If you have a home equity line of credit, private student loan, commercial mortgage or business loan, your payment may be tied to LIBOR. The London Interbank Offered Rate serves as the starting point for figuring out how much borrowers owe. But the interest rate underpinning trillions of dollars of loans will be changing.
In the week ahead, the Federal Reserve Bank of New York begins publishing the SOFR. The Secured Overnight Financing Rate aims to be more reliable and less contrived. It also begins a new chapter in the massive move away from LIBOR and its lock as a fundamental price of borrowed funds.
Deep inside most variable interest rate loan documents is LIBOR. Since the 1980s, lenders have leaned on LIBOR as the gauge to set other market interest rates. As LIBOR moves, so moves repayment costs. But it is an imperfect reflection of the cost of cash.
LIBOR isn't based on actual borrowing. It is a daily poll of banks, asking them what they think would be the cost to borrow from each other without using any collateral. Those are unsecured loans, and fewer banks are conducting business like that. So the poll has become less accurate. And since it's a survey of expected costs, not actual costs, the poll is vulnerable to manipulation. A dozen banks have paid billions of dollars in fines for rigging LIBOR rates.
LIBOR lied. The benchmark is broken.
Over the past four years a group of bankers, financiers and American regulators have been working toward a new reference rate. That rate, the SOFR, makes its debut Tuesday morning. It differs from LIBOR in two significant ways; It will be based on actual lending rates between banks, and it will be based on loans using US Treasuries as collateral — a more common practice than LIBOR's unsecured loans.
The introduction of what may become the new benchmark is far from complete. Whereas LIBOR rates include different durations ranging from overnight loans to those lasting one year, the SOFR is solely short-term money — one day.
New variable interest rate loans likely will include references to SOFR as the new standard. Other loans may include fallback language allowing them to swap the old benchmark for a new one.
This may seem like an arcane action by the financial industrial complex, but with trillions of dollars of consumer and business loans tethered to LIBOR, a smooth and orderly transition to a new interest rate benchmark is vital for the American economy.
Tom Hudson hosts “The Sunshine Economy” on WLRN-FM; @HudsonsView.