The London Interbank Offered Rate (LIBOR) – which serves as the reference basis for an estimated $200 trillion worth of financial transactions globally – is on the verge of being retired, and there are several aspects of the impending sunset date that consumers should be aware of. This is according to James R. Schenck, the president and CEO of PenFed Credit Union and CEO of the PenFed Foundation, in a “council” post at Forbes.
“Consumers may not realize it, but they have a huge stake in the accuracy of LIBOR,” Schenk writes. “When interest rate changes become more volatile than consumers expect, LIBOR takes money out of consumers’ wallets.”
To offer perspective, Schenck paints a hypothetical scenario involving how LIBOR can affect a consumer’s auto loan.
“[Let’s say] a bank may have priced a $30,000 auto loan with an adjustable rate indexed to the six-month LIBOR rate +2.5%,” Schenck writes. “If the LIBOR rate was 3% when the loan was signed, then for the first six months, the borrower’s rate on the loan was 5.5%. But at the end of six months, if the LIBOR rate had risen to 4%, the consumer’s loan rate rose to 6.5%. And the monthly loan payments increased substantially.”
Because some changes in LIBOR appeared to be subject to manipulation by certain international banks, the rates offered to consumers may not have accurately reflected the true market conditions at the time that certain loans using the LIBOR index were originated, he adds. This is why the index is being retired next year.
The U.S. Federal Reserve has recommended moving over to the Secured Overnight Financing Rate (SOFR), though educating consumers about all the implication that will come with such a transition will be a tall order for financial institutions, Schenck says. He adds that consumers would be well-served by educating themselves on the transition, while adding that such a change should not be a cause of worry for a few key reasons.
“SOFR is simply a better benchmark,” Schenck offers as one reason consumers shouldn’t be concerned. “Because it is collateralized by U.S. Treasury securities, it is more accurate, more stable, and has more depth and breadth of market. Unlike LIBOR, SOFR is less prone to manipulation.”
Other reasons consumers shouldn’t be worried, according to Schenck, is that rates are not likely to change quickly; not all consumers will be uniformly affected by the transition; and consumers can always consider refinancing their existing LIBOR-indexed transactions.
According to 2018 research from the Urban Institute, a transition from LIBOR to SOFR could translate into gains for the reverse mortgage industry. For Home Equity Conversion Mortgages (HECMs), 90% of recent originations and 60% of the overall HECM market as of late 2018, equalling approximately $50 billion, is based on the LIBOR index.
“In the $50 billion LIBOR HECM market, the likely beneficiary would be the heirs or the Federal Housing Administration (FHA) for any paid insurance claims, and the investors in Ginnie Mae securities would face increased costs,” Urban researchers wrote at the time. “We estimate this transfer could be about $125 million a year, or a present value of $2 billion.”
Read the council post at Forbes.
