The London Interbank Offered Rate (LIBOR) is on an unusual tear, currently at its highest since 2009. What’s causing the rise, and is it something real estate professionals need to be concerned about?
First, some background.
Adjustable rate mortgage (ARM) interest rate adjustments can be tied to a variety of indices. Each index adjusts based on different criteria, set by the “owner” of the index. The LIBOR is one of the more popular indices used by lenders.
According to Freddie Mac’s 31st Annual ARM Survey, large national lenders prefer the LIBOR index while community and regional lenders are more likely to offer Treasury-indexed ARMs. Thus, the LIBOR index was used in roughly half of ARM originations in 2014, the most recent survey year.
Here’s how the LIBOR is set: every day, 11-18 banks give an estimate for how much they are willing to pay to borrow funds. To avoid price setting, the individual rates submitted are not published until three months later. The LIBOR is referred to as a benchmark since it is used as a starting point to price other financial products and services. A common phrase bandied about in the world of finance is “LIBOR plus x percent.”
Once the top and bottom 25% values are removed, the average of these estimates is rounded to the nearest 1/16 and used as the LIBOR index rate. The LIBOR is set for seven different maturities, from an overnight maturity to up to 12 months, produced in five different currencies, including the U.S. dollar, for a total of 35 rates published daily. The most commonly used maturities are seen here:
|Nov 2016||Oct 2016||Nov 2015|
|1-month LIBOR rate||0.55||0.53||0.20|
|6-month LIBOR rate||1.27||1.26||0.60|
|1-year LIBOR rate||1.59||1.59||0.94|
The chart above shows a steady rise in LIBOR rates over the past two years, with rates today two-to-three times higher than two years ago. The rise in December 2015 makes sense, as the Federal Reserve (the Fed) increased the short-term benchmark rate that month, and ARM indices jumped across the board. But the LIBOR continues to rise in 2016, while most other ARM indices have experienced a level or even down year since the late-2015 rate jump.
Why does the LIBOR continue to rise?
The recent LIBOR Scandal
The LIBOR is an influential factor in the mortgage market since it is the index used by the largest mortgage banking operations. However, many members of the public were unaware how great its influence was until it became the object of scandal due to corruption within the banks that controlled the figures.
Scrutiny of the LIBOR was triggered in 2008 when market perceptions of financial risk began soaring, sending short-term interest rates through the roof, yet the LIBOR remained static and did not respond to the explosion of panic in financial markets. The anomalous refusal of the LIBOR to adjust upwards during what we now know to be the greatest global financial crisis since the Great Depression caused many regulators and watchdogs to suspect foul play.
The LIBOR debacle uncovered at Barclays had to do with keeping rates on ARMs (and all other LIBOR-indexed products) artificially low. This occurred leading up to and during the 2008 financial crisis when market participants were responding to the finance fiasco by raising rates through the roof to reflect the then astounding amount of risk in the market. Yet, LIBOR remained unchanged, a deliberate deception supposedly to quell fears of a pending massive money meltdown and soothe the markets.
This caused a problem because rates on ARMs were held down not just to keep investors confident, but also to remain enticing to homebuyers. Even when it was abundantly clear the real estate market had inflated into an unprecedented bubble, the lure of easily attainable financing at absurdly low ARM rates kept the buyers coming in. This kept the securities bond market machine cranking, which continued to feed hungry investors lulled into credulity by the golden LIBOR benchmark.
The deal was had at the cost of grotesquely inflated real estate prices and equally dramatic hybrid adjustable payments. Then came on the cyclical recession of job losses, defaults, foreclosures, bankruptcies; the rest is history.
As news of the scandal broke, the main financial regulator in the UK initiated a sweeping review of the LIBOR process. Several low-level bankers were arrested for their involvement in the LIBOR index fixing. The review also determined that among the most questionable aspects of the LIBOR was the fact that rather than being based on actual transactions (which show actual market performance) bankers set the rate themselves. The result was a disastrous conflict of interest.
Prior to the LIBOR scandal, the rate was considered an excellent benchmark since it was updated daily. Since the banks rely on one another for the liquidity crucial to their business, no one bank would cook their estimates since their profitability depends on the accuracy of the rate on any given day. But this was clearly not the case.
Is another scandal taking place in 2016?
Are the uniquely rising rates of the past year an indication of another scandal taking place?
The Economist explains the rise in rates has to do with a change the Security Exchange Commission (SEC) made to Prime funds on October 14, 2016.
Prime funds are a type of money market fund, specifically funds that invest in corporate debt securities — this is similar to owning stock in a company, but instead of owning a part of the company, the investor is essentially lending their money to the company and in return receives interest (rather than profits, as with stocks).
Prior to the SEC change, Prime funds were available at $1 a share, regardless of the value of the assets these shares represented. During the 2008 Financial Crisis, investors pulled out of Prime Funds en masse, expecting to redeem their investments for $1 a share, even though their value had vastly deflated. Since banks were unable to meet the surge, the U.S. Treasury had to guarantee these funds. The SEC has since drafted new rules to lessen the risk to investors and taxpayers of another crisis.
Now, along with other changes like more diversification requirements and lower interest rates, Prime funds are required to have a floating net asset value (NAV) rather than the previously fixed $1 per share. Therefore, when the investor’s share values decline, they won’t be as inclined to sell since they will now sell at a loss. This will encourage greater continuity between Prime fund performance and the value of the assets backing these funds.
In anticipation of the change, investors have been dumping the less appealing Prime funds all year. Instead, investors have switched focus to money market funds that invest in treasuries — over a trillion dollars in Prime funds have been shifted to government funds throughout 2016, according to the Financial Times.
As demand falls for Prime funds, foreign banks have been hit hardest. It’s become more expensive to borrow at these banks, which is reflected in the LIBOR’s higher rates.
The result? Homeowners with mortgages tied to the LIBOR are seeing higher rates, even while other non-affected benchmark rates are holding relatively steady.
So, scandalous price-fixing is not to blame this time around. But, as occurred in 2008, borrowers are ultimately paying the price.