Libor All Set To Phase Out In 2021, Potentially Causing Mortgage Costs To Rise
20 Feb 2020
Approx Reading time: 4 minutes
- Experts believe the Libor could be phased out as early as end-2021.
- This would force global financial markets to switch over to SOFR, an alternative to Libor.
- Consumers with outstanding debt obligations, including mortgage loans, could expect to see their finance costs increase, especially if they are paying a floating rate that is tied to Libor.
Recent developments have indicated that banks and other financial institutions may be shifting away from Libor, the rate at which banks are lent money by other banks in the financial system. Changes in Libor also impact other financial services, including consumer debt and mortgages, especially those that use a floating rate, and experts believe shifting from Libor to another inter-bank offer rate system could cause the cost of mortgages and consumer loans to go upwards.
The shift from Libor to another inter-bank offer rate has been under consideration ever since the financial crisis of 2008. At that time, it became apparent that financial companies had manipulated Libor to boost returns and hide weaknesses.
However, the lack of an alternative, one that could be considered as credible as Libor, seems to have delayed the possibility of a shift, as per a report
published by CNN.
The most probable outcome seems to be a switch from Libor to SOFR, or Secured Overnight Financing Rate, that is managed by the New York Federal Reserve. A major advantage of using SOFR over Libor is that the former is harder to manipulate, which is the core issue money managers around the world have with Libor.
So far, it has become apparent that a general consensus exists among regulators around the world that a shift away from Libor is necessary. The Fed had set up the Alternative Reference Rates Committee, a working group that had been tasked with facilitating this transition, and this Committee recommended SOFR, according to the Consumer Financial Protection Bureau
. A plan for said transition has also been published by the panel which calls for a voluntary use of the SOFR.
But, not all banks are convinced that a switch to SOFR is required. According to Mark Cabana, who works for the Bank of America Merrill Lynch as its head of US rates strategy, the market is not ready to make such a shift, although he agreed that the transition is already underway. Experts believe the Libor would be automatically phased out of the financial system by the end of 2021, even if a few players in the global financial industry don’t fully agree that it would be a seamless transition.
However, if the global markets fail to fully adapt to the new system, it could result in a liquidity crunch and can potentially cause financial instability, according to Steven Mnuchin, the Treasury Secretary, in a warning issued within the 2019 annual report published by the Financial Stability Oversight Council.
Cabana argues that among the reasons the market is reluctant to adopt the SOFR as an alternative to Libor, one pressing concern is the market’s lack of understanding about the ways in which the SOFR poses greater volatility compared to Libor.
Also, it is more difficult to make an estimation of future costs under SOFR compared to Libor. Since the SOFR is based on actual transactions, it is not as credit-sensitive as Libor, which means investors and borrowers have a difficult time predicting future rates under SOFR. Rates that can be expected in the future are readily available under Libor, as it includes movements in the credit market as well.
But this issue will soon be addressed by the Fed as well, as it would start publishing forward rates for the SOFR from 2nd March, including the 30-day, 90-day, and 180-day forward SOFR rates. Reportedly, the calculation methodology would be different for these rates compared to the one used to calculate Libor forward rates.
Regardless of the speed at which SOFR is adopted by global financial markets, it is clear that Libor is being phased out. And once that happens, consumers with outstanding debt obligations, especially those paying a floating rate, could expect to receive notifications about a change in interest rate charges that they would have to bear moving forward.