Extra Credit: The impending Y2K you probably never heard of: a new interest rate used to price everything from mortgages to car loans

Starting in the new year, supervised financial institutions will need to stop using Libor as a reference rate for new contracts in order to be in compliance with guidance issued by several U.S. financial regulators. 

What does that mean practically?  The price of certain goods and services could change. Loan contracts between financial institutions and companies seeking capital to manufacture products are often tied to Libor. It remains to be seen whether the cost of credit in those scenarios will increase or adjust to reflect uncertainty surrounding the transition, said Yesha Yadav, professor of law and associate dean at Vanderbilt Law School. 

The end of Libor also could result in a change — though stakeholders are hoping it will be an unnoticeable one — in the amount consumers pay each month for certain loan contracts and the schedule on which the rates in these contracts are adjusted. 

“This is a brave new world that we’re entering,” Yadav said. “We have used Libor for the better part of five decades to price everything from a car loan to the biggest interbank loans you can imagine.” 

This week, we’re digging into how policymakers and financial institutions are preparing for the change as well as its implications for consumers. But first, we’ll explore how we got here. 

Libor’s origins

Libor’s origin story dates back to the late 1960s, when a group of banks, organized by London banker Minos Zombanakis, , were looking to make a loan to the Shah of Iran. As part of the deal, Zombanakis developed a system to price the loan that was based on how much the banks would have to pay to borrow from one another. 

At the time, the idea seemed like “an amazing innovation,” Yadav said. By providing a daily benchmark of the average cost of a bank to borrow, the system reduced one of the biggest costs in pricing credit, performing detailed due diligence on a borrower’s risk of default. Suddenly financial institutions had an easy measure for the cost of capital for a bank and all they had to do to price other loans was determine how much to charge riskier borrowers on top of that base rate. 

In addition, Libor provided an indication of the credit risk in the banking system — in general, the more it cost for banks to borrow, the more risk was present and vice versa. 

The system grew in popularity and instead of just making loans at rates tied to Libor, the panel banks began to borrow at those rates as well. In 1986, the British Bankers’ Association started overseeing the rate out of concern that banks’ borrowing behavior would create an incentive for the institutions to underreport the rate at which they could borrow. 

Eventually, Libor encompassed several currencies and maturities and at its peak was the basis for an estimated more than $300 trillion in financial transactions. 

But around the onset of the financial crisis, suspicions grew that this “amazing innovation” was also vulnerable to manipulation. “Like any system based on self-reporting, the institutions involved are going to have an incentive to make themselves look good,” Yadav said. 

This influence came largely in two forms, she added. The first was panel banks underreporting their cost of borrowing so they would appear less risky. The second was colluding with other members of the panel to push the rate in a direction that would benefit certain positions the banks held in complex financial products, like swaps and derivatives. 

Ultimately, “it became apparent this was a deeply problematic index with a very high level of endemic corruption,” Yadav said, with internal emails revealing directives to keep Libor low to protect banks’ reputations and instant messages indicating traders were targeting a specific rate that would make their employers the most money. 

The ensuing scandal pushed financial regulators all over the world to look at the possibility of ditching Libor by the 2010s. 

The process of transitioning away from Libor

That process began in earnest in the U.S. in 2014 when the Federal Reserve Board and the New York Fed convened a group of expert market participants, called the Alternative Reference Rate Committee, to map out how best to transition away from U.S. dollar Libor. 

A big part of that effort was finding a rate financial institutions could use to replace Libor for all of the transactions that used it as a reference. 

The decision has big implications for consumers. The interest rates on mortgage, private student and auto loans where the rate shifts with the market — known as variable rate loans — are often set by using Libor as a base and adding a certain number of percentage points. 

Starting next year, financial institutions won’t be able to make new loan contracts using Libor as the reference, but in some cases, consumers may have already signed Libor-based contracts where the reference rate will ultimately switch. Financial institutions have to transition away from Libor in legacy contracts after June 2023. 

If lenders choose “the wrong index,” Pizor said, it could make consumers’ rates more expensive and drive them towards default, especially if the index being used is unstable or results in a rate that is higher than Libor. 

“That could have a pretty broad effect across the economy,” he said. If lenders choose a benchmark that’s more volatile than Libor, “that could just cause problems with people trying to budget” because consumers’ monthly payment amounts would change more frequently. 

When the ARRC members first began meeting in 2014, “our goal was to find a rate that avoided the fault lines that were within Libor,” said Tom Wipf, the chair of ARRC and a vice chairman of institutional securities at Morgan Stanley. The group also wanted to support the transition away from the U.S. dollar Libor, he said. 

They landed on the Secured Overnight Financing Rate, or SOFR, which is derived from the cost of overnight loans between financial institutions that are secured by U.S. Treasuries. The panel and consumer advocates like this rate because instead of being based on self-reported information about a hypothetical loan, SOFR is based on actual transactions in an active trading market. 

“We picked a rate that was going to be entirely based on transactions and not use any judgment, that would significantly, if not entirely, reduce the risk of manipulation, and that is based on an active underlying market,” Wipf said. 

In addition to being calculated in a different manner from Libor, SOFR’s history — it’s performed dependably in good and in bad times — indicate that it will be a good benchmark for all types of market environments, Wipf said. 

Despite these benefits, SOFR isn’t the same as Libor, which means there’s no guarantee the  mortgage loans, supplier contracts and other transactions that have historically been based on Libor will perform in the same way once the switch occurs. 

“We’ve really struggled to come up with a rate that does everything that Libor has been doing,” Yadav said. One of the issues with SOFR for lenders is that it’s not forward-looking since it’s based on an overnight rate and can’t assess credit risk up to a year in the future. In addition, because the transactions underpinning SOFR are secured by ultra-safe U.S. Treasuries, it doesn’t show the credit risk Libor did. 

Wipf said that SOFR doesn’t substitute for the credit sensitivity inherent in Libor, in part because the markets that measure credit risk do not have sufficient trading, especially during periods of market stress. 

“To find a robust, credit sensitive, transaction-based replacement of that turned out to be impossible,” he said. 

ARRC is recommending a number of ways to smooth the transition from Libor to SOFR, including by basing their transactions on a 30-day average SOFR and adding a spread to SOFR. 

“Most people don’t expect the SOFR and the LIBOR measures to yield very different costs for consumers,” Yadav said. “There’s a level of optimism here that consumers won’t feel the difference too heavily, but it’s really hard to say.”  

Hard for consumers to prepare

Right now, it’s still unclear how lenders will approach their legacy contracts with consumers when the rate ultimately changes in June 2023. Though ARRC is recommending lenders replace Libor with SOFR, they don’t have to use it. 

Recently regulators provided some guidance that stakeholders are hopeful will help facilitate a smooth transition. The Consumer Financial Protection Bureau issued a rule earlier this month recommending lenders use SOFR requiring that lenders choose a replacement rate that fluctuates similarly to Libor. 

The House of Representatives also passed a bill this month that would shield lenders with Libor-based legacy contracts that don’t have provisions for switching reference rates from lawsuits as long as they switched to SOFR. The risk of lawsuits comes from both investors, who have bought up these contracts in securitized form, and consumers, who are paying on them. The bill’s sponsor, Representative Brad Sherman, a California Democrat, called the legislation “the most important, genuinely boring bill” that would come before the body in 2021. 

Typically, consumer advocates are wary of provisions that promise to shield companies from litigation, Pizor said. 

“It usually takes away consumers rights and leaves them exposed to harm,” he said. But in this case, “the risk of lenders and servicers choosing all kinds of different rates is much much greater than anything that could be lost by the safe harbor. This is one of the rare chances where we’re willing to give up a consumer protection right.” 

In the meantime, there’s not a ton consumers can do themselves to prepare for the switch away from Libor. For those who have a Libor-based loan, Pizor suggests checking monthly statements to ensure everything looks right. 

“This is completely unprecedented,” he said. “I don’t think there’s really anything consumers can do, except read their mail.”

Despite the dramatic shift, Wipf and other stakeholders are confident they’ve done the work to ensure a smooth transition.  

“Our goal is always to be over prepared as the world was for Y2K,” he said.  “We’re of the mind that if we’re really over prepared and nothing happens we’ve really hit it right on the head.”