A Q&A with Richard Sandor focused on the impact on consumer finance as LIBOR is going way at the end of 2021.
Q3 2020 hedge fund letters, conferences and more
The Most Important Number in Finance (LIBOR) is Going Way: Here’s why consumers should be paying attention
By Richard L. Sandor
Next year the interest rate benchmark known as LIBOR (the London Interbank Offering Rate) will be retired. Trillions of dollars on financial instruments are pegged to this number and the ramifications are significant not just to Wall Street but to Main Street. Here’s why: if you have variable rate loans on your credit cards, your car loan or your mortgage, it could make a difference in your payments. You will be hearing about this from your lenders soon and here’s what you need to know about the end of LIBOR and the new batch of interest rate benchmark alternatives now emerging.
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[1] currently track LIBOR—and most of them are mortgages.
Why is LIBOR going away? Wasn’t there some kind of scandal?
Yes, in 2012, the British Bankers Association discovered that several large international banks 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. Banks were submitting rates that were artificially low in order to cut their interest costs, cheating their customers out of billions of dollars. 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 US 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, mid-sized and community banks in the United States. AMERIBOR better reflects the banks real cost of borrowing. Country-specfic 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.
That sounds confusing. 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 my mortgage?
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 find out if you have an adjustable rate mortgage and which interest benchmark it tracks by reviewing your loan documents. Your bank will also be in touch if they have to change the interest rate benchmark your loan is set to.
What about my car loan?
You should also check to see if you have an adjustable rate auto loan and whether it’s tied to LIBOR. If it is, your bank will probably contact you soon to let you know how your loan is changing.
Credit card debt?
Many credit cards tie interest rate payments to LIBOR, too, so you may see a change here, as well. Your bank should notify you if it is changing the way it calculates interest payments due to a switch to another benchmark like the Prime Rate or SOFR.
Student loans?
Many private student loans—that is, not the ones guaranteed by the government—charge interest rates that are linked to LIBOR. You will hear from your lender if there is any change in your loan structure.
How will the switch from LIBOR affect my 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 double check all your loan documents and credit card statements to see if you have any LIBOR-linked debt. If you do, you may wish to contact your lender to find out how they are going to handle the transition.
In addition, the Consumer Financial Protection Bureau (CFPB) has guidelines that deal with the transition from Libor. It’s also a great opportunity to look at your overall financial picture, and consolidate or reduce your debt if you have the resources.
About the Author
*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, ameribor.net, an electronic exchange for direct interbank/financial institution lending and borrowing.* @the\_AFX
Footnote
[1] New York Fed. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report
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