appropriate.

Don’t wait for me.  I would urge everyone raise this issue with your favorite trade organization and ask them to take leadership and at a minimum convene a forum in which these issues can be discussed.  (God help me, I think I’m talking about a safe place.)

Maybe, as I have said earlier, SOFR is the best house on a bad street, but I’m not convinced that markets yet think that.  Consider this: Even if there is a remote possibility that SOFR doesn’t sweep the table and become the overwhelmingly dominant index upon which we price trillions of dollars of floating rate debt, consider the chaos that will follow when, after a hesitant, somewhat skeptical and unconvinced adoption, the market changes its mind and begins to grasp for alternate indexes.  Consider the chaos that will ensue if we wait until buyer’s remorse sets in to begin thinking about all this.  We can’t let that happen.

Inaction now, hoping for some great reveal resulting in clarity leading us to either fully embrace SOFR or to pursue alternatives is not the answer.  Even though it’s already late, we have time to think through the possibility of validating credit-sensitive rates for at least some segments of the market and we should do so.  I urge everyone to approach their trade organizations now and ask to get a process under way.

While it will make the ARRC pouty, and while I hate to think so, it might even disrupt relationships with regulators, it needs to be done.

So, who goes first?  How about all of us.  All we’re talking about here is a gentle nudge to the organizations that should, and I am certain, will be responsive.  Let’s sidestep the Tragedy of the Commons and get something done.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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