By Robet Pozen and Adam Schneider.
This article first appeared on Market Watch on June 28, 2018.
Libor, the London interbank offered rate, is currently the most popular interest-rate benchmark for around $200 trillion in U.S. financial products with floating interest-rates. For example, a business loan, home mortgage, or an interest-rate option could be based on Libor + 2%, with Libor changing every three months.
Yet, Libor has long been a problematic benchmark and is at substantial risk of going away after 2021. While Libor will be replaced by a better U.S. benchmark for variable-rate products, the demise of Libor will present transitional challenges to many U.S. financial firms and their customers. The financial firms include banks, brokers and companies trying to hedge their exposures to interest rates. Their customers include home owners with variable rate mortgages, business borrowers with floating rate loans and funds investing in mortgage-backed securities
Libor is based on quotes for inter-bank loans, as reported to a private association by a small group of mega-banks in London. However, several of these mega-banks were accused of manipulating the calculation of Libor for their own benefit during the 2008 financial crisis. Since then, regulators have become further concerned about the validity of Libor because of the paucity of interbank loans — which have been sharply reduced by recent capital requirements.
Last year the head of the U.K. Financial Conduct Authority put a sunset on Libor by announcing that mega-banks in London would not be required to submit quotes on interbank rates after 2021. At that time, most banks will likely stop submitting these quotes. Last month, Bill Dudley, the president of the New York Fed, urged financial markets to quickly and safely shift to alternative benchmarks.
The best U.S. alternative to Libor is called SOFR — the Secured Overnight Financing Rate — which the Federal Reserve Bank of New York began publishing in April. SOFR is superior to Libor in three key ways:
First, SOFR is more robust and realistic than Libor. SOFR is based on interest rates in the U.S. market for repurchase agreements — a type of overnight lending with a huge daily volume. By contrast, Libor is based on estimated quotes by bankers in a thin market for interbank loans.
Second, SOFR is much less susceptible to manipulation because it is based on actual transactions, as compiled by the New York Fed. By contrast, Libor represents the middle range of quotes submitted by a small group of megabanks and collated by a private sector firm.
Third, SOFR is more reliable and closer to a “risk-free” rate than Libor. SOFR is based on repurchase agreements, which are typically secured by over 100% in U.S. Treasurys. Libor implicitly contains the interest rate on interbank loans as well as a credit spread for the risk that the bank might default — a volatile element based on market perceptions. During times of market stress, Libor has spiked up.
To expedite the transition from Libor to SOFR, the U.S. Federal Reserve formed the Alternative Reference Rate Committee. The Committee comes from a broad cross-section of the financial sector — with representatives from financial institutions, industry associations, regulatory agencies, and public interest groups. The Fed has tasked the Committee with helping financial firms resolve the operational problems in shifting to a new benchmark for variable rate products, while helping educate investors and borrowers about the need for this shift.
Since Libor is being replaced by a superior benchmark in a few years, forward-looking U.S. financial institutions are now diligently preparing for the transition to SOFR. They are designing new products based on SOFR and carefully examining their existing products based on Libor. But this is hard work and we have noticed many banks and brokers seem reluctant to make this shift. They may be quite comfortable with Libor because it is well-known on Wall Street and already embedded in their internal processes. Or they may just be hoping that the regulators will change their minds by 2021.
If financial firms start soon to issue new loans and derivatives based on SOFR, that will make the transition away from Libor much easier. There will be a relatively small portion of variable-rate products based on Libor by the end of 2021, when that benchmark is at substantial risk of disappearing. However, if financial firms continue to roll out Libor-based products, they could face major legal problems in finding a Libor equivalent after 2021
For instance, mortgage-backed securities are widely held by mutual funds and exchange-traded funds, seeking variable yields based on Libor. The contracts for these securities typically provide a “ fallback” clause if Libor is temporarily unavailable. However, most of these fallback clauses do not contemplate the end of Libor, and most can be amended only by a majority of the securities holders. Given this legal ambiguity, issuers of mortgage-backed securities might become embroiled in years of litigation after 2021.
For derivatives and swaps — the bulk of the products now based on Libor — the transition to SOFR is being facilitated by an international trade association called ISDA. The association is going to promulgate standard terms and conditions for launching new products that deal with this issue. This transition can happen rapidly since derivatives and swaps generally have short maturities, and their rates are set by financial professionals. ISDA’s recommendations are likely to be followed for most wholesale products.
On the retail side, more than $2 trillion in small-business loans and over $1 trillion in home mortgages are based on Libor. Many of these will remain outstanding beyond 2021. For instance, a home owner with a variable rate mortgage based on Libor plus 2.5% may make monthly payments for 10 years past 2021. As a result, borrowers must be educated about the differences between Libor and SOFR, as those will affect their rates. Since SOFR is close to a risk-free rate, it typically would be lower than Libor. As a result, a home mortgage with an interest rate of Libor plus 2.5% may equate to SOFR plus 2.8%. Explaining that difference to a home owner will be a communications challenge.
All participants in the U.S. market for variable-rate loans, especially bankers and issuers, should be preparing now for the demise of Libor after 2021
As soon as possible, they should implement new processes and start issuing products based on SOFR. They should also carefully examine their inventory of existing products based on Libor and the underlying contracts. Although these both involve substantial efforts, they need to be undertaken in order to be ready for the transition to SOFR by the end of 2021. The alternative is simply unacceptable: Libor is no longer published, but market participants are still dependent on this vanishing rate.