So far with SOFR
Commercial Mortgage Broker messages may not always be flowery. But they’re always honest. Now that the new SOFR index is settling in, I have to speak out about a capital markets injustice affecting the little guy. The borrowers. Our clients. SOFR derivatives ain’t all they’re cracked up to be. Let me explain
BS- Before SOFR. That was then, this is now
The move from Libor to SOFR made alot of sense. It heralded in a new era where the predominant interest rate index was a pure play. It was no longer LIBOR, set by a small cartel of large banks, and no longer subject to abuse and moral hazard. SOFR started as the average rate of cash overnight borrowing in the repo market with US Treasuries as collateral. This repo market averages over $1 trillion per day of trading volume. Nobody could criticize this market derived index. It seemed to be the best proxy for determining credit risk in the capital markets.
Life was good. Well it was good for about 9 months until the capital markets came up with some SOFR derivatives. SOFR is still a great rate. Maybe the best index in the history of the finanical system. You can learn alot about risk by studying SOFR.
But after a few months of perfection, derivatives set in. Popping up came 1 month term SOFR, and 3 month term SOFR. Who sets these rates? They are not market derived from $1 trillion of daily trading volume. Term SOFR is starting to sound alot like the term structure of LIBOR the way the rate is set. Its LIBOR all over again.
AS- After Some SOFR
Capital markets will argue the place for 1 month Term SOFR, and 3 month Term SOFR. And these are the SOFR derivatives that are used to quote most SOFR based deals. I hesitate to call these SOFR rates, and prefer to call them derivatives. Because these are not SOFR. There are a synthetic, humanly derived term structure for SOFR. SOFR is getting lonely because nobody is quoting spreads above it. Instead they are using these derivative SOFR term constructs.
Terms of Term Structure
What should be happening is that lenders should look at duration risk on their own. There is no one size term structure that fits all. For example, a bank with short term depositors faced with making a 5 year fixed rate loan is going to look at the risk of fixing lending costs for 5 years quite differently than a life insurance company whose assets are long term life insurance policies. Just as financial institutions have to match their assets with their liabilities, so too should they match their lending rate decisions with these same liaibilities.
So if a bank uses, say a 50 bps spread over 3 month term SOFR to make a 5 year fixed rate loan, and a life insurance company also uses a 50bps spread over 3 month term SOFR for a 5 year fixed, both lenders are lending out 5 year money at the same rate even though the duration of their liabilities is far different.
Commercial Mortgage Broker would suggest that lenders look at their spreads and adjust for the duration in a personal, institution specific way. SOFR is a great indicator of credit risk. Lets please separate out the credit risk from other subjectively determined risks like duration risk. Things get alot less complicated this way. As an example, say SOFR is 4% and 3 month term SOFR Is 4.5% and lenders make a 5 year loan at 250bps over 3 month SOFR, all lender who buy into that are lending out 5 year money at 7%. But 5 year money is worth different rates to different types of institutions.
Capital markets understanding would be more transparent if each institution chose their own term structure to account for their unique duration risk, and priced off pure SOFR. So the bank might be at 350 bps over SOFR on a 5 year fixed or 7.5%, and a life insurance company may be comfortable at 300bps over SOFR for a 5 year fixed, or 7% rate. Term structure is better asssesed on an institution specific level. Its personal!
We want non GMO SOFR
Demand pure SOFR. Lets your lender price their other perceived risks on their own. Where it gets hairy is where lender use 3 month Term SOFR and then have spreads increase for longer loan durations. This commercial mortgage broker would argue that is double counting. To the borrower’s detriment. Did you even realize there is a difference between SOFR and 1 month term SOFR? Its not really being advertised. Ask you lender to be specific about which SOFR index is being used. Get it codified in the term sheet. Lets hold the capital markets accountable. What is a commercial mortgage broker if we cannot ask these questions.