By Joe Teichert • Corporate, Business and In-House Counsel Committee chair
The London Interbank Offered Rate is the most common reference rate used for short-term floating rate financial contracts and adjustable-rate loans.
It is calculated and published daily in five currencies and seven different tenors ranging from overnight to a 1-year term. As of 2018, LIBOR underpinned more than $200 trillion in U.S. dollar-based derivatives and loans.
Everything from swaps and futures to adjustable-rate mortgages and private student loans are tied to LIBOR.
Considering so many of the world’s financial instruments reset against LIBOR, why is it being phased out at the end of 2021? Further, what can be done to prepare for the transition?
To answer the first question, we must understand how LIBOR is set, which requires a brief look at its inception – a story equally as compelling as LIBOR’s downfall.
The first LIBOR-based loan is attributable to an $80 million syndicated loan in favor of the Shah of Iran in 1969. Then, in the mid-1980s, when the use of derivatives was booming and banks began borrowing heavily based on LIBOR, the British Banker’s Association took control of the rate to standardize the data collection process.
The data in question comes from responses by large global banks to the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in reasonable market size just prior to 11 a.m.?”
Essentially, the world’s largest banks self-report on how much it would cost them to borrow money in a specific currency over a particular maturity, and their submissions are averaged to come up with LIBOR.
The self-reporting aspect of LIBOR is ripe for manipulation, and as was widely reported over the past decade, many of the panel banks misreported their LIBOR submissions not only to project strength amidst the financial crisis but also to manipulate the rate to realize gains on LIBOR-based contracts.
Investigations ensued, settlements totaling more than $3.5 billion were entered into by banks who engaged in the fraud, and in 2014, the Financial Stability Board, a global financial watch group, recommended the replacement of LIBOR.
So, what now? After December 2021, LIBOR is widely expected to be unavailable as an index rate.
Following the Financial Stability Board’s recommendation, the Federal Reserve and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee to identify a LIBOR alternative.
In June 2017, the ARRC recommended that the Secured Overnight Financing Rate replace LIBOR.
Despite these developments, LIBOR-tied ARMs continue to be issued without addressing the end of LIBOR or have broad fallback language such as “if the index is no longer available, the Note Holder will choose a new index that is based on comparable information.”
Experts are anticipating the transition from LIBOR to prove disruptive for the mortgage market, and it may be worsened by broad fallback language and the confusion that will ensue as interest rates reset.
As consumers or practitioners representing businesses and individuals alike, what can we do to prepare for the transition? To date, the ARRC has identified a replacement rate and published its Paced Transition Plan, providing “specific steps and timelines designed to encourage adoption of SOFR.”
We’re awaiting guidance from the ARRC regarding revisions for existing LIBOR ARMs, but that is not expected until later this year.
As the ARRC continues to publish recommendations, we’ll get a clearer understanding of the potential effects of the transition so hopefully we are better prepared. As we wait, I recommend staying informed by visiting newyorkfed.org/arrc where you can subscribe to receive updates.
Joe Teichert is underwriting counsel for First American Title Insurance Co.