The United Kingdom’s Financial Conduct Authority (FCA) recently announced that the London Interbank Offered Rate (LIBOR), which has for three decades served as the primary benchmark for short-term interest rates, will be phased out and replaced by one or more alternative benchmarks by the end of 2021. Lenders have for decades built LIBOR into contracts for adjustable rate loans, from residential and commercial mortgages and credit card agreements, to student debt. Replacing LIBOR will cause countless compliance and operational concerns for mortgage originators and servicers, as origination and servicing platforms will require substantial development, consumer disclosures will need to be revised, and some loan agreements will need to be rewritten.
LIBOR is a notional rate at which banks lend to each other, and is based on the average rate at which twenty panel banks estimate they would be able to borrow funds from each other. Because interbank lending transactions have decreased in number in recent years, however, LIBOR is not based on actual market transactions. In fact, interbank lending transactions involving certain currencies occur only a handful of times in a given year across the entire marketplace—meaning there is no viable market. While significant improvements have been made to LIBOR in response to recent rate-manipulation scandals, the FCA recently concluded that the absence of active underlying markets of sufficient scale raises serious questions about the LIBOR as a sustainable benchmark rate.
As an alternative, the FCA proposes a transaction-based index, but consensus has not yet formed around a single index. In June 2017, the New York Federal Reserve’s Alternative Reference Rates Committee recommended that banks adopt an index rate based on the overnight lending rate in Treasury-backed repurchase agreements, which reflects the cost of borrowing cash secured against U.S. government debt, and, unlike LIBOR, is based on actual transactions. The Treasury repurchase rate is not expected to become available until next year at the earliest, at which time the Federal Reserve Bank of New York is expected to publish the rate daily.
An alternative initiative gaining momentum in the United Kingdom proposes the use of the Sterling Overnight Index Average (SONIA), which measures the Sterling-denominated overnight funding rates from actual transactions in the unsecured lending and borrowing market. Adoption of either the Treasury repurchase rate or the SONIA as a benchmark rate would carry out the FCA’s desire to shift toward a transaction-based index.
To account for the many hybrid ARM loans that are indexed to LIBOR, origination, servicing, and compliance management systems will need to account for the new benchmark rate. To comply with Truth In Lending Act disclosure requirements, for example, loan originators will need to update existing origination systems to account for the appropriate rate index in calculating the fully indexed rate and maximum loan payment. Moreover, Fannie Mae has specifically called on lenders to advise borrowers that alternative published indexes will be selected (consistent with the provisions of the mortgage note) should the original index for a specific ARM plan no longer be published. Servicers will need to make similar updates to their servicing platform to ensure that borrowers continue to make the correct payments. Mortgage notes may also need to be revised in some instances to account for LIBOR’s eventual dissolution.
The logic underlying the decision to phase out LIBOR is to force market participants to use more reliable benchmark rates that are based on transactions, not judgments.
The FCA’s announcement may be found here.