Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators (MLOs). This video breaks down the LIBOR scandal and why lenders have transitioned to SOFR. For course credit toward renewing your NMLS license, visit firsttuesday.us.
What was the LIBOR?
The London Interbank Offered Rate (LIBOR) was a frequently used benchmark interest rate common in the mortgage market prior to the 2008 Great Recession.
The LIBOR was created by the British Banker’s Association (BBA) to report the cost of borrowing between banks, an essential practice for banks to maintain profitability to lend funds to consumers.
The LIBOR was used as an international benchmark for setting interest rates for a myriad of financial products and services. A separate calculation was made for each currency, with the U.S. dollar-denominated LIBOR being the most widely used.
How did the LIBOR work?
Bankers at large institutional lenders would report on the following day how much they charged one another for interbank loans. They then submitted these rate figures as best estimates, based on current market conditions, to Thomson Reuters, an independent third party, who calculated the average and published the rate daily.
Since the daily rate was based on estimates by bankers relating their lending activities from the previous day’s market behavior, the actual rate at which banks charge one another for short term loans varied. In this way, the LIBOR acted as a guide – updated daily – but not a rule for interbank loans.
The LIBOR was frequently used as a starting point to price other financial products and services: think “LIBOR plus X percent.”
The mortgage market was primarily reliant on the LIBOR-indexed adjustable rate mortgage (ARM).
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Why was the LIBOR so popular?
It was understood that since banks rely on one another for the profitability crucial to their businesses, no individual banker would cook the estimate rates they reported.
Further, since the LIBOR was an average of many banks’ estimates, any discrepancies from one banker’s reporting to another was eliminated by the averaging involved.
However, in 2008, scrutiny of the LIBOR was triggered when market perceptions of financial risk began soaring, sending interest rates through the roof. But despite this, the LIBOR remained static.
ARMs were held down not just to keep investors confident, but also to remain enticing to borrowers, including homebuyers.
Even when it was abundantly clear the real estate market was hyper inflated into an unprecedented bubble, the lure of easily attainable financing at low ARM rates kept the homebuyers borrowing to fund their purchase of a home.
And what happened to those buyers who jumped in due to the rate manipulation? For many, job loss, default, insolvency and foreclosure.
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After news of the scandal broke, the main financial regulator in the UK initiated a sweeping review of the LIBOR process.
The review determined that among the most questionable aspects of the LIBOR was the fact that bankers set the rate themselves, creating a conflict of interest. Ultimately producing a disastrous mortgage market collapse.
The BBA was removed from the equation and LIBOR was handed over to an independent third party.
What comes after the LIBOR?
The LIBOR based on governmental intervention an planning began to be phased-out in 2021, now replaced in 2023 by the Secured Overnight Financing Rate (SOFR). Existing ARMs which call for periodic adjustments based on changes in the LIBOR are now adjusted based on the SOFR index movement as the substitute for the now defunct LIBOR index.
The SOFR is set and published daily by the Federal Reserve Bank of New York. The key is the rate is based on completed transactions, specifically on overnight funds collateralized by Treasury Securities, not what the individual bankers might wish to report as their best estimate of a day’s transactions.
Thus, the SOFR is more reliable than LIBOR and is not susceptible to fraud by the bankers involved. As a result, it provides an index without manipulation by mortgage bankers to increase profits which better protects homeowners with ARMs.
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