Regulators recently gave lenders and market-makers definitive guidance on the end game for Libor, the tainted interest-rate benchmark, tied to trillions of dollars in loans, credit cards and securities: They must switch to an alternative benchmark by the end of 2021.
Lenders will be reaching out to borrowers if there is a change of interest rate, which may cause confusion or even alarm. Here is some background about the end of Libor and what comes next so you can be prepared to advise your clients on the issues.
WHAT IS LIBOR ANYWAY?
Libor is an index used to set interest rates for many different adjustable-rate loans and investments. If your adjustable-rate mortgage payments are based on Libor, they will go up and down when Libor changes. Experts say that at least $1.3 trillion in consumer loans currently track Libor — and most of them are mortgages.
WHY IS IT GOING AWAY? WASN’T THERE SOME KIND OF SCANDAL?
Yes, in 2012, the British Bankers Association discovered that several large international traders were manipulating Libor to boost their profits. It was relatively easy, because the rate was calculated by averaging rates that participating bankers submitted every day — on an honor system. Libor was reformed in 2012 and 2013, but as problems continued, regulators announced that the index would be phased out in 2021.
IS THE FADING OUT OF LIBOR A GOOD THING?
Yes. The Libor rate is based on a poll of 11 to 16 international banks on what interest rate they expect to pay. It was a confidential process based on a limited underlying volume of borrowing, which is why the rate was vulnerable to manipulation. New benchmarks that arise after Libor will be more transparent, secure and reflect the true costs of borrowing.
WHAT’S GOING TO REPLACE LIBOR?
The Federal Reserve has developed SOFR, the Secured Overnight Financing Rate, which is secured with Treasury bonds. There are other rates emerging, such as Ameribor, an unsecured rate (meaning that banks have to lend to one another without collateral being posted) used by regional, midsize and community banks in the United States. Ameribor, which is set on the American Financial Exchange, which I founded in 2015, better reflects the banks’ real cost of borrowing. Country-specific alternatives to Libor have also emerged in the U.K., Japan and Switzerland. All of these benchmarks are based on actual lending activity, rather than what leading banks think interest rates should be, so they more accurately represent lending costs than Libor.
WHY DO WE NEED SO MANY BENCHMARKS?
Actually, choice is a good thing. There are lots of different kinds of loans, and different benchmarks would allow them to be priced more accurately. It’s like the stock market, which has the Dow Jones and S&P 500 Indexes to track the biggest stocks, the Nasdaq to gauge performance in dynamic small company and tech stocks, and even indexes that track specific sectors and country markets.
WILL THIS AFFECT MORTGAGE PAYMENTS?
It might, especially if you have an adjustable-rate mortgage. Many adjustable-rate mortgages are structured so that you pay Libor plus some margin, say Libor plus 2%. When Libor is retired, these loans will have to be reset to existing benchmarks like SOFR, the prime rate or Ameribor.
You can suggest that clients review their loan documents to determine if they have an adjustable-rate mortgage and which interest benchmark it tracks. Their bank will also be in touch if it has to change the interest-rate benchmark the loan is set to.
WHAT ABOUT CAR LOANS?
Clients can also check to see if they have an adjustable-rate auto loan and whether it’s tied to Libor. If it is, the bank will probably contact them soon to let them know how their loan is changing.
CREDIT CARD DEBT?
Many credit cards tie interest-rate payments to Libor, too, so they may see a change here as well. The issuer should notify credit-card customers if it is changing the way it calculates interest payments as the result of a switch to another benchmark, like the prime rate or SOFR.
Many private student loans — that is, not the ones guaranteed by the government — charge interest rates that are linked to Libor. Clients will hear from their lender if there is any change in their loan structure.
HOW WILL THE SWITCH AFFECT CLIENTS’ INVESTMENTS?
Investment managers are planning for the transition with guidance from government agencies such as the Federal Reserve’s Alternative Reference Rates Committee. Investments that will be affected include derivatives and asset-backed securities.
WHEN WILL THINGS START TO CHANGE?
It’s already happening, and the transition should be complete by the end of 2021.
WHAT’S THE BEST WAY TO GET READY?
Now is a good time to tell clients to double-check all their loan documents and credit card statements to see if they have any Libor-linked debt. If they do, you may suggest they contact lenders to find out how they are going to handle the transition.
In addition, the Consumer Financial Protection Bureau has guidelines that deal with the transition from Libor. It’s also a great opportunity to suggest a meeting or call to review your clients’ overall financial picture, and consolidate or reduce their debt if they have the resources.
Dr. Richard L. Sandor is the Aaron Director Lecturer in law and economics at the University of Chicago Law School. He is also chair and CEO of the American Financial Exchange, an electronic exchange for direct interbank/financial institution lending and borrowing.
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