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House Financial Services Subcommittee LIBOR Hearing

House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets                                                                                                 

The End of LIBOR: Transitioning to an Alternative Interest Rate Calculation for Mortgages, Student Loans, Business Borrowing, and Other Financial Products

Thursday, April 15, 2021

Witnesses

  • Dan Coates, Senior Associate Director, Office of Risk Analysis and Modeling, Federal Housing Finance Agency
  • John Coates, Acting Director, Division of Corporation Finance, Securities and Exchange Commission
  • Brian Smith, Deputy Assistant Secretary for Federal Finance, U.S. Department of the Treasury
  • Mark Van Der Weide, General Counsel, Board of Governors of the Federal Reserve System
  • Kevin Walsh, Deputy Comptroller, Market Risk Policy, Office of the Comptroller of the Currency

Opening Statements
Chairman Brad Sherman (D-Calif.)
In his opening statement, Sherman noted that this is a test to see if Congress can work together to pass necessary legislation that is neither Democratic nor Republican. Sherman stated that $200 trillion of business loans, mortgages, and other instruments have adjustable interest rates keyed to the London Inter-bank Offered Rate (LIBOR). Sherman explained that by June of next year, no LIBOR rates will be published. Sherman said that 99 percent of the problem is one that does not have to be dealt with, as they are short term and will expire. Sherman noted that some were made with the foresight that LIBOR might not be published, and parties agreed to what would happen. However, Sherman also noted that the remaining one percent left to deal with is worth $200 trillion in instruments, many of which were drafted without anticipating the end of LIBOR. Sherman stated that Jerome Powell, Chair of the Federal Reserve, said that this is a systemic risk to the entire economy. Sherman also stated that within the last two months, both Chair of the Federal Reserve Powell and Secretary of the Treasury Janet Yellen have said that federal legislation is necessary. Sherman shared that drafts of bills have been circulated and are being finely tuned, adding that 30 organizations wrote to the Committee about the need for legislation along the lines of the discussion drafts. Sherman explained the five reasons why states should not handle the transition: (1) some states will not, (2) choice of law litigation, (3) lenders will be left with 51 systems to deal with, (4) no state has jurisdiction where the Trust Indenture Act of 1939 is applicable, and (5) some instruments have two levels.

Ranking Member Bill Huizenga (R-Mich.)
In his opening statement, Huizenga noted that regulators have acknowledged the need for a federal approach, which they were not previously enthusiastic about until recently. Similar to Sherman, Huizenga said that this is not a Republican or a Democratic issue, but it does need to be open to input. Huizenga stated that $223 trillion is a lot of money that has exposures in derivatives, credit cards, and student loans, arguing that many things are tied to LIBOR. Huizenga explained the creation of the Alternative Reference Rates Committee (ARRC), which identifies risk free alternative reference rates, best practices for contract robustness, and creates an implementation plan and timeline. Huizenga also explained the Secured Overnight Financing Rate (SOFR), the recommended alternative to LIBOR, which is an overnight interest rate “based on treasury repurchase transactions or overnight corporate loans secured by U.S. treasuries securities.” Huizenga noted that a challenge is the thousands of existing legacy contracts that reference LIBOR, but do not have contractual fallback language should LIBOR be discontinued. Huizenga said that $74 trillion will remain outstanding after June of 2023, $69 trillion of which is in derivatives. Huizenga argued in favor of federal legislation to assist in a smooth transition away from LIBOR.

Rep. Maxine Waters (D-Calif.)
In her opening statement, Waters noted that trillions of dollars in consumer contracts are tied to LIBOR, which will cease as a reference rate in 2023. Waters stated that LIBOR was easily manipulated, institutions paid fines to settle fraud, and that consumers must be protected.

Testimony
Dan Coates, Senior Associate Director, Office of Risk Analysis and Modeling, Federal Housing Finance Agency (FHFA)
In his testimony, Coates argued that the preparation for the LIBOR transition is an enormous undertaking that has a variety of implications. Coates explained the FHFA’s transition is guided by the same core principles that guide other agencies, including to protect homeowners and renters. Coates noted that he is confident in meeting the goal of transitioning the enterprises and federal home loan banks away from LIBOR before 2021 ends. Coates noted how some contracts did not contemplate the end of LIBOR, and that the FHFA does not support a wait-and-see approach. Coates said that while the date was extended, the FHFA continues to ensure its entities are ready by the end of this year. Coates argued that federal home loan banks and enterprises are moving away from LIBOR, and that the enterprises are no longer purchasing from LIBOR, but using SOFR. Coates noted that he is looking for ways to enhance awareness of the transition.

John Coates, Acting Director, Division of Corporation Finance, Securities and Exchange Commission (SEC)
In his testimony, Coates argued that the discontinuation of LIBOR and the transition to alternatives will have a significant impact on financial markets and market participants. Coates noted that there are material risks for companies, investors, and SEC supervised entities, as well as greater risk if this is not completed in a timely manner. Coates explained how cross-agency teams are collaborating and staff are monitoring the extent to which market participants are preparing for and addressing the transition. Coates noted that public companies are encouraged to plan for the transition, consider disclosure obligations, and consider transition risks. Coates stated that risk identification and mitigation, as well as anticipated material impacts, may impact companies facing financing constraints. Coates noted the importance of information technology systems, internal controls, and policies and procedures, stating that the back office will be important in the transition. Coates explained that risk management frameworks may be affected, and that advisors have been encouraged to consider impacts on mutual funds, as well as encouraging funds to provide tailored disclosures. Coates stated that municipal issuers are encouraged to focus on issues relevant to their market, including retail.

Brian Smith, Deputy Assistant Secretary for Federal Finance, U.S. Department of the Treasury
In his testimony, Smith noted that the widespread use of LIBOR underscores the use of timely and effective transition. Smith stated that the ARRC has recommended SOFR and contract language, and they applaud New York’s LIBOR transition law. Smith argued that federal legislation is needed for tough legacy contracts that do not have fallback rates, and that new contracts should begin to reference SOFR.

Mark Van Der Weide, General Counsel, Board of Governors of the Federal Reserve System
In his testimony, Van Der Weide mentioned that larger firms have engaged in misconduct in their use of LIBOR and that LIBOR rates will cease to be published in 2023. Van Der Weide noted that ARRC’s voting members are private firms, as the private sector must drive the transition. Van Der Weide explained that SOFR is a measure of the cost of borrowing overnight, and that market participants are not required to use SOFR in place of LIBOR. Van Der Weide argued that banks should be able to use any interest rate they choose but should include fallback language. Van Der Weide noted that entities are encouraged to stop their use of LIBOR by the end of this year, and that they do not know if legacy LIBOR contracts can transition. Van Der Weide expressed support for legislation to mitigate risks regarding legacy contracts without fallback rates and argued that legislation should be targeted narrowly and not dictate the use of particular benchmark rates.

Kevin Walsh, Deputy Comptroller, Market Risk Policy, Office of the Comptroller of the Currency (OCC)
In his testimony, Walsh argued that the importance of transition planning cannot be overstated. Walsh noted that the OCC wants to ensure banks have flexibility to determine a replacement rate and encourages banks to consider mitigation plans and exposure assessment. Walsh stated that banks should use any reference rate that is necessary to them. Walsh explained that the transition process for smaller banks may present operational challenges, and that they support regional and larger banks monitoring the planning of mitigation protocols. Walsh said that New York’s new law has reduced the risks in the derivatives market. Walsh expressed appreciation for Congress’s efforts to clarify contracts by incentivizing counterparties to agree to a replacement rate.

Question & Answer
Growing Urgency and Impact to Consumers and Businesses
Sherman asked all witnesses if it is important to promptly adopt federal legislation to provide a statutory fix for LIBOR-based contracts lacking sufficient background language. All witnesses said yes, but John Coates said the SEC has not formally taken a position on the Discussion Draft legislation. Sherman asked if in the absence of a clear solution we will see increased price volatility on two contracts that look identical but will be trading differently. John Coates said any risk, including litigation risk, could affect prices and cause discrepancies in pricing.

Rep. Steve Stivers (R-Ohio) stated that unanimous consent in practice is impossible to achieve, arguing that this could harm investors. He said he believes narrow and targeted guidance related to the application of the Trust Indenture Act (TIA) is necessary and asked if the SEC will be able to issue such guidance. John Coates agreed and said the SEC has an ability to provide exemptive relief, but it would require some rulemaking, which takes time. He said he believes the bill being discussed would directly address those questions as well.

Rep. Juan Vargas (D-Calif.) applauded efforts to address LIBOR, saying most of the potential problems seem to have been anticipated. He asked about the remaining piece and how consumers could be hurt if they do not fix this legislation. Dan Coates said their hope for federal legislation is mainly that many mortgages are governed differently across states, and they would like all consumers to be ensured fair and equitable rates and see minimal disruption. Smith said if the transition does not go well, consumers may not know what their mortgage payment is, their credit card payments may be disrupted, lending to businesses may be disrupted, and litigation may take over.

Rep. Sean Casten (D-Ill.) asked what there is to be concerned about in the coming days before LIBOR ends and what we should watch out for in terms of the futures and swaps markets. Walsh said the OCC has had a very well-thought-out transition since 2018 and they are confident that the future and swaps markets will stay robust.

Rep. Ann Wagner (R-Mo.) asked what steps the Treasury and the SEC have taken to facilitate transition from LIBOR. Smith said every step taken has the goal to ensure a smooth transition. He said the Financial Stability Oversight Council (FSOC) has highlighted risks surrounding the LIBOR transition and encouraged participants to evaluate their own risk and to stop using LIBOR where feasible. John Coates said at a high level the SEC has been monitoring the extent to which public companies are identifying and disclosing their potential risks.

Rep. French Hill (R-Ark.) asked for the status of Fannie Mae and Freddie Mac in their transition. Dan Coates said their regulated entities have done a lot of work to be ready for this transition, starting with writing new language alongside AARC, and they have prohibited entities from purchasing LIBOR mortgage-based products. Dan Coates said the one remaining area is derivative activities, but he expects LIBOR-related activities to drop off as SOFR derivate liquidity increases.

SOFR Concerns
Wagner asked about the differences between LIBOR and SOFR and how SOFR might address risks of manipulation compared to issues seen with LIBOR. Smith explained that LIBOR is a survey-based rate, while SOFR is based on transactions and collateralized borrowing, not a survey of where people think they can borrow. He said based on the robust set of transactions in SOFR, it is a very transparent process and would be hard to manipulate.

Rep. Bill Foster (D-Ill.) asked if one should expect to see systematic differences after the transition, if LIBOR will be higher or lower on average, and who the winners and losers are in this process. Van Der Weide said there may be some differences because SOFR is different in nature. He said daily averages of SOFR will show more volatility and behave differently in times of economic stress, but that he believes the averages between rates correlate quite closely together and will not lead to big groups of winners and losers. He added that there certainly are investors taking positions on the speed and nature of the transition away from LIBOR.

Huizenga asked if it is this specific bill language needing a response or rather the concept of federal legislation in general, and what conflicts arise in using SOFR. Dan Coates said they support any federal legislation to smooth the transition. John Coates also said they are supportive of any efforts, not confirming it needs legislation. Walsh said federal legislation is very constructive, and they have offered comments and want to work with the staff on this bill. He said he does not see any problem with SOFR, but noted that the scope of banks that the OCC supervises is very diverse with different needs. He said the OCC wants to respect that and give banks the opportunity to use any replacement rate that fits their particular model.

Hill asked about the discomfort expressed by community banks. Walsh explained that SOFR is an overnight risk-free rate and is transparent, but the main issues of concern by community banks is that it does not include a credit component. He suggested trying to create a credit spread. He added that the other area of concern is around SOFR being an average rate, which makes it difficult to manage cash flow positions, but noted there is work being done to find a forward-looking term rate for SOFR.

Rep. Warren Davidson (R-Ohio) raised concerns about past spikes seen in the repo market, and asked if there are concerns about this happening in the future or what implications there would be under a new SOFR-based system. Van Der Weide said they are looking to improve the resiliency of markets, but noted that because of how SOFR is integrated, spikes in SOFR are not going to be long lasting or have a bad volatility effect. He said he believes SOFR’s averaging mechanism will be enough to deal with the natural volatility in repo rates. He added that SOFR will not be a mandated rate, so if people are concerned about the volatility of SOFR they can migrate to a different alternative rate.

Legacy Concerns
Hill asked for an estimate of outstanding legacy contracts. Van Der Weide said the number they are focused on is 10 trillion.

Rep. Trey Hollingsworth (R-Ind.) asked Van Der Weide if he is concerned about the Federal Reserve essentially picking a rate and making it conclusive and binding upon parties who agreed to a contract but then will not be afforded any litigation avenue should they disagree with it. Van Der Weide said it should be a rare situation when Congress is overriding a private contract and it should only be done in a very narrow way, and strictly limited to legacy contracts that do not have an appropriate fallback rate.

Litigation Concerns
Sherman asked how much time there is to adopt legislation to solve this problem, saying his hope is to have this signed into law by the end of October 2021. Van Der Weide said Congress needs to act expeditiously, but he does not have a specific deadline in mind. He said having eight months would be great but anything completed decently in advance of June 2023 is good.

Huizenga asked if the New York state legislation only fixes their problem rather than for the entire country, and what happens in the absence of federal intervention. Walsh said the contracts that do not have fallback language could be very problematic, and the short answer to potential consequences is litigation. Huizenga expressed some concern that in an effort to avoid litigation, we still may be susceptible to litigation in challenging the constitutionality when interfering with private contracts. John Coates said there is a risk of litigation no matter what but believes it is possible to mitigate it as much as possible.

Rep. Anthony Gonzalez (R-Ohio) asked if the longer it takes to implement legislation at the federal level, that it would bring about additional litigation. He also asked for an explanation of the implication of mass litigation on financial markets and who would bear the cost. Dan Coates said there are a lot of entities that will bear the cost if people do not move. He said trustees will start going to courts to seek resolution, and this transition would be stalled in 51 jurisdictions each ending with different outcomes and in turn affect consumers.

For more information on this hearing, please click here.