Commentary: Like many, I have a personal interest in the ups and downs of the London Interbank Offer Rate, so called Libor, as my flexible rate mortgage is tied to it. If Libor is up, then so is my rate; if Libor is down, so to does my rate go down.
The problem is that Libor is about to go away. My mortgage, along with $400 trillion worth of other debt pegged to Libor, are about to become orphaned. Affected contracts include derivatives, business loans, and corporate bonds. Much of this Libor-linked debt has inadequate fallback provisions, creating uncertainty. No one knows what the ultimate solution will be.
Libor is calculated based on a survey of banks conducted by the UK bank regulators. The problem is that the British interbank lending market, in which Libor is set, is thin. This makes it hard for banks to make a precise estimate of Libor, introducing a role for judgement in responding to regulators. This introduces an opportunity for mischief, an opportunity, of which banks have taken advantage. Back in 2008, during the financial crisis, several British banks colluded to manipulate Libor to their benefit.
The Libor scandal made clear the problems with Libor. Ultimately, UK regulators concluded that Libor was fatally flawed. They have announced that the Libor survey will end in 2021, meaning Libor will no longer be available for use in setting rates.
Financial markets have known of the end of Libor for years. Most new debt contracts either don’t use Libor, or else carefully specify what alternative to Libor to be used after 2021.
However, all this was not known in 1999, when I took out my mortgage. My contract has no provision for using anything other than Libor. What is true for my mortgage may well be true for many of you reading this article with adjustable rate mortgages and it is true for much of legacy debt contracts.
This has serious implications for the the financial system. Contracts that lack adequate fallback provisions could plunge in value. To the extent that large banks are exposed, losses could impair lending. Because of its reliance on Libor, the trillion-dollar derivative market is exposed.
We really don’t know the full extent of Libor exposure. There is an estimated $200 billion in dollar denominated Libor-linked contract subject to U.S. regulation, but this number doesn’t reflect the Libor contracts denominated in other currencies.
Could the end of Libor cause systemwide instability? Unlikely. Could the end of Libor cause problems for a few exposed banks and financial markets? Possibly. Could the end of Libor be a pain in the neck to parties to Libor-linked contracts? Almost certainly, yes.
Contracts with inadequate fallback language cause uncertainty and likely will trigger a wave of lawsuits. New York Fed General Counsel Michael Held has called Libor a “DEFCON 1” legal event.
The good news is that going forward there is an alternative to Libor, which is the secure overnight reference rate (SOFR). While not used that much now, it is becoming more popular and with the end of Libor, is expected to become common.
Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He teaches money and banking, where he lectures on Libor. The opinions expressed may not be shared by the regents and administration of NMSU. Chris can be reached at chrerick@nmsu.edu.