The Collapse of Libor
Braden W. Just, Investment Analyst
In June, a committee of 15 U.S. banks announced that they will replace the use of the London Interbank Offer Rate, also known as Libor, before the end of 2021. Libor is the benchmark interest rate that banks charge each other for overnight loans and is the standard for bank rates all over the world. Beginning in 2018, banks will begin to phase in a new benchmark that is derived from a broad set of borrowing transactions secured by U.S. Treasury notes.
It is widely known that bank proprietary traders were manipulating the Libor benchmark. Traders would take a position on a trade, contact their fellow employee who submitted the rate and ask them to submit a number which would benefit their position. This manipulation grew and eventually groups of traders were colluding to manipulate rates in their favor. The price fixing scandal prompted a change in the way Libor was calculated and additionally an oversight committee, called the FCA, was assigned to monitor the banks and Libor. These actions in turn caused banks to not submit their rates, which underpins the system that is used to price more the $350 trillion of financial products.
The collapse of Libor will mainly affect commercial adjustable-rate mortgages/loans which are often closely tied to Libor. Many lenders have already begun quoting rates based on treasuries or other indices. Most loan contracts specify that if the underlying index is no longer available, the lender or investor will pick a new “comparable” index. What qualifies as a comparable index isn’t clear and presents problems because of potential lost income on the lenders side, or increased interest costs on the borrower’s side. For example, the one-year Treasury is trading around 1.42% compared with the one-year Libor at 1.81%.
Luckily for some real estate investors the terms laid out in their loan documents include clauses that state what would occur if Libor is replaced or does not exist for the entire term. However, it is likely that the terms in the documents were not negotiated or possibly even looked at prior to funding. The change in the benchmark truly only affects holders of loans that extend beyond 2021 and if investors have or are seeking loans that go beyond the 2021 period, it is essential that they seek the advice of lawyers or advisors who are familiar with the benchmark change.
- Libor will begin to be phased out starting January 2018. Borrowers that currently have loans tied to Libor and expire before 2021 do not need to worry.
- Libor was a widely manipulated benchmark. Widespread manipulation by banks has caused the downfall of Libor.
- Loan documents likely contain clauses for new indices. If your loan documents include clauses for a replacement index, it is suggested that you seek an advisor to determine the impact that the new index will have.