Why Is LIBOR Being Replaced?

Introduction to Libor

For over four decades, the London Interbank Offered Rate (Libor) stood as a pivotal reference for setting interest rates on an array of financial products such as adjustable-rate loans, mortgages, and corporate debt. However, in the recent past, its reputation has been tarnished by controversies, leading to its upcoming discontinuation. Effective from January 2022, the U.S. has started the transition from Libor to the Secured Overnight Financing Rate (SOFR), deemed by many as a safer and more reliable benchmark.

To understand what is replacing LIBOR, read our blog "What Is The LIBOR Transition? 2023 Breakdown".

Understanding Libor

Libor served as a cornerstone for loan issuers, providing a rate benchmark for diverse financial products. The rate was determined daily, based on estimates from a panel of up to 18 major banks. They provided insights on potential interest rates for various loan durations, influenced by their perceptions of regional economic conditions. Libor rates were computed in five significant currencies, namely, the UK Pound Sterling, Swiss Franc, Euro, Japanese Yen, and the U.S. Dollar.

As of 2019, Libor was instrumental in pricing $1.2 trillion in residential mortgage loans and another $1.3 trillion in consumer loans.

Example: Consider a private student loan pegged on the Libor three-month rate + 2%. If the Libor rate for three months was pegged at 0.22%, the resultant loan's base rate would be 2.22%, though this could be influenced by factors like credit scores and income.

Interestingly, while the usage of Libor for pricing new loans is being phased out, its publication will persist, with several maturities continuing until mid-2023.

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How Is Libor Calculated?

A panel of 18 banks, hailing from different corners of the globe, submitted their anticipated rates for interbank loans in London. To ensure balanced outcomes, the Intercontinental Exchange (ICE) Benchmark Administration filtered out the top and bottom four estimates before deriving an average. One catch: Libor wasn't determined by the actual borrowing rates but was based on these speculative figures, making it susceptible to potential manipulations.

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Libor Scandals and the 2008 Financial Crisis

Libor's downfall can be attributed to its detrimental role during the 2008 financial crisis and its subsequent manipulation scandals.

1. Libor and the 2008 Financial Crisis

Credit default swaps (CDS) anchored on Libor were pivotal to the 2008 financial debacle. Companies like American International Group (AIG) were at the forefront of the CDS disaster, having issued copious amounts of CDS on various financial products. When AIG faltered, it unveiled the inherent risks in subprime mortgages and their associated securities, causing a domino effect in the financial sector. As trust among banks diminished, Libor rates surged, making borrowing costly despite efforts by global central banks to curtail interest rates.

2. Libor Manipulation

A 2012 probe into Libor's workings unearthed widespread collusion among several banks, including heavyweights like Barclays and UBS, to distort Libor rates for monetary gains. This manipulation not only skewed financial markets but also eroded trust in this once-reliable benchmark.

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The Replacement: SOFR in the U.S.

The Secured Overnight Financing Rate (SOFR) is set to take Libor's place in the United States. SOFR's foundation lies in the rates that U.S. institutions offer for overnight loans, with Treasury bonds serving as collateral in repo agreements. These transactions help institutions maintain liquidity, and SOFR aggregates the rates from these exchanges to offer a more transparent benchmark.

For a comprehensive breakdown of the most popular market data providers, read our blog "Bloomberg Terminal vs. Refinitiv Eikon: 2023 Comparison".

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How Does the End of Libor Impact Your Loans?

The cessation of Libor will significantly affect the financial industry, and by extension, individual consumers and businesses with loans or financial products tied to this benchmark. To fully grasp the implications, it's essential to break down how Libor's discontinuation might impact different aspects of loans and related products.

1. Adjustable-Rate Loans:

Loans, especially adjustable-rate ones, often use benchmarks like Libor to set interest rates. As Libor is phased out:

• Existing Loans: For loans that are already in place, lenders will need to shift from Libor to another benchmark rate. This transition could mean a change in the interest rate, which could either be beneficial or detrimental to the borrower, depending on the new benchmark's behavior.
• New Loans: Future adjustable-rate loans will utilize other benchmarks from the outset. It's crucial for borrowers to understand the new rate's dynamics and how it might fluctuate in different economic conditions.

2. Contractual Challenges:

Many existing financial contracts may not have envisioned a scenario where Libor would be unavailable. Adapting to a post-Libor world might involve:

• Fallback Clauses: Contracts often include fallback provisions that specify what happens if the referenced benchmark (in this case, Libor) is unavailable. These clauses will activate, leading to the use of an alternative rate.
• Contract Renegotiation: In cases where fallback provisions are unclear or nonexistent, borrowers and lenders might need to renegotiate terms, potentially leading to legal complexities.

3. Market Uncertainty:

Libor's phase-out might cause temporary market uncertainty. Borrowers could experience:

• Rate Fluctuations: As markets adjust to new benchmarks, there could be short-term rate volatility, which might impact loan interest rates.
• Evaluation of New Benchmarks: Borrowers will need to educate themselves about the dynamics of new benchmarks like SOFR. Understanding these can help anticipate potential interest rate shifts.

4. Fixed-Rate Loans:

For those with fixed-rate loans, the immediate impact might be minimal since the interest rate remains constant for the loan's duration. However, for those considering refinancing or acquiring new loans, it's vital to recognize how the new benchmarks influence the market rates.

5. Cost Implications:

The transition might entail costs:

• Administrative Costs: Lenders might face administrative challenges in updating systems, processes, and documentation to align with the new benchmarks. Some of these costs could be passed on to consumers.
• Risk Management: Lenders and borrowers alike will need to invest in understanding and managing the risks associated with new benchmarks. This might involve seeking financial advisory services, which come at a cost.

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Frequently Asked Questions

Q1: Why was Libor considered unreliable in recent years?

‍Answer: Libor faced criticism due to its speculative nature, being based on what banks believed they would pay rather than actual transaction rates. This structure made it prone to manipulation, as evidenced by the scandals in 2012.

Q2: How is SOFR different from Libor?

‍Answer: SOFR is based on actual transaction rates in the Treasury bond repo market, making it more transparent and less prone to manipulation compared to the speculative nature of Libor.

Q3: Will the transition from Libor to SOFR affect existing loans?

‍Answer: If you have an adjustable-rate loan tied to Libor, it's essential to check with your lender about the transitioning index. Depending on the chosen index, there might be changes to the base rate.

Further Reading on Libor and its transition