LIBOR Transition: The Most Important Number is Changing
Within the new year, a key benchmark that sets the interest rates charged on adjustable-rate loans and a variety of mortgages will undergo a new mechanism by 2021.
Since the mid-1980s, Libor, the London Interbank Offered Rate, plays a big role in determining the interest rates loan providers charge on different financial products.
For consumers, this means interest rates for credit products such as credit cards, car loans, adjustable-rate mortgages, and private student loans that banks and credit unions issue out.
According to Forbes, “Libor is set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions.”
Meaning that banks get to submit a number based on what they would pay for a loan not what they actually pay.
The Intercontinental Exchange (ICE) Benchmark Administration chooses the average between those 18 banks to avoid extremely high or low rates as the set base rate for the day.
When you apply for a loan, the firm your borrowing from takes a LIBOR rate and then adds their own percentage. That percentage then varies from each bank creating an unfair advantage for consumers and for competitors.
“As of 2019, $1.2 trillion worth of residential mortgage loans and $1.3 trillion of consumer loans were priced using Libor, “ according to Forbes.
Because it is easy for banks to submit a low rate based on what they would want to pay not on what they actually pay, it is easy for those numbers to be manipulated.
By the end of 2021, firms should stop using LIBOR and choose an alternative for determining interest rates to charge their consumers.
LIBOR is set to be phased out for a new pricing mechanism that will adopt new interest reference rates for new loans and for existing loans.
In 2017, the Federal Reserve Board endorsed the Secured Overnight Financing Rate (SOFR) as the preferred benchmark interest reference rate replacing LIBOR.
This major decision was based on the 2008 Financial Crisis that completely changes the reliability of the LIBOR Rate.
The 2007 real estate crash led to the disaster of abuse with the credit default swaps that led to a range of interrelated financial companies insuring risky mortgages and other questionable financial products. Because LIBOR drives the economy, this abuse led to a financial crisis within that same year.
LIBOR is based on what banks would pay for the banks which then leads to manipulation. By 2012, a number of banks were being investigated for manipulating these rates for their benefit.
A lower rate equals smaller risk so by submitting a lower rate a bank will appear as the preferred choice than the competitor who issues a higher rate.
As the Secured Overnight Financing Rate (SOFR) begins its transition by the new year, it is important to understand how it differs from LIBOR.
Transactions in the Treasury repurchase market, where investors offer overnight loans backed by their bond assets, offer a more reliable source than the estimated borrower rate that LIBOR provided.
ARRC, Alternative Reference Rates Committee, that is intervened by the Federal Reserve announced their approval for SOFR in April 2018 and have been hosting series of sessions to help banks and borrowers transition and overcome some of their challenges.
With over a trillion dollars in LIBOR contracts, firms are facing multiple challenges from switching to SOFR rates.
As SOFR now determines the interest rates for our mortgages, student loans, car loans, plus many more, this transition evaluates a monumental moment that could potentially increase the base rate.
Not all loans will be directly affected considering that not all banks choose LIBOR for their interest rates. However, private student loans and adjustable-rate mortgages will be affected.
As the transition is expected to be completed within the new year, it is important to check with your lender to understand any changes that may occur with your loans.
Lenders understand that borrowers have many choices and will almost always try to gain your trust to prevent you from choosing an alternative lender.
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