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What is “Libor” and Why Is It Being Phased Out?

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RANDY FREDERICK: Libor—it’s a term you’ve probably heard before, but you may not know exactly what it is. Collin Martin, a fixed income strategist at the Schwab Center for Financial Research, joins me for the August 9 Schwab Market Snapshot to talk about some important changes that have been proposed for Libor, and how you might be impacted.
 
Welcome back, Collin.
 
COLLIN MARTIN: Hi, Randy, thanks for having me back.
 
RANDY: So, Collin, the London Interbank Offered Rate, or Libor, has been in the news lately. Now this is a really important rate, but I have a feeling most people are probably not that familiar with it. So can you tell us, what is Libor used for and why is it being changed?
 
COLLIN: Libor is a rate that banks charge each other for short-term loans. There’s a lot of different Libor rates out there based on different maturities and different currencies. The maturities range as short as overnight loans, and go out to 12-month loans. For U.S. investors it’s usually the U.S. dollar Libor rate that matters the most. And for a lot of our loans and investments based on Libor, three-month Libor tends to be the most popular.
 
Now Libor is actually being phased out now due to a scandal that’s hit the market over the past handful of years. It’s expected to be phased out by the year 2021. Libor is set by banks submitting their own estimate of what their borrowing costs are. And it’s come out that a lot of banks were manipulating those numbers—manipulating their estimates, for their own benefit. So by manipulating what their expected borrowing costs were, and therefore moving Libor in a certain way, their investments based off of Libor could therefore benefit. And they could make a profit on those trades.
 
Now over the years, regulators in the U.S., the U.K. and the European Union have fined banks a total of more than $9 billion dollars for this scheme.
 
RANDY: Well now, if I heard you correctly, it sounds like these changes aren’t going to be happening for about four years. So why is this important to investors now, and what does it mean going forward?
 
COLLIN: It’s important not for investors but also for consumers. Libor affects a lot of things we do in the world today. For borrowers, Libor influences and is referenced to a lot of home equity loans, auto loans, certain types of adjustable-rate mortgages. And then in the investment world, a lot of investments are based off of Libor. Things like investment-grade floating-rate notes, certain preferred securities and bank loans.
 
Now investors sometimes will invest in these types of products because their coupons will rise or fall with short-term interest rates. Now that’s advantageous when short-term rates are rising. Of course, if short-term rates fall, those coupon rates would fall with them.
 
Now there’s a lot of working groups out there that are coming up with potential alternatives. According to the Treasury Department’s Office of Financial Research, the New York Fed plans to publish a potential replacement sometime in the first half of next year. The proposed alternative will probably be based off of overnight loans that have U.S. government debt as collateral.
 
Now for now, Libor is still functioning as it has, and as it has for the past handful of years, so investments that track a various Libor index are still tracking that and should continue to do that in the near-term. But there are questions about what will happen going forward. Now a lot of investments that track Libor tend to be short-term in nature, so they could mature before this phase-out happens.
 
But, again, there are questions about investments that have maturities beyond 2021, and we don’t have a hard answer about what’s going to happen with them yet. It’ll probably depend based on the individual security and the terms of their prospectuses. Hopefully we’ll get more clarity as we get closer to the 2021 phase-out year.
 
RANDY: Thank you so much, Collin. It does sound like this is going to be a pretty big change. Listen, if you want to read more from Collin you can do that in the fixed income section of Schwab.com. And don’t forget, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely, own your tomorrow.

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Definitions

LIBOR – The London Interbank Offered Rate is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks.

(0817-7R8K)

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