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Justin Fitzhugh

Redefining LIBOR: A Plea for a Robust Interest Rate Index for U.S. Mortgages

Tuesday, September 9, 2014 - Article by: Justin Fitzhugh - Nations Lending Corporation - Message

LIBOR is a reference rate that is currently used in more than $3000 trillion dollars worth of contracts. This rate is part of the international financial system, and every American household and business that holds a LIBOR-linked mortgage and loan is vulnerable to it. However, the credibility of this rate was devalued after the LIBOR manipulation scheme that came to light in 2012.[1] The scandal has lead Federal public officials to analyze this interest rate and look for alternatives that offer more accurate information about risk-free, or nearly risk-free, cost of borrowing. So it is no surprise that last week, Federal Reserve Governor Jerome H. Powell delivered a speech about redefining the U.S. Dollar LIBOR.[2]

THE LIBOR RATE

The LIBOR rate was standardized by the British Bankers Association in the 1980s with the intention to normalize the interest rates banks used for swaps, future contracts, floating-rate mortgages, commercial loans and other financial products like mortgage- and asset-backed securities.

The rate can be broken down into two components; one that measures the average level of risk-free rates, and another that measures the risk premium associated with a borrowing bank. Governor Powell argues there are two problems with the pervasive use of this rate as a leading benchmark.

The first problem stems from the fact that LIBOR is widely used in derivative and secure borrowing contracts, but the credit risk component of this rate is not an accurate measure of the credit risk of these instruments.

The second problem is the material decrease of interbank borrowing that was exacerbated with the global financial crisis.

These two problems translate to the fact that LIBOR no longer represents a measure of the thing it was meant to represent.

THE PROPOSAL

In his speech, Governor Powell proposed we update LIBOR in such a way that it actually reflects the intrinsic risk of unsecured funding markets. He urged regulators to work with stakeholders in developing an alternative reference rate which would signals a level of risk that more accurately represent the level of risk in U.S. financial markets. This reference rate could replace LIBOR as the index to which tie derivatives and other domestic financial instruments.

ALTERNATIVES

A Group of Market Participants and the Financial Stability Board did a preliminary analysis that concluded in a report which outlines a number of reforms. The analysis identified the redefinition of a U.S. dollar based LIBOR would not be enough to eliminate the weaknesses on the current system. Some of the reforms include the linking of a large portion of derivatives to a risk-free rate based on a robust and liquid market; this rate should not be tied to bank credit risk. Possible alternatives include rates derived from the U.S Treasury Market or of other highly liquid secure funding markets.

Whatever alternative we choose, it should reflect current market practices, risk levels, and level of liquidity. This would decrease the risk of market (benchmark) manipulation.

INTEREST RATE FLUCTUATIONS HAVE A DIRECT IMPACT IN OUR INDUSTRY, and business is tough. We are facing more than the ongoing regulatory overhaul and business cycle forces that demand the best of us; today, we are facing a more educated borrower, a growing competition, and an ever shrinking profit margin; I say I dont want to put my bets on an obsolete system. I want to lend a lot, and I need the ability to offer the best available rate to inquiring borrowers. Do you feel different?

1) Infographic about the LIBOR Manipulation Scheme: http://www.nytimes.com/interactive/2012/07/10/business/dealbook/behind-the-libor-scandal.html?smid=pl-share

2) http://www.federalreserve.gov/newsevents/speech/powell20140904a.htm

3) A group established to coordinate the work of Federal Financial Authorities at the international level, as well as the standardization of practices that promote financial stability at the international level: http://www.financialstabilityboard.org/about/overview.htm

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