London Interbank Offered Rate (LIBOR) Replacement

London Interbank Offered Rate (LIBOR)The British Bankers Association recently announced they would end publishing of the London Interbank Offered Rate (LIBOR) index in 2022. LIBOR has been troubled by a manipulation scandal when traders that were polled to set the rate colluded to move the index up or down to benefit their portfolios. Large fines have been levied on the institutions that employed the traders. Where does that leave some $500 trillion of financial instruments that are tied to LIBOR? Mortgages are still being written today that are tried to LIBOR even though the index will disappear before the rate reset on a 7-year ARM.

There are many proposals to replace LIBOR. The Federal Reserve recently brought together a group of fifteen banks that voted to use a rate derived from a broad set of actual borrowing transactions secured by U.S. Treasury instruments. Banks are pressing Freddie Mac, Fannie Mae and Ginny Mae to adopt a new index for mortgages. However with the huge pool of instruments tied to LIBOR a small variance will cause indexed mortgage payments to rise or fall. Either borrowers or lenders could be on the losing side of the reset. The mortgage crisis has not been forgotten in the halls of Congress, so any new index will be subject to political scrutiny. A rate derived from short term T-Bill repurchase agreements (repos) could be 1% less than current LIBOR. This could make a significant difference in mortgage payments. If the government sponsored mortgage giants adopt a uniform index, the mortgage servicers will have a safe harbor for any LIBOR substitution. Likewise mortgage bond holders will have a predictable index to base their pricing.

Where does this leave commercial and retail loans? Banks will soon need to settle on a widely published index that reflects actual lending transactions. There are many rate indexes that may be used. LIBOR normally settled into a range that was 1% below most bank’s prime rate. Lenders will want to preserve this floor under any newly adopted index rate. Any erosion of the index rate would adversely impact lender’s margins. Borrowers will also be confronted with a new index they may not be familiar with and is not widely reported by the financial news media. There will be no quick fix. LIBOR has been embedded in our financial transactions since 1969. It will be many years to replace or renew the documents that underlie this pool of transactions.

The differences in any new index and historical LIBOR will be measured in Basis Points or 1/100 of 1%, a small increment. However given the size of all the instruments tied to LIBOR these small increments will have a large impact on the income of lenders and the payments of borrowers.