The London Interbank Offered Rate (LIBOR) will no longer be published after June 2023. The transition to a different rate is expected to raise conflicts of interests among various parties, including borrowers, lenders, investors, and intermediaries. The Alternative Reference Rates Committee (ARRC) has proposed to transition adjustable-rate mortgages (ARMs) away from LIBOR to the Secured Overnight Financing Rate (SOFR) and rely on the five-year median difference between LIBOR and SOFR to create an adjusted benchmark.

NERA Global Securities and Finance Practice Chair Dr. Faten Sabry and Senior Analyst Ramisa Roya, et al. examine the method for adjusting the replacement benchmark between LIBOR and SOFR using almost one million ARMs originating between 2005 and 2007. Their empirical analysis demonstrates the need to account for differences between the benchmark rates based on contemporaneous differences between the rates, and does not necessarily support the choice of a five-year lookback period as proposed by ARRC.

The authors find that mortgage lenders usually set the prices of loans based on the contemporaneous values of the benchmark indices and not of their values over a historical time period as ARRC is proposing to do. Their results based on the analysis of almost one million adjustable mortgages from 2005 to 2007 demonstrate that margin values were selected to offset contemporaneous discrepancies between benchmark rates so that mortgage loans would have consistent costs to consumers. The historical pricing of mortgages does not support ARRC’s proposal to rely on a five-year lookback period to adjust the differences between LIBOR and its replacement rate. The analysis is applicable to other consumer loans, such as student, auto, and credit loans. The challenge until mid-2023 is developing a transition plan that mitigates the conflicts of interests in consumer loans.