5/11/2023
Lately, a new concept for naming mortgage interest rates has become very fashionable among homebuyers. This is the SOFR or Secured Overnight Financing Rate.
This is a very important indicator for financial institutions in the United States and the rest of the world, and here we are going to explain what it is and how it is calculated.
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What is the SOFR?
The Secured Overnight Financing Rate is a reference rate for loans and derivative financial products that are denominated in dollars and is replacing LIBOR (London Interbank Offered Rate).
The SOFR is based on transactions in the U.S. Treasury repurchase market and is preferable to LIBOR as it is based on observable transaction data rather than estimated borrowing rates.
Background on the Secured Overnight Financing Rate
Since its emergence in the mid-1980s, LIBOR has been one of the primary benchmark rates used by banks and investors to establish their lending arrangements.
Since LIBOR includes 7 maturities and 5 currencies, its calculation is given by the average interest rate that global banks use to lend to each other.
The currencies we have mentioned are: US dollar, pound sterling, Japanese yen, euro and Swiss franc. Also, the most widely used London Interbank Offered Rate is the 3-month interest rate on the USD, which is also known as the current Libor.
After the 2008 financial crisis, regulators felt that it was not good to have so much reliance on this indicator. On the one hand, the London Interbank Offered Rate is generally based on estimates from global banks that are consulted, rather than on real-time operations.
The downside of giving financial institutions such freedom was clearly seen in 2012, when it was revealed that more than a dozen banks were altering their figures to make more profit from derivatives.
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In addition, subsequent regulations caused a reduction in interbank lending and this lower trading limit made Libor less reliable.
For this reason, many countries and markets that previously used LIBOR as a benchmark had to switch to another index. In the case of the United States, it was changed to the SOFR (Secured Overnight Financing Rate).
What you should know about the SOFR?
The Secured Overnight Financing Rate is a very important indicator used by banks to price their loans and derivative products in dollars.
The SOFR arises from transactions in the U.S. Treasury repurchase market, where investors offer financing backed by their bond assets.
As an attempt to replace Libor, the Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate in 2018.
This kind of 'benchmark' is critical for trading in derivative products, especially interest rate 'swaps', which corporations and other organizations use to manage risk and to speculate on changes in funding costs.
Interest rate swaps are agreements where those involved exchange fixed interest rate payments for floating interest rate payments.
In a vanilla swap, one party promises to pay a fixed interest rate and the receiving party agrees to pay a floating interest rate out of the SOFR.
Given this situation, the payer benefits when the benchmark rate rises because the value of incoming payments based on the Guaranteed Overnight Funding Rate has increased. This happens while the cost of payments to the counterparty remains under a fixed rate scheme. If the benchmark rate falls, the opposite occurs.
Calculation of the Secured Overnight Financing Rate
To obtain the Secured Overnight Financing Rate, the Fed takes into consideration data from the country's major financial institutions. Using the average of overnight loans as a reference, the SOFR is obtained.
Challenges of the transition from Libor to SOFR
The transition to a new benchmark presents difficulties, as there are $3 trillion worth of Libor-based contracts that will mature until the Libor rate is withdrawn. Reassessing the contracts is complex because of the differences between the benchmarks.
For example, Libor represents unsecured loans, while SOFR represents Treasury-backed loans. In addition, Libor has 35 different rates and SOFR is a single benchmark for overnight financing.
Moving to SOFR will have major implications for the derivatives market. However, it will also play a role in consumer credit products (including some student loans and adjustable-rate mortgages or ARMs), as well as debt instruments.
Español: ¿Qué es la tasa SOFR y cómo se calcula?