The end is nigh for Libor
The 1980s brought us DOS, junk bonds, pocket phones, and a curious British interest rate convention called Libor that became the mainstream small print in variable rate contracts.
Libor is slated to begin dying on December 31, the remaining parts are slated to be buried six months later.
The British Bankers’ Association passed the “London Interbank Offering Rate” in 1986, which was used in contracts ranging from credit cards to interest rate swaps.
Unfortunately, scammers have figured out how to play Libor, a practice that was uncovered in 2008. Attempts have been made to address its vulnerabilities, but in 2017 the Bank of England threw in the towel and said Libor would expire by December 31, 2021.
The International Swaps and Derivatives Association (ISDA) estimated in 2018 that Libor was pegged to $ 370 trillion in derivatives, bonds, loans, and other instruments.
Major global banks will spend more than $ 100 million this year to prepare for Libor’s funeral, according to Bloomberg.
So what about credit unions?
NCUA chairman Todd Harper sent a letter to the credit unions earlier this month telling them that it would be good to have a plan to sever ties with the Libor by the end of the year. At the very least, they should make sure that their contracts offer alternative tariffs.
“The Libor transition is a major event that credit unions should handle carefully,” wrote Harper.
“The NCUA encourages all federally insured credit unions to withdraw from using the US dollar Libor as soon as possible, but no later than December 31, 2021,” he wrote. “Failure to prepare for Libor disruptions can undermine the financial stability, security and soundness of a government-insured credit union.”
Harper noted that the Libor administrator announced on March 5 that it would stop posting the weekly and two-month Libor settings after they were posted on December 31. It said it would release some other common Libor rates by June 30, 2023.
“While extending the release of certain Libor settings through June 30, 2023 does not provide an opportunity to continue using Libor, some older Libor contracts can expire naturally,” Harper wrote.
In an accompanying supervisory letter, Myra Toeppe, Director of the NCUA’s Bureau of Auditing and Insurance, provided guidelines to assist auditors in assessing a credit union’s preparations for transitioning from Libor to an alternate reference rate or rates.
“While some smaller and less complex institutions may have limited exposure to Libor-indexed instruments, the move to alternative benchmarks will affect almost every financial institution,” she wrote.
Contracts should contain a clearly defined alternative reference rate to Libor. “A robust fallback language also includes specifying a number of triggers, adjusting the spread and describing the changes required.”
Federally insured credit unions should measure and report their commitment to management and their board of directors. “Exposure reporting should include product details for the number and total number of contracts as well as the cost of moving from Libor,” Toeppe wrote.
Your analysis should include vendors and they should “create an emergency plan in case a service provider cannot deliver a timely solution”.
The NCUA said it is not in favor of a specific USD Libor replacement rate. However, Toeppe’s letter indicated that the Fed’s Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the recommended alternative to the US dollar-denominated Libor in 2017. The SOFR is a broad government bond repurchase rate and has been generated daily by the Federal Reserve Bank of New York since the second quarter of 2018.
Toeppe’s letter described some of the areas Libor lurks in:
Adjustable rate mortgages (ARMs) are the most common living space for credit unions, with Libor as the benchmark rate. Toeppe said one workaround is for credit unions to create an ARM using credit insurance standards set by a government sponsored company (GSE) like Fannie Mae or Freddie Mac. “The GSEs also provide fallback language that describes what steps to take when Libor is no longer available and how a replacement index is replaced in various circumstances.”
Student loans are another common place for libor-indexed loans from credit unions. “Given the potential for high numbers of individual student loan accounts and the likelihood of frequent address / job changes, student loans can present difficulty in communicating loan rate changes to a borrower,” she wrote. “If a credit union has a significant number of student loan accounts that are Libor indexed, auditors may consider reviewing the credit union’s transition plan, reviewing the fallback language, and see if the credit union has sufficient resources to do Libor indexing Change student loan accounts. ”
The investments will also contain many Libor indices, but should be less of a concern. On the one hand, the GSEs stopped issuing new securities with a Libor index on December 31st. While older Libor-indexed securities still make up a significant percentage of floating rate assets held by credit unions, Toeppe wrote that these investments typically have bond trustees who represent investors. “Responsible for implementing a robust fallback language to a new reference rate or new reference rates on transition from Libor that will allow auditors to review such holdings with little concern. “
Interest rate derivatives are the most fertile ecosystem for Libor, but credit unions have little benefit from this financial environment. Toeppe provided convincing explanations of ISDA fallbacks and protocols that went into effect on January 25th.
In addition, a significant number of financial contracts related to Libor are governed by New York law, and the state passed laws in April “to minimize the legal uncertainty and adverse economic effects associated with the Libor transition.”