Future of floating rates: LIBOR endgame

Originally utilized in 1969, LIBOR—the London Interbank Offered Rate—was officially adopted by the British Bankers Association in 1986 as a benchmark rate. It has subsequently become the global standard for the rate at which banks lend to one another. LIBOR rates are set by banks daily, with each bank providing the estimated rate at which it expects to borrow funds at a series of maturities (as well as a variety of currencies, which has led to Euro and Yen LIBORs, among others).

The presence of such a robust interest-rate setting process led market participants to adopt LIBOR rates as the basis for a wide variety of financial products. Recent estimates place LIBOR as the reference rate in over $200 trillion of active financial contracts in the cash and derivatives markets. LIBOR exposure can most commonly be found in the investment portfolios of banks and credit unions in the form of variable rate mortgage-backed securities and collateralized mortgage obligations.

In the United States, the Alternative Reference Rates Committee has chosen the secured overnight funding rate as the replacement for LIBOR, and in previous articles, we discussed the differences between the two benchmarks and the challenges to a smooth transition. In 2020, Fannie Mae, Freddie Mac, and Ginnie Mae each released superseding fallback language for outstanding securities ensuring a smooth transition into the post-LIBOR era. This complimented previous fallback language that was implemented into prospectuses for new securities issued over the last few years. The fallback language has eliminated the risk of legacy government-sponsored enterprises’ floating-rate mortgage-backed securities and collaterized mortgage obligations becoming fixed-rate securities in the absence of a LIBOR rate.

 

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