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  #81  
Old 08-08-2017, 03:06 PM
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https://www.wsj.com/articles/a-mortg...way-1502098201

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A Mortgage Mystery: What Happens to ARMs When Libor Goes Away?
Many adjustable-rate mortgages are pegged to Libor. What comes next is anyone’s guess.

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 -- on which 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 that 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 pricier 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 in the U.S., 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 2 to 3 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.
.....
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 offer 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.

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 point 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."




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  #82  
Old 08-08-2017, 04:18 PM
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"once Libor disappears it is unclear what those mortgages would be pegged to."

Each other?
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  #83  
Old 08-09-2017, 09:48 AM
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There are a lot of variable rate preferred stocks and bonds which are tied to Libor. Whereas mortgage lenders would like a high substitute rate, preferred stock and bond issuers would prefer a low substitute.

Most of the referred stocks and bonds are callable; I expect that the issues will be called and reissued.
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Old 08-09-2017, 10:24 AM
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The proposal is to calibrate the replacement LIBOR so that it is = BTFR + a spread to equal the LIBOR rate (approximately) until all the LIBOR reference rates are gone.

So if LIBOR today is 1.7% and the BTFR rate is 1.2%... upon conversion, all the LIBOR rates are replaced with BTFR + 50 bps
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Old 02-21-2018, 10:33 AM
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http://knowledge.wharton.upenn.edu/a...m_medium=email

Quote:
What’s Behind One of the Biggest Financial Scams in History
Spoiler:
In 2012, the global markets were rocked by revelations about a scam so massive it was almost hard to comprehend: the LIBOR ( London Interbank Offered Rate) scandal. Like the U.S. federal funds rate, LIBOR is a key benchmark short-term interest rate upon which other financial instruments are based. While the target for the U.S. rate is set by the Fed, LIBOR is the average of self-reported interest rates major banks charge one another to borrow money. By colluding to manipulate LIBOR, the banks’ traders raked in a fortune by betting on assets influenced by the interest rate.

David Enrich followed the story while he was working for The Wall Street Journal and got close to the central figure in the scandal — star derivatives trader Tom Hayes. In the book, The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History, Enrich, now with The New York Times, shares the tale of this brazen scam on the Knowledge@Wharton show on Sirius XM channel 111.

An edited version of the interview appears below.


Knowledge@Wharton: David, that’s a phenomenal book title. It covers about everything there. This book started with a series of articles you did for The Wall Street Journal several years ago.

David Enrich: That’s right. The mastermind of the LIBOR scandal was a guy named Tom Hayes, a mildly autistic mathematician who was a star trader at some of the world’s biggest banks. He was accused, at the end of 2012, of being the central figure in this scandal by both American and British prosecutors. Right around that time, I started to get to know Tom Hayes really well personally. I first interviewed him for an article that I was doing in The Wall Street Journal. Over the ensuing months and years, I’ve spent an enormous amount of time talking on the phone with him, having coffee with him, drinking beers with him. I got to know him really well, his wife really well, and the rest of his family as well. And that gave me this interesting glimpse into the world in which Hayes was operating.

Knowledge@Wharton: Was it surprising to you that you had such free access to the guy who essentially started this whole scam?

Enrich: That’s what I thought at first. I was stunned by the serendipity of the thing. This all got started because Hayes was the central person who had been accused by prosecutors. Not a whole lot was known about him, so I started talking to some of his friends and former business school classmates. One of them turned out to be pretty helpful and offered to pass on my phone number to him, with the caveat that, obviously, this guy is facing criminal charges — the last thing he’s going to do is call a reporter to talk to him.

I was in the London bureau of the Journal at the time, and I was sitting at home one evening, and my iPhone buzzed with a text message from a number I didn’t recognize. And it said, “This goes much, much higher than me. Not even the Justice Department knows the full story. I’m willing to talk to you, but I need to make sure I can trust you.” It was Tom Hayes.

“The mastermind of the LIBOR scandal was a guy named Tom Hayes, a mildly autistic mathematician.”

He offered to meet me the following morning at a really busy train station in London outside a Burger King. He said he’d be wearing a brown leather jacket. And I’m thinking to myself that I’m stumbling into All The President’s Men or something.

Knowledge@Wharton: I was just going to say Watergate all over again.

Enrich: I’m thinking I’m Bob Woodward here. He ended up canceling the next morning because his wife had somehow seen his text messages to me, and his wife was a lawyer and thought this was a really bad idea. But the most fascinating thing to me is that what I’d thought about this at the outset was, “I cannot believe this criminal mastermind is na´ve enough to be talking to me.” It turned out part of the reason he was so eager to talk to me is because the story was a lot more complicated than I had originally thought.

It wasn’t as clear-cut and black-and-white as prosecutors and regulators were portraying it, which was that he was the bad apple or the evil mastermind or evil genius who had orchestrated this scheme to rip off all these innocent people. It was much more a story about a financial system run amok, and how the overall banking system encouraged, more or less, this type of behavior not just from Hayes but from a really wide range of people, including a lot of his superiors who ended up not suffering particularly severe consequences from that.

Knowledge@Wharton: When we talk about the LIBOR, … it’s unique in that it’s reliant on so many banks around the world to work together in setting it.

Enrich: That’s right. Here’s a quick primer on LIBOR for the people who focused on this briefly a few years ago and promptly forget about it — which I think was probably the vast majority of the human population. It’s the London Interbank Offered Rate. Every day around lunchtime in London, some of the worlds biggest banks, including a bunch of American ones, estimate how much it would cost them, theoretically, to borrow money from another bank. They then take that number, and zip it over in an email to the British Bankers Association, which is basically a lobbying group in London.

The BBA tosses out the high and low estimates, and then averages the rest. Then — presto! — that’s LIBOR. And LIBOR is often described as the world’s most important number because it is the basis for interest rates on huge quantities of debt all over the world — a lot of variable-rate mortgages, auto loans, credit cards, student loans, things like that. But the bigger issue is that when companies borrow money, the interest rate they pay is often based on LIBOR.

“My iPhone buzzed with a text message. … And it said ‘This goes much, much higher than me.’”

And if towns or cities or pension funds or university endowments are looking to protect themselves against swings in things like interest rates, they often use instruments that are tied to LIBOR. So if LIBOR is being skewed by banks, it has the potential to ripple through the financial system in a way that almost no other type of manipulation has the power to do.

KNOWLEDGE@WHARTON HIGH SCHOOL

Knowledge@Wharton: How did Tom Hayes, with his mathematical background, fit into this puzzle? Was it because he was able to gauge what these markets were going to do, and what the impact was going to be so that potentially the banks could profit?

Enrich: Well, yes. He was really building on the important work done by some of his predecessors. Because starting about 20 years ago, when LIBOR became increasingly prevalent in the financial system, a lot of traders at banks realized — and these are guys, by the way, that are transacting in huge volumes of derivatives that are based on LIBOR. So they stand to gain or lose a lot of money based on very small movements in LIBOR up or down, on a daily basis.

These guys realized that no one’s paying any attention to how LIBOR’s set. No one’s supervising the process. They can place a phone call or send an email to the relatively low-ranking person elsewhere in their bank or in another bank and say, “Hey, can you do me a favor, can you today move LIBOR up by a few hundredths of a percentage point?” Generally, the answer is yes.

Hayes’ genius realization was that he could take things a step further. Instead of just quietly pestering people elsewhere in his bank, he also went to people at other banks — his competitors. He used brokers to reach out to even more people. He basically took what was a long-standing industry practice to a new, higher, more ambitious, more creative level. In some ways, he just pushed the envelope a little bit further and a little more aggressively than anyone else had before him.

And that’s in keeping with the financial industry’s long-time mantra, which is, the way you make money as a trader is, first, you identify inefficiencies in the market: weaknesses, loopholes, things like that. Then you find ways to exploit those loopholes and those weaknesses and those inefficiencies. That can be in the form of having better information than your competitors. It can be in the form of having dumber clients than your competitors, or faster trading systems, or better technology — or the ability to subtly nudge something that you’re trading on. That’s what Hayes did with great pleasure, and great applause from his superiors.

“These guys realized that no one’s paying any attention to how LIBOR’s set.”

Knowledge@Wharton: But it seems like at some point he had hesitation, and he understood what was going on and the impact that manipulation was having around the world.

Enrich: I’m not sure he ever realized what the impact it was having. He did, at times though, have real qualms about some of what he was doing. This was something that he told me over and over again as I was first getting to know him — that he did not think that most of what he was doing was wrong because he saw everyone else doing it, and it was so embedded in the industry’s DNA. But he did acknowledge that there were a number of times where they pushed the envelope especially far, to the point where he felt like he was colluding with his competitors.

He felt like he was doing something that was really just false and misleading. And he took solace in the fact that the bosses knew about and generally approved of what he was doing. But as most of us learn from a very early age, just because everyone is doing something bad doesn’t mean it’s OK for you to do something bad yourself. That’s a message that was really lost on an entire generation of people in the financial industry, I think.

Knowledge@Wharton: I want to ask about the governments involved in this. What roles did they have? What did they see, and what did they fail to see, that allowed this to play out the way it did?

Enrich: The government’s role in this is really important. At a starting point, the basis for this scam was that no one was paying any attention to this really important instrument. That was a direct and immediate result of the fact that governments in both the U.S. and elsewhere, in the 1980s, 1990s and early 2000s deliberately took a totally hands-off approach to the banking industry. And at the time, there was a race under way between different financial centers — especially between New York and London — to see which could take the lightest touch to supervising the banks. The reason for that was they were competing with each other to land jobs and investments and things like that. So there was a really aggressive back-and-forth between these cities trying to deregulate as quickly as possible.

Then, as LIBOR manipulation took hold, there were, over and over again, warnings given to central banks on both sides of the Atlantic, saying: “This is exactly what’s happening. Please intervene. Please help. Please stop this from spreading.” And those requests, which came from the banks themselves, fell on completely deaf ears.

“It was staggering seeing just the kind of depths of depravity that some of these bankers and traders demonstrated.”

Knowledge@Wharton: To a degree, that’s not so surprising, given the way government is run.

Enrich: They knew; they just didn’t care. They didn’t want to do anything about it because LIBOR is so deeply embedded in the financial system, and acknowledging a problem with it was potentially very destabilizing. In fairness to governments, there was a lot of other stuff going on at the time. This was happening during the height of the financial crisis. The banking system seemed to be on the precipice of disaster. That context is important, because there are only a certain number of hours in every day, and you have to triage in situations like that. LIBOR didn’t seem like an existential issue. Something untoward was clearly going on, but was it a priority? Apparently not.

I think a bigger thing was that there generally is an attitude among regulators and prosecutors to take the path of least resistance, and do the thing that is most likely to quickly yield a positive result. That’s human nature, to an extent. But it generates a very unambitious, very uncreative way of policing these very complicated sectors.

So with LIBOR, what you saw is that initially, they just didn’t want to deal with it at all. The CFDC [Commodity Futures Trading Commission] in Washington, which was — especially at the time — an obscure, very underfunded government agency, was the only institution in the world that expressed any interest in doing this. For years, they were on this lonely mission — a lonely, very slow mission — trying to persuade banks to cooperate and, frankly, trying to persuade other government agencies elsewhere in the world to get out of their way and let them do their job. Were it not for their stubbornness on this, a lot of this stuff never would have come to light.

Knowledge@Wharton: Nobody has been doing any jail time because of this. That’s a disturbing pattern on a lot of fronts, because we’ve seen a similar result here in the U.S. after the financial crisis, and many of the other banking-related scandals that have occurred.

Enrich: You know what’s interesting? As part of the publicity for this book, I’ve done a tremendous amount of radio. And radio, as you know, can be very deeply polarized on both the right and the left in this country. So just as preparation for a lot of these interviews, I did some quick research: Is this a Trump radio station or Clinton or Bernie Sanders radio station? And I was expecting different slanted questions. You know what? Everyone’s asked the exact same thing, which is, ‘Why do the financial elites keep getting away with murder?’ It seems to be this really unifying theme across the country right now. It just makes people’s blood boil. There was so much public pressure on politicians and prosecutors after the crisis to find some individuals to hold to account for the massive harm that the banking industry caused to the country and to the economy, really to the world.

“The thing that would scare some of these bank CEOs is … the prospect of being perp-walked in front of TV cameras in handcuffs.”

And prosecutors, instead of going after people at the top of the food chain — the CEOs and business leaders who are responsible for setting the culture at their institution, responsible for in many cases the practices of their institutions — instead of going after those guys, they uniformly went after a small group of relatively low-level people. Don’t get me wrong, Hayes in particular did things that were wrong, he knew they were wrong, or at least should have known they were wrong, and deserves to be punished. But what is crazy to me is that Tom Hayes is currently serving an 11-year sentence in a maximum-security prison. And as far as I can tell, he is the only banker currently in jail for crimes committed during the financial crisis.

… One of the things I found interesting researching this book is that there are a lot of people out there, experts in law enforcement and criminal justice, who really think that the situation we’re now in is a direct result of a lack of ambition and creativity and guts among prosecutors in some of the biggest countries in the world, including the U.S. The thing is, prosecutors do not like to lose cases, so they’ve taken, in general, a very conservative approach to what cases they’re going to bring because they don’t want to gamble on losing. They’ve built up these very impressive win/loss records as prosecutors. Some of them are undefeated. And they boast about that.

To me, that’s a really unhealthy sign, because the thing that would scare some of these bank CEOs is not losing some money or losing their jobs; it’s the prospect of being perp-walked in front of TV cameras in handcuffs, or the prospect of possibly losing your liberty in front of a jury of your peers. That is a terrifying thing. To me, the great missed opportunity of the financial crisis was that prosecutors didn’t do that a single time with a CEO or a top executive of any major financial institution. They might have lost those cases, but at least it would have struck some fear in the hearts of people. That’s just a tremendous missed opportunity, in my opinion.

Knowledge@Wharton: You got access to all kinds of data in the course of doing this book. Going through it, were there times where even you were surprised at the lengths that these bankers were able to go to?

Enrich: Yes, absolutely. I got access to basically an entire hard drive’s worth of evidence that prosecutors had collected — everything from emails and chat transcripts to recorded phone calls and personnel records for dozens of traders and brokers who were involved in this scandal. And one of the things that was really fun about this book, the goal was for it to read almost like fiction or like a thriller, not like a banking or finance book. So there’s a ton of personal stuff in here about what was motivating these people on an individual basis.

To me, it was staggering seeing just the kind of depths of depravity that some of these bankers and traders demonstrated, some of the completely amoral, unethical things they were doing. But at the same time, it was really interesting to see how, on the one hand, these guys would be having a phone conversation bantering with their colleagues about the prostitutes they were out with the night before, and the next moment, their phone rings at work and it’s their wife on the line, complaining that the guy screwed up the DVR and Law and Order didn’t record properly. It’s this combination of wild antics and then mundane normal life. It’s just a reminder that these are all human beings, and that these aren’t institutions committing crimes. These are individuals who commit crimes and individuals who are affected by their institutions’ cultures. It was really interesting for me as a journalist to see this all connected to human faces.

Knowledge@Wharton: I understand that you still stay in touch with Tom Hayes family. What have they said, or what has Tom said, about the fact that he’s the only guy in jail?

Enrich: He’s furious. Furious doesn’t even begin to describe it. He is in a deep, dark, angry depression, just raging at the world. His wife, Sarah, who is a lawyer by trade, is a little more emotionally balanced, I would say, than Tom. … It’s enraging for them. They’ve got a little boy, a little son, who is growing up at home without his dad. And it’s enormously painful and enormously difficult for them. Again, I’ve developed a lot of sympathy for them and their situation there. I do want to make clear that he is not an innocent victim here. He is someone who was participating, and he was not acting properly. He was acting illegally, and I think deserves to be punished. I just find it galling that he is alone in being punished.

“My concern is that as memories of these massive penalties fade … the pressure is going to return for banks to amp up their profits.”

Knowledge@Wharton: What we’ve seen since this story played out is that there doesn’t seem to be any concern in the banking industry that there are potential situations where people could actually go to jail. Obviously, Tom Hayes did in this case, but it appears they don’t feel like there’s any cause for fear or concern at this point.

Enrich: I’m not sure I agree with that, actually. I think the culture of the industry has actually changed quite a bit in the past few years, partly as a result of how severe and stiff the penalties have been that are imposed on the banks. The ultimate people who drive behavior at banks are actually the shareholders. And right now, the shareholders of banks are very worried about banks getting slapped with multibillion-dollar fines.

My concern is that as memories of these massive penalties fade and memories of the crisis fade, the pressure is going to return for banks to amp up their profits. As that becomes the priority among shareholders, it’s going to become the priority among senior executives. At that point, the cultural stuff goes out the window, and the No. 1 priority once again becomes just making as much money as quickly as you can.

And we’ve seen how that movie ends — it ends with envelope-pushing being the norm and being encouraged. It leads to people breaking the rules. It leads to normal people being hurt. And it leads to big scandals and crises that engulf the industry, and that’s not in anyone’s interest.

Knowledge@Wharton: You talk as well about the personalities involved in this, and the fact that Tom Hayes, out of all the people involved in this process, was leading one of the calmest lifestyles. Obviously, anyone who has seen The Wolf of Wall Street has a little bit of an idea about what that Wall Street lifestyle can be. And a lot of the other bankers and traders who were around Tom Hayes in this behaved something like that.

Enrich: This is part of the reason I love Hayes as a central character for this book — because he’s not your cookie-cutter banker out of central casting. This is a guy who is much happier going home after a day of work and having a bucket of fried chicken and an orange juice and watching Seinfeld reruns than he is going out to Michelin-starred restaurants or a swanky club. To me, his massive social awkwardness — the fact that he would go to a dinner party, and sit next to a stranger, and start talking to her very loudly about his dandruff problem — he had no idea how to behave in normal society.

That makes him slightly endearing as a character, I think, but it also kind of helped explain how he stumbled into this. He was just completely unable to pick up on any subtle cues or social boundaries that normally would help moderate someone’s behavior. That makes him the perfect guy to emerge at the center of a scandal like this, because he just has no filter and no ability to distinguish shades of gray.
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  #86  
Old 03-26-2018, 07:27 AM
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https://www.bloomberg.com/news/artic...ebut-quicktake

Quote:
America's Libor Replacement Is Ready for Its Debut

Spoiler:
Regulators around the globe began work on replacements for Libor, the London interbank offered rate, well before the U.K.’s Financial Conduct Authority set to put the beleaguered interest-rate benchmark out of its misery. In the U.S., enter the Secured Overnight Financing Rate, or SOFR, a new reference rate being introduced next week by the Federal Reserve Bank of New York in cooperation with the U.S. Treasury Department’s Office of Financial Research. The debut of SOFR is a critical step in a quest to wean more than $350 trillion of securities off Libor.


1. Why the push to replace Libor?
For decades, Libor provided a reliable way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s derived from a daily survey of about 20 large banks that estimate how much it would cost to borrow from each other without putting up collateral. Because fewer banks make such unsecured loans, Libor was becoming more theoretical than real. That was vastly compounded by the discovery of rampant manipulation by U.S. and European lenders that were forced to pay billions of dollars to settle rigging and other charges. All this is why the FCA pledged to stop compelling firms to provide estimates by the end of 2021, and why regulators around the world are rushing to establish alternatives.

2. How did the U.S. come up with SOFR?
To develop and implement a replacement for the dollar-denominated version of Libor, the Federal Reserve in 2014 set up the Alternative Reference Rates Committee (ARRC), which brought together representatives from the private sector and regulators. By May 2016, the committee had narrowed the search to two options: the New York Fed’s overnight bank funding rate, and a rate based on repurchase agreements, which are transactions for overnight loans collateralized by Treasury securities. After a series of roundtables, and with feedback from advisory groups, the committee identified the latter -- SOFR -- as the best candidate.

3. How does it differ from Libor?
Where Libor relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money-market funds, asset managers, insurance companies and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets. It’s an overnight rate, based specifically on overnight loans; Libor, by contrast, covered loan maturities ranging from one day to one year. And the volume of trading underpinning SOFR is significantly larger: In 2017, it regularly exceeded $700 billion daily, versus an estimated $500 million for three-month dollar Libor, according to ARRC data.

4. When will the change take place?
The New York Fed will start publishing SOFR (as well as two other repo-based rates) on April 3, around 8 a.m. New York time. The rate will reflect transactions from the previous day.

5. What comes next?
The ARRC is instituting a six-step plan that includes the creation of various derivatives based on SOFR. Along those lines, CME Group Inc. plans to launch monthly and quarterly SOFR futures on May 7, pending regulatory review. Development of a derivatives market is critical, because without a deep and liquid one, regulators won’t be able to create longer-term SOFR-based reference rates, a key goal in expanding usage among market participants.

6. Is the market ready to dump Libor for SOFR?
So far there’s been a degree of complacency in reducing long-term exposures to Libor, according to NatWest strategist Blake Gwinn. ARRC has established working groups in order to get credit-based market participants to adopt fallback language in contracts for products such as loans and mortgages in the event Libor stops being reported. That’s a first step toward the eventual goal of getting firms to make SOFR their benchmark of choice.
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Old 03-26-2018, 08:49 AM
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SOFR so good.
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Old 03-26-2018, 08:54 AM
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Nobody is really paying attention to this across the pond.

Until they build a liquid enough market, thus hitting longer terms...I don't see companies jumping ship from LIBOR.
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Old 03-26-2018, 09:44 AM
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SOFR so good.
The first thing that popped into my head reading this is that future exam 9 TIA users may get the impression that rates are benchmarked by couches.
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Old 04-11-2018, 06:14 PM
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Mary Pat Campbell
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https://www.bloomberg.com/view/artic...when-it-s-gone

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Banks Will Miss Libor When It's Gone
Spoiler:
SOFR vs. Libor.

Libor, the London Interbank Offered Rate, is a lot of things. It is the standard interest rate for floating-rate loans: If a company borrows money at a rate that resets every three months, the rate that resets every three months is normally Libor. (Well, Libor plus a spread: A company might borrow at, say, Libor plus 3 percent or whatever.) It is the reference rate for trillions of dollars of interest-rate derivatives: If you are making some sort of bet on the future of interest rates, there's a decent chance that the interest rate whose future your betting on is Libor. Beyond that, it was -- it's not really anymore, but for a long time it was -- the standard "risk-free rate" that people would use in financial models for pricing other derivatives; if you bought, say, a call option on Microsoft stock, the formula for valuing that call option has a spot to plug in an interest rate, and the interest rate you'd plug in was probably Libor. Almost every part of the financial world was touched by Libor; it was plausibly "the world's most important number"; it was just part of the atmosphere, a basic given of the financial system.

But deep down, at its origins, Libor was a simple risk-management tool for banks. The classic business of banking is borrowing short-term to lend long-term: Banks take deposits (short-term loans), and give out business loans and mortgages and stuff (long-term loans). If you borrow short-term and interest rates rise, you soon have a higher interest bill. If you lend long-term and interest rates rise, you don't get paid any more interest on those long-term loans. But if you instead lend long-term at floating rates -- if you reset the loan rate every three months -- then you do get paid more when interest rates rise; your interest-rate risk is reduced.

Even better, though, if you lend long-term at Libor, then you really reduce your interest-rate risk, because Libor is notionally the short-term rate at which banks themselves can borrow. Libor, in its original form, was meant to represent the banks' cost of getting money to make loans, and Libor-based loans were a simple cost-plus model of lending. If a company borrowed at Libor plus 3 percent, then that meant more or less that the bank would pay Libor to get money, and lend it to the company at Libor plus 3 percent, and so lock in a profit of 3 percent on the loan.

There is an obvious conflict of interest here, which is that Libor is calculated by surveying the banks to see what their cost of borrowing is, and the banks get paid on their loans based on Libor. So there's a simplistic incentive for the banks to respond to the survey "yeah our cost of borrowing is 30 percent, weird," so that Libor will be really high, so that they'll get paid a lot of money on their loans. It is a curious historical fact that that never really happened. Oh Libor absolutely was manipulated, but the manipulation wasn't really for the dumb simple reason that overstating your costs in cost-plus lending model will make you more money. Instead, as Libor became a vital reference rate for interest-rate derivatives, the banks' derivatives traders pushed their Libor submitters to manipulate Libor, up or down, depending on their positions. And then, as Libor became a proxy for the health of the banking system during the financial crisis, the banks' executives pushed their Libor submitters to understate Libor, to make them look healthier than they were.

This manipulation was bad enough that Libor fell into disrepute, and regulators and market participants demanded a replacement, and slowly and creakily some replacements are coming online. In the U.S., the preferred replacement is the Secured Overnight Financing Rate, or SOFR, which the Federal Reserve Bank of New York started publishing this month, and which is "a broad measure of the general cost of financing Treasury securities overnight." Libor is notionally the interest rate that banks pay to borrow money unsecured from each other for a night or a month or three months or whatever; SOFR is the interest rate that you pay to borrow money secured by a Treasury bond overnight. The advantage is that banks don't really borrow money unsecured from each other in all of the Libor tenors, so the Libor numbers are unavoidably made up; the repo market -- the market for borrowing secured by Treasuries -- is quite robust, so SOFR is based on real transactions and thus much harder to manipulate.

But change is hard. Here is a fascinating post from Joe Rennison at Alphaville about how hard it will be to replace Libor with SOFR in the floating-rate loan market: Interest-rate derivatives markets are relatively willing to transition to SOFR, but "Libor has some features which work for the $4.1tn syndicated loan industry that are less crucial to the derivatives industry."

There are at least four distinct things going on here. One is that there are a lot of existing loans that reference Libor, and they're not going to magically become SOFR loans overnight, so it will be a long time until SOFR replaces Libor as the most common reference rate for loans. (Or derivatives for that matter.) Another is that there are a lot of people -- bankers, lawyers, corporate treasurers -- who are used to Libor, and who will grumble a bit at having to change their documents and look up a new loan rate. These are both real and important social problems in the adoption of a new reference rate, but they're not particularly financially interesting.

A third issue is that SOFR is an overnight lending rate, and no one wants a floating-rate loan that floats every day. Floating every three months is okay, but you want a little bit of predictability; you want your interest costs locked in for at least a quarter. Rennison:

SOFR is an overnight funding rate that resets every day, whereas Libor measures a bank's cost of borrowing cash over different periods (one month, three months, six months, etc).

Corporate borrowers say that Libor's term structure provides more predictability and helps them manage cashflow. And because no predictable term structure for SOFR exists just yet, treasurers will need to either stick with Libor until one is provided -- or grapple with the uncertainty of paying interest based on a daily rate.

This does not strike me as an especially substantive problem. It's easy enough to build a three-month SOFR. A confession: When I was a banker, I thought for an embarrassingly long time that there was a thing called "five-year Libor." There is not. (The longest Libor is 12 months.) But there are interest-rate swaps that reference Libor, and there's a five-year swap in which I pay you a fixed rate and you pay me six-month Libor every six months, and that swap trades quite liquidly and is a good market reference point, and it is effectively an extension of Libor out to five years: The fixed rate on that swap is the fixed rate that buys you five years' worth of Libor. For many practical purposes -- figuring out what sort of rate a company should pay on a five-year bond, for instance -- that swap rate really works like five-year Libor.

Similarly, if SOFR really becomes the standard reference rate for interest-rate derivatives, then it will not be a problem to find a fixed rate that buys you three months' (or whatever) worth of SOFR. And in fact that rate is coming pretty soon:

The CME's launch of SOFR futures might help, since the contracts measure the compounded cost of interest over a three-month period. But there is still a difference between futures estimating a three-month borrowing rate and an actual three-month borrowing rate.

Eh, not really; a thing that lets you pay a fixed rate in exchange for three months' worth of overnight rates really does give you a three-month rate. (Here is CME Group's description of the SOFR futures, and the contract specification.) And it seems to me that there's no special trick about writing a floating-rate loan contract where the floating rate is not overnight SOFR but the three-month SOFR rate determined by the futures. A floating-rate loan indexed to SOFR itself would be annoying for a corporate treasurer, but a floating-rate loan indexed to three-month derivatives indexed to SOFR would be fine. And three-month SOFR, like actual SOFR, and unlike three-month Libor, would be computed by real market transactions rather than guesswork. (One hopes -- of course the SOFR futures market might not take off.) Derivatives markets might have made Libor unsustainable, but they could also make SOFR work.

But there is a fourth issue, which is that Libor was fundamentally a risk-management tool for the banks, and SOFR isn't. Rennison hints at that issue here:

The derivatives industry appears intent on moving away from Libor. If it does so before the loan market can figure out a way to create a long-term SOFR rate, it would create an entire new basis market between Libor and SOFR.

Say Company Z gets a loan from a bank and then hedges out its interest-rate risk in the derivatives market by putting on an interest-rate swap (let's say receiving the floating side). The company would have a basis differential between its Libor-based loan and its SOFR-based hedge. But problems could easily arise if the financial system comes under stress. ... Its Libor-based loans would push up its borrowing costs in a banking crisis, while the payments it would receive from its SOFR-based swap would fall, as rising demand for Treasuries would depress overnight rates.

So, yes, if companies borrow at Libor and hedge at SOFR, they will effectively take on the risk that banks' funding costs rise. But that problem doesn't go away if companies borrow at SOFR and hedge at SOFR. Instead it just becomes the banks' problem. Banks ... well, they don't exactly borrow at Libor, do they, but they borrow at something like Libor. They borrow at the rate at which banks borrow. Libor was meant to measure that, and that measurement broke down, but the point is that banks do more or less fund their business, at the margin, by short-term borrowing. If they make floating-rate loans indexed to Libor, and their cost of funds rises because people start worrying about the banking system, then their lending income will automatically rise, and they will be hedged. But if they make floating-rate loans indexed to SOFR, and their cost of funds rises because people start worrying about the banking system, then their lending income won't automatically rise -- it will probably fall -- and the problem will get worse. Libor gave banks a useful safety valve; it's a shame they ruined it.
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