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Afflicted by scandals and even crime over the past two decades, the London Interbank Offered Rate, commonly known as the LIBOR, is the globally accepted benchmark interest rate most major banks use to lend short-term loans to each other.
It is published each business day but is being phased out due to its role in the 2008 financial crisis as well as its penchant for manipulation.
What Is London Interbank Offered Rate (LIBOR)?
Still, in limited use but without the faith it once had, the LIBOR represents the average borrowing costs between credit-worthy international banks. It is based on five currencies and seven different maturity lengths from overnight to 12 months, resulting in 35 different LIBOR rates calculated almost daily. The LIBOR is administered by the Intercontinental Exchange, or ICE, a Fortune 500 company that provides mortgage technology and data and manages global clearinghouses and exchanges.
How Does LIBOR Affect My Mortgage?
The LIBOR is the foundation for consumer and corporate loans worldwide. It serves as the basis for over half of the country’s adjustable-rate mortgages (ARMs), auto and student loans, plus corporate and government debt.
When financing homes, lenders consider the six-month and one-year LIBOR rates for ARMs. This is when homeowners lock in a low-interest rate for a fixed period, and once that ends, the mortgageresets to the current rate of an index, often the LIBOR. Monthly payments can increase or decrease depending on the direction of the LIBOR. If you have a home equity line of credittied to your ARM, its rate will also move.
The coronavirus pandemic reduced rates significantly though we are starting to see them increase amid inflation.
How is LIBOR Calculated?
Each business day, ICE asks anywhere from 11 to 18 notable global banks what they would hypothetically charge each other for short-term loans, ranging from overnight to one week. Financial institutions lend money to each other to meet reserve requirements and manage liquidity. ICE doesn’t consider the highest or lowest 25% of responses but instead averages out the middle numbers. This is called the “trimmed average.”
In 2018, the ICE Benchmark Administration proposed using the Waterfall Methodology, a “standardized, transaction-based, data-driven, layered method” designed to produce a truly representative rate instead of mere estimates. This methodology applies only to the U.S. dollar LIBOR output.
Based on five currencies (U.S. dollar, euro, British pound, Japanese yen, Swiss franc) and seven maturity lengths (overnight/spot next, one week, one, two, three, six, 12 months), the 35 different LIBOR rates are published at approximately 11:55 am London time each business day. The three-month U.S. dollar rate is commonly referred to as the “current” rate.
Why Is LIBOR Being Phased Out?
Announced in 2017 after 40 years of use, the LIBOR will be fully phased out by June 30, 2023, though the process began at the close of 2021. Due to a rate-fixing scandal and its part in the Great Recession, the LIBOR is less credible than previously thought. Read on to learn about its erosion of public trust and dishonesty.
LIBOR Scandals and History
In 1984, the British Banker’s Association (BBA) set up its own uniform interest-settlement rates, which eventually turned into the BBA LIBOR. It became the default interest rate for currency-based and interest rate-based financial commerce between banks both locally and abroad.
The LIBOR has faced challenges to its authenticity because it’s based on estimates rather than real data. Nevertheless, the LIBOR has been reasonably accurate throughout the years until 2003, when banks began manipulating it for their financial gain.
By submitting artificially low estimates to the BBA, certain financial institutions managed to keep the LIBOR at a low level to boost traders’ profits in LIBOR-based securities. And we’re talking major players like Barclays, Deutsche Bank, UBS, and more. An internal investigation proved employees colluded in the malpractice, and over 20 individuals have been criminally charged since 2015, but the success of the prosecutions has ultimately been mixed. Sixteen financial institutions were ordered to pay over $9 billion in fines to U.S. and U.K. regulators. In February of 2014, the BBA handed the reigns over to ICE.
Did LIBOR Contribute to the 2008 Financial Crisis?
Another reason the LIBOR’s legitimacy came into question was due to its role in worsening the 2008 financial crisis. Countless lenders insured risky mortgages and questionable banking products by using credit default swaps (CDS) based on the LIBOR. These investments were supposed to insure against defaults on hazardous home loans.
But once the real estate market started to crumble in 2007, it became clear that failing subprime mortgages and their corresponding derivatives like mortgage-backed securities would not hold up. Banks became wary of lending to each other, causing the LIBOR to rise daily. Rates on trillions worth of financial products rose. Money dried up in the economy, and the crash ensued. The LIBOR was just one of many elements leading to the Great Recession disaster.
What Is Replacing LIBOR in the United States?
The Secured Overnight Financing Rate (SOFR) replaces the LIBOR in the U.S. and the U.K., while other countries determine their benchmark rate. The SOFR is more transparent because it is based on actual lending transactions rather than estimates like the LIBOR.
Are Mortgage Rates Based on LIBOR?
Mortgage rates are not based solely on the LIBOR, but they move in step. When rates decline, consumers with adjustable-rate mortgages pay less monthly. When rates increase, consumers are forced to pay more. Remember, this doesn’t apply to fixed-rate mortgages.
If you have an ARM loan, your rate will still move in unison with the SOFR once the LIBOR is fully phased out. Check with your lender to see what benchmark your home loan is tied to.
