The London Inter-Bank Offered Rate (LIBOR) has had its fair share of problems over the years. This rate is the benchmark used to set the rates for various financial products, including adjustable rate mortgages (ARMs). A common phrase in the financial world is “LIBOR plus x percent.”
The biggest hit to its reputation came in 2008 when it became known that bankers had been rigging the LIBOR to keep ARM rates artificially low to induce more borrowing, even when it was clear that the market was tanking.
The LIBOR is especially vulnerable to this kind of deceitful behavior since it’s not based on actual transactions. The LIBOR rate is decided based on self-reported rates determined by what banks would lend each other in certain types of transactions if they were to lend (and they do not always lend). This immense conflict of interest leaves the rate wide open to manipulation.
Goodbye LIBOR, hello SOFR
In 2014, the Federal Reserve (the Fed) began planning a transition away from the outdated and vulnerable LIBOR. They ultimately chose the Secured Overnight Financing Rate (SOFR), published by the Federal Reserve Bank of New York.
Unlike the LIBOR, the SOFR is based on actual transactions, totaling roughly one trillion dollars in transactions every day. Therefore, manipulation of the rate is extremely unlikely.
Despite its reliability, there are some drawbacks to using the SOFR. The SOFR has a short history, with reporting of the rate beginning just in April 2018. It’s also more volatile than the LIBOR, with daily fluctuations beyond what most would consider normal.
But, as the Executive Vice President of the New York Fed pointed out in a recent talk, SFOR users are able to use weekly or monthly average rates, which will decrease the impact of the daily rate’s volatility. Further, despite its short history, it remains the preferred LIBOR replacement for many world banks.
SOFR is not the official or required LIBOR alternative, but it is the Fed’s recommended replacement and is emerging as the strongest candidate for banks and lenders that currently use the LIBOR.
Until recently, talk of transitioning away from the troubled LIBOR was not particularly urgent. But in 2017, the U.K.’s Financial Conduct Authority announced an expiration date for LIBOR of December 21, 2021. And yet, banks continue to write contracts reliant on the LIBOR with end dates beyond the rate’s expiration.
What will happen when the LIBOR expires?
Contracts with expiration dates beyond the deadline will need to be rewritten — an immensely expensive but necessary project. Just 2.5% of the contracts traded in the first quarter of 2019 used LIBOR alternatives.
Regulators are urging banks and other institutions to switch to LIBOR alternatives like the SOFR before the deadline hits two years from now. Or, as the Vice President of the New York Fed said in his recent talk about the LIBOR transition: “If you find yourself in a hole, stop digging.”
Mortgage and real estate professionals can expect a rough transition from the LIBOR to the SOFR over the next two years. Stay tuned for updates as the LIBOR expiration approaches.
