The London Interbank Offered Rate (LIBOR), defined and explained

When you get an adjustable-rate mortgage, the rate is determined by adding a margin to an index. There are a few different indexes that are commonly used. Up until recent years, one of the more prominent indexes was LIBOR. We’ll go over why it was replaced and what replaced it.

What was the London Interbank Offered Rate (LIBOR)?

The London Interbank Offered Rate (LIBOR) was an index that was formerly used to establish the interest rate for many adjustable-rate consumer financial products. This index was determined by leading banks in London and across the globe who would submit estimates for what they would be charged if they borrowed from other banks.

LIBOR has been phased out now, but it was in use as recently as 2023. According to the Consumer Financial Protection Bureau (CFPB), in 2019 there were about $1.3 trillion in consumer loans backed by LIBOR.

Why was LIBOR phased out?

LIBOR originated with a banker from Greece named Minos Zombanakis, who was working on a loan between Manufacturers Hanover and the Iranian Shah in 1969. The index was intended to be based on the funding costs of several large banks. As more lenders started to use it as an index for their offerings, it came under the control of the British Bankers’ Association in 1986.

Despite this wide adoption, LIBOR had a number of shortcomings and was tainted by scandal and fraud. Because the index relied on prediction as opposed to past transactions, it could be exploited. Since LIBOR is based on self-reporting and good faith estimations by participating banks, traders figured out ways to manipulate it for fraudulent purposes.

When the scandal broke revealing this deception in 2012, the BBA transferred regulatory oversight of the LIBOR rate to British regulators as part of the Financial Services Act 2012. It also tightened the repercussions and deemed it a criminal offense to make deliberate or knowing statements that were related to setting the LIBOR benchmark.

Even after the new rules, financial regulators decided there needed to be a new option and preparations were soon underway to find an alternative to the LIBOR rate. In 2014 the U.S. Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Rates Reference Committee (ARRC) in order to review potential replacements for LIBOR. In 2017, the ARRC made its recommendation, and the UK’s Financial Conduct Authority followed up with a planned LIBOR phase out after 2021.

What replaced LIBOR?

LIBOR was replaced by the Secured Overnight Financing Rate (SOFR) in the U.S. Other countries made their own decisions, but they landed on similar types of metrics. SOFR is based on the cost of funding as determined mainly through repurchase volume for U.S. Treasuries.

SOFR is a benchmark rate that uses the rates banks were charged for their overnight transactions, and therefore is harder to manipulate because it is based on actual loans. In other words, the transactions are secured by U.S. Treasuries, rather than the estimates that were used to set the LIBOR rate.

Why does the LIBOR change matter?

The LIBOR change matters because LIBOR was used as the index underlying the cost of many consumer loans including adjustable-rate mortgages. Let’s examine this in more detail.

How did the LIBOR phase out affect me?

If you previously had a fixed-rate loan, you wouldn’t have been impacted by the discontinuation of LIBOR. Fixed-rate mortgages are based on yields in the bond market at the time your loan was initially locked.

The only way you might have experienced this change is if you previously had an adjustable-rate loan or line of credit based on LIBOR, as your lender would have needed to change to a different index around the date of discontinuation.

It’s possible that you experienced movement in your interest rate on your adjustable-rate mortgage (ARM) and other loans due to the change in index. However, the mortgage industry had been working to ensure there would be minimal disruption in your payment process.

ARMs were often switched to SOFR, but they might also use the constant maturity treasury or the prime rate published by the Wall Street Journal.

How does LIBOR differ from SOFR?

How did LIBOR rates work?

When you apply for a mortgage, you might wonder what factors affect the rate you pay. The first metric lenders checked to price various types of ARM loans used to be LIBOR, which served as a “base.” Then to more accurately determine your interest rate, they would also consider factors like your credit score, debt-to-income ratio (DTI), amount of down payment and more.

The LIBOR rate wasn’t the amount you’d see in your interest calculation, as it was what banks charged each other, not individual borrowers. Instead you’d be charged an interest rate indexed to LIBOR.

Your initial rate would be based on your specific circumstances, which impacted the lender’s judgment about your ability to repay your loan – in other words, how much risk they believe they were taking on according to your past experience with credit and repaying your bills. LIBOR would only come into play on the adjustment.

For example, your rate might have been stated as LIBOR + 2, with the LIBOR part as the index, which would vary with economic changes, and the “2” (or whatever number you were assigned based on your specific risk factors) as the margin, which would stay the same.

There are also caps and floors associated with ARMs so that the rate will never fall above or below a certain point relative to your initial rate. The rate floor is also limited by the margin.

But here’s why it only affected certain types of mortgages. As you were shopping for your loan and talking to a professional about the right financial product for your situation, you were likely offered a wide variety of mortgage loan products, including ARMs and fixed-rate mortgages.

Many homeowners choose an ARM, particularly in higher-priced housing markets, because they prefer the lower monthly payments that ARMs offer during the early part of their terms. Non-fixed interest rate payments were generally tied to the LIBOR benchmark, which is why this index played a large role in how much interest you pay on your mortgage if you had an ARM.

How was LIBOR calculated?

Depending on how many banks contributed their estimates to the daily calculation, it impacted the number of banks whose data was included. Anywhere between 11 and 16 banks submitted their estimates each day.

Given the number of participants, they would drop either the highest and lowest three or four rates and do a mean average of the rest to come up with the LIBOR rate for that day.

The history of LIBOR

LIBOR has always been a rate based on a projection of where things were going to be in the future rather than a look at the past. However, this led to issues that ultimately resulted in the demise of the index.

LIBOR manipulation issues

Before reforms in the wake of the manipulation scandal, each bank set its own methodology for their LIBOR submission. Fundamentally, it was a guess. You may have based it on internal data including from trades, but there was no transparency requirement. Additionally, you’re trying to predict the future, so no one has that answer.

A drop in trading volume is what happened after the financial crisis of 2008. People were pulling back from the financial markets. In this environment, the expert opinion was being relied on more and more.

The problem is traders started talking to the decision-makers and telling them where they needed the number to be to make the most return for the bank. This led to manipulation of the rate, which ended in an investigation by British authorities. Moreover, management of the rate setting process was transferred away from the British Banking Authority to the Intercontinental Exchange^® (ICE).

Changes to LIBOR over time

Prior to the scandal, each bank had their own approach for the LIBOR submissions. The only requirement was that they were supposed to answer the following question: At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?

In the wake of the manipulation, the ICE Benchmark Association moved to tie the submissions more closely to transactions whenever possible. They created the following hierarchy:

• Looking at the average price of unsecured deposits, commercial paper issued and certificates of deposit weighted based on volume and also with an emphasis placed on transactions closer to 11 a.m. in London. Eligible trading partners would be banks of various sizes, government entities and non-bank financial institutions, among others.
• If there wasn’t enough data, the banks on the panel were supposed to use historical transactions, with a preference for the most recent data available.
• If neither of these were practical, the bank would then give the rate at which it felt it could fund its operations at 11 a.m. based on unsecured wholesale funding.

Once the panel was dissolved, there had to be some mechanism for contracts that didn’t have language that would fall back to an index other than LIBOR. In this case, a synthetic version of the index was used to give more time to get alternate contract arrangements in place. This is actually based on a version of the SOFR index and will be published until September 30, 2024.

The bottom line

LIBOR was a benchmark that asked major banks what the cost would be to fund their operations through borrowing each day. It served as the basis for rate changes and many consumer loans including ARMs. However, because it was based on a forward-looking prediction rather than past transactions, the system could be rigged.

After a manipulation scandal in the wake of the 2008 financial crisis, changes were made to LIBOR, but it was ultimately decided to move away from the index. In the U.S., this mostly involved a transition to SOFR, but lenders had other options as well.