The misdeeds of a few rogue bankers in London are going to cause headaches for millions of American home buyers and homeowners.
The bankers falsified a widely used interest rate index called the London Interbank Offered Rate, or Libor, during the financial crisis. They did it to make their banks look deceptively strong, the way a scared cat makes its fur stand on end to look fierce. British and U.S. regulators levied billions of dollars in fines and tossed some bankers in prison.
Soon, roughly a decade after the scandal, American homeowners will get dragged into the mess.
Conflict on the horizon
The British rate manipulation will affect people who have adjustable-rate mortgages tied to Libor (pronounced LIE-bore). In the fallout from the rate-fixing, the American mortgage industry will have to find a replacement for Libor. Hundreds of billions of dollars’ worth of Libor ARMs will be affected. No one knows what the new index will be, and there are no obvious candidates. Fannie Mae and Freddie Mac, the agencies that buy and securitize mortgages, have not publicly discussed any preferences they might have.
And the change has to happen by the end of 2021. That might sound like plenty of time, but it’s not, because differences will have to be resolved among many potential winners and losers: lenders, borrowers, mortgage servicers, investors, regulators, and Fannie Mae and Freddie Mac. If the switchover causes mortgage rates to be lower than they otherwise would have been, investors will complain — probably in court. If the new rate makes borrowers pay more, then voters, politicians and regulators will raise a ruckus in courthouses and Congress.
What is Libor?
Libor is an index rate, which means that other interest rates are based on it. If you aren’t familiar with Libor, you might have heard of another index: the prime rate. When prime goes up, so do credit card rates because they use the prime rate as an index. A similar relationship exists between Libor and Libor ARMs.
British bankers come up with Libor rates by estimating the interest rate they would have to pay if they borrowed from other banks.
The ‘lie’ in Libor
In 2007 and 2008, banks underreported the interest rates they would have to pay, like a guy who brags that he pays 10% interest on his credit card, when he really pays 30%. This underreporting made the banks look deceptively creditworthy.
It was a big deal because hundreds of trillions of dollars in derivatives and loans are linked to Libor, making it the most commonly used rate benchmark in the world. Roughly 5 million American homeowners have adjustable-rate mortgages, and the majority of those loans are Libor ARMs.
Libor will be abandoned at the dawn of 2022.
The end of Libor ARMs
In July 2017, Andrew Bailey, the head of England’s Financial Conduct Authority, announced that regulators will keep Libor on life support until the end of 2021 and then pull the plug. Not only has Libor lost credibility, but Bailey said the rate is based on a dwindling number of bank-to-bank transactions.
So after 2021, there won’t be a Libor to tie adjustable mortgage rates to. Yet today, American homeowners are still getting ARMs indexed to Libor. What does that mean for people who have Libor ARMs now and in the future?
Hard to replace Libor
No one knows yet what will happen to mortgage rates and monthly payments after Libor is abandoned. The call would seem to rest with the owners of the loans. When an index is no longer available, the contract typically allows the loan’s owner to “choose a new index that is based upon comparable information.”
Investors might be tempted to adopt a newly created index that would result in higher interest rates and loan payments. But that would invite attention from regulators, backlash from politicians and lawsuits from borrowers. Yet it’s hard to imagine that investors would choose an index with lower interest rates and monthly payments.
The key is to find a replacement that’s roughly the same rate as Libor and fluctuates at a similar speed, says David Battany, executive vice president of capital markets for Guild Mortgage. “If people can pick a new index that’s about the same level, it would not be a big deal at all,” he says. But few, if any, experts believe it’s possible to create a “Goldilocks” index that behaves exactly as Libor would.
Making the replacement stick
It will be a challenge to put a new index in place, says Bill Banfield, executive vice president of capital markets for Quicken Loans. “But probably the bigger topic is what the heck is the new index and how do you explain it to the consumer who is genuinely interested in getting an adjustable-rate mortgage but doesn’t understand what the new index is.”
Matt Hackett, operations manager for Equity Now, a mortgage bank based in New York City, says he believes Fannie Mae and Freddie Mac will eventually adopt an index for new loans, and the rest of the industry will follow.
As for existing ARMs, Hackett’s guess is that Fannie and Freddie will urge mortgage servicers to replace Libor with the 1-year Treasury index. The 1-year Treasury has been lower than the equivalent Libor in the last few years, so such a move could be a windfall for borrowers. It would be interesting to see if investors would go along with such a plan, which would reduce their incomes.
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