NEWPORT BEACH, CA—On many levels, it was inevitable that Libor, a key interest-rate indicator, will be phased out, but where do we go after it exits in 2021? We spoke with Landmark Capital Advisors managing director Adam Deermount about what this means for the real estate industry and what lies ahead.
GlobeSt.com: What’s your take on Libor and recent developments with this indicator?
Deermount: Libor, the London Inter Bank Offer Rate, is a scandal-ridden mess, and now it’s going to die. The 50-year old global borrowing benchmark has been plagued by corruption and manipulation of late, which has led to a decision to pull the plug. From BloombergMarkets: “The U.K. Financial Conduct Authority will phase out the key interest-rate indicator by the end of 2021 after it became clear there wasn’t enough meaningful data to sustain the benchmark that underpins more than $350 trillion in securities, Andrew Bailey, the head of the regulator, said in a speech Thursday at Bloomberg’s London office.
“The end of the London interbank offered rate, or Libor, is welcome on many levels for regulators. It was tied to some of the banking industry’s biggest scandals, leading to about $9 billion in fines and the conviction of several bankers for manipulating the rate. Relying on the opinions of industry insiders to set the daily estimates based on interbank lending—some in markets that saw fewer than 20 transactions annually—was unacceptable, Bailey said.
“‘Libor is trying to do too many things: it’s trying to be a measure of bank risk and it’s trying to substitute for interest-rate risk markets where really it would be better to use a risk-free rate,’ said Bailey in an interview with Bloomberg News before the speech. ‘It’s had to come to a conclusion.’”
On many levels, this was inevitable. As mentioned above, the benchmark was ripe for manipulation that could result in substantial economic rewards for lenders, given the incredible amount of debt that is priced off of it.”
GlobeSt.com: Where do we go now that Libor is set to disappear in 2021?
Deermount: That problem could be a particularly perplexing one for real estate, as Christina Rexrode explained in a recent Wall Street Journal article (emphasis mine): “The Libor index is going away. For US consumers, its demise is most likely to be felt in adjustable-rate mortgages.
“So-called ARMs—where the interest rate rises and falls with broader indexes—are often closely tied to Libor, or the London interbank offered rate. While ARMs are out of favor these days, they are still a sizable portion of the mortgage market, and once Libor disappears it is unclear to what those mortgages would be pegged.
“U.K. authorities recently said Libor would be phased out over the next five years due to allegations bankers manipulated it, which could prove troublesome for borrowers, lenders and investors in mortgage securities.
“‘In a fairly short amount of time, no one is going to know how to compute what the next payment is going to be’ for this kind of mortgage, said Lou Barnes, a capital markets analyst with Premier Mortgage Group in Boulder, Colo. ‘And that’s why it’s important.’”
“Such mortgages were popular before the financial crisis, when lenders used their low teaser rates to get borrowers into bigger homes. They have been a tougher sell in an era of super-low interest rates, but still account for roughly $1.33 trillion of mortgages outstanding, according to Black Knight Financial Services Inc., a mortgage-data and technology firm.
“That is nearly 14% of the overall market, and lenders had been expecting that share to grow as the Federal Reserve continues to raise interest rates. Banks also favor ARMs for jumbo mortgages, high-dollar amount loans they view as a source of revenue growth.”
GlobeSt.com: So, what does all of that mean for real estate investment?
Deermount: First off, I suspect that the percentage of adjustable-rate mortgages is substantially higher in a place like California, where jumbo loans are the rule and not the exception. In reality, pretty much every loan has a provision for index replacement should the initial pricing index become discontinued or unavailable. The problem is that no one knows what that index is going to be, which has led to uncertainty. In the world of residential mortgages, it probably makes sense to have a universal standard set by Fannie Mae and/or Freddie Mac since so many of these loans are packaged and sold in the secondary market. However even this approach has issues since there is a continued push in some political and financial circles to get rid of the two mortgage giants completely.
GlobeSt.com: What about commercial real estate loans?
Deermount: Commercial real estate loans could be a bit more difficult since it is a substantially more fragmented world. It would be nice to know what the replacement is going to be up front since many (most) adjustable-rate loans are still being underwritten today using Libor even though it will be gone long before maturity. However, it has not happened yet. This is going to cause a not-unsubstantial amount of uncertainty for commercial borrowers going forward, not to mention a mountain of paperwork and compliance issues when the vast majority of adjustable-rate loans need to change indexes en masse. If I had to make one prediction on how the situation works out, it would be this: as a general rule, the borrower never ends up better off in this sort of situation, but the lender quite often does. Stay tuned.