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Good News, Bad News – Replacing LIBOR

raining money credit riskThe London Interbank Offered Rate (LIBOR) expires in a few years, and while the full set of consequences remain unclear, this event is certain to bear major repercussions for investors and borrowers alike. The Urban Institute attempts to suss out what these consequences will likely be.  

LIBOR sets the benchmark interest rate for adjustable-rate mortgages (ARMs) and the majority of reverse mortgages, not to mention the rates for millions of additional financial contracts that exceed $200 trillion. But as a consequence of the “LIBOR fixing” scandal—in which it was revealed that several banks intentionally distort their lending rates so as to affect LIBOR—the Urban Institute's recent article explores a plan in the works set to replace LIBOR with an alternative index before the beginning of 2022.

The index recommended by a group convened by the Federal Reserve to replace LIBOR and set the future benchmark is the Secured Overnight Financing Rate (SOFR), the Urban Institute said. If SOFR does replace LIBOR as recommended by this group, it could represent an annual gain of $2.5 billion to $5 billion for forward mortgage holders—and a corresponding loss for investors.

Approximately $1 trillion worth of ARMs mortgages is based on LIBOR’s benchmark, or about 2.8 million mortgages. That’s nearly 10 percent of the entire outstanding mortgage market. Bank portfolios and private-label securities contain the majority of these loans. Of these, 57 percent originated before the subprime mortgage crisis. Other than the private label securities market, LIBOR ARMs are similar to other pre-crisis fixed-rate loans. For the private label securities market, however, the LIBOR ARMs are generally larger loans than those taken out with fixed rates. For instance, in the bank portfolios, the average ARM loan is almost double that of other portfolio loans—$582,400 compared to $306,200.

According to the Urban Institute Regulatory bodies have continued to ask banks to comply with the numbers set by LIBOR through the end of 2021, but at that point, a substitute index such as SOFR will need to be in place. The legal documents for most ARMs allow a new index based on comparable data to substitute for an original index if it is rendered obsolete, but even so, the contacts largely omit to discuss what makes a substitute comparable or an original index obsolete.

One problem the Urban Institute discusses is LIBOR’s increasing unreliability. Banks will begin withholding information soon, and when they do it could create what has been dubbed a “Zombie LIBOR,” or an unreliable LIBOR that poses a serious risk to the market’s stability.

SOFR’s substitution for the LIBOR could have serious consequences. Unlike LIBOR, which is an unsecured rate, SOFR is secured, which means less volatility and lower rates. SOFR is also an overnight rate, whereas LIBOR is a product of a variety of numbers. According to the Urban Institute, replacing LIBOR with SOFR could cause a drop in the mortgage rate on the outstanding LIBOR-indexed ARMs by 25 to 50 basis points.

But in addition to ARMs mortgages, nearly 90 percent of the recent reverse mortgage market originations—or home equity conversion mortgages (HECMs)—as well as 60 percent, or $50 billion, of the overall HECM market, is also set by LIBOR’s benchmark. In this sizable market, the likely winners would be the heirs or the Federal Housing Administration (FHA) for any paid insurance claims, while investors in Ginnie Mae’s securities would face increased costs. Urban Institute expects that this could be a windfall of about $125 million a year, or a present value of $2 billion.

About Author: Staff Writer


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