A Mortgage Mystery: What Happens to ARMs When Libor Goes Away?

The Libor index is going away. For U.S. 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 what those mortgages would be pegged to.

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 superlow 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.

In a typical ARM, borrowers pay a fixed rate for five, seven or 10 years. After that, their rate resets each year, calculated as Libor plus a margin, often two to three percentage points.

"One issue is, should we be changing our product line now?" said Kirstin Hammond, who runs capital markets for United Wholesale Mortgage, one of the 20 largest mortgage lenders in the U.S. "Does it make sense to offer a [seven-year] ARM tied to Libor when Libor is not going to be around in seven years?"

Lenders have a vague blueprint for what to do when Libor disappears. Most ARM contracts specify that if the underlying index is no longer available, the lender or investor will pick a new "comparable" index.

What qualifies as "comparable" isn't clear, but banks are already studying alternatives.

For banks that plan to keep the mortgages on their books, they could presumably set the ARMs to any index they wish. To sell the ARMs to investors, they will likely follow whatever guidelines are set by Fannie Mae and Freddie Mac, the government-backed housing finance agencies that buy, bundle and sell mortgages.

A Fannie Mae spokeswoman said the agency is "monitoring the Libor situation closely and will notify the market when we come to a decision." A Freddie Mac spokeswoman said it will try "to minimize the impact on borrowers."

It isn't clear if there will be a single replacement, though some industry officials said they would prefer for Fannie, Freddie or regulators to mandate a replacement.

Investors would prefer that, too, said Mr. Barnes. They don't want to deal with mortgage pools where the underlying loans react differently to Libor's disappearance, he said.

The Alternative Reference Rates Committee, a group of banks convened by the Fed to look at Libor alternatives after the scandals broke, has proposed switching to a benchmark based on short-term loans known as repurchase agreements, or "repo" trades, backed by Treasury securities.

Meanwhile, some ARMs are tied to the yield of the one-year Treasury rate. While banks might be willing to make new ARMs tied to Treasury rates, they will probably be reluctant to switch current ARMs to that because of potential lost income. The one-year Treasury is trading around 1.2%, compared with the one-year Libor at 1.7%.

Global investors could also balk at that substitute, preferring something less dependent on the whims of the U.S. central bank, said Keith Gumbinger, vice president of the mortgage information website HSH.com.

Having an outside group mandate a new reference index for ARMs could also help to quell concerns that banks could use a switch to reap more profit from customers.

Already, some politicians are worried about that. Rep. Brad Sherman, a Democrat from California on the House Financial Services Committee who has advocated for replacing Libor because of the manipulation scandals, said he would be watching to see how consumers are affected.

Imagine if banks figured out a way to add just 0.10 percentage points to the cost of a mortgage, he said. "It would cost a consumer hundreds of dollars in the first year ... and it would be very unfair."


(END) Dow Jones Newswires

August 07, 2017 05:44 ET (09:44 GMT)