The LIBOR (London interbank offered rate) index is being phased out. UK authorities recently announced that they are going to phase out the index over the next five years because of certain banking improprieties.
Why does this matter?
Currently, your adjustable-rate mortgage may be tied to the LIBOR index. Often times, the ARM is a spread to the LIBOR index and resets on an annual basis. As interest rates rise and fall, so do the ARMs. Once LIBOR disappears it is unclear what index or instrument will be used to serve as a basis for the ARMs and the calculation of the interest portion of the mortgage payment. Although ARMs are less popular today because of historically low fixed rates, they still represent about 15% of the overall market.
So, two issues:
1. If you have an ARM tied to LIBOR and LIBOR is phased out, what is the new index? Most ARM contracts have a provision for a replacement although the replacement is more art than science. That is, the lender will choose a new “comparable” index. Most likely Fannie Mae and Freddie Mac will get involved and standardized the replacement index since they are the government-backed housing finance agencies that buy and repackage a majority of new origination. That said, there is no perfect replacement and either banks or the consumer are going to get pinched.
2. What index will Banks use today to originate new ARMs? Clearly, they don’t want to use the LIBOR index since it will be phased out in the near term. Banks will move to other funding indexes like repurchase agreements or the one-year Treasury rate.
If you have an ARM, reach out to your bank that originated the loan and begin a dialogue about the replacement index. Also, this may be a good time to refinance to a fixed rate mortgage so as to eliminate any risk associated with the replacement index. Please give Brian Meier or Doug MacFaddin a call if you need additional information or clarification. 212.500.7054.