Mortgage Financing Could Depend on LIBOR

LIBOR? What’s LIBOR?

It may be an obscure question to some, but it’s important enough that homeowners may need to know the answer in the not-too-distant future when they choose a mortgage.

The U.S. Treasury this month stops selling 52-week bills, the benchmark for setting rates in a relatively small but key adjustable-rate loan market for mortgages that are popular with first-time home buyers.

Lenders are considering replacing the bill with other pricing mechanisms such as LIBOR--the London Interbank Offered Rate, which top international banks charge one another for large loans--to set rates for adjustable-rate loans.

For consumers there could be a bite.

LIBOR rates usually are higher than one-year Treasury bill rates--by less than half a point to 1.33 percentage points over the past two years--implying that consumers could pay more for adjustable rate mortgages (ARMs) linked to LIBOR.

“They will have to rethink how they go about pricing adjustable rate loans,” said Steve Davidson, an economist at America’s Community Bankers, an industry trade group.

The key will be the margin that lenders charge over LIBOR to set the final consumer rate. David Beadle, a mortgage consultant based in Boston, said that for a standard one-year ARM product, lenders in recent years typically added 2.75% to the one-year Treasury-bill rate.

So at today’s Treasury-bill rate of 4.73%, a mortgage would be 7.48%. But one-year LIBOR rates are at 5.19%, so a loan using the same margin would be at 7.94%.

For six-month LIBOR-linked mortgages, the margin recently has been lower--2.00%.

A study conducted by America’s Community Bankers found that 77% of 220 community banks, who are active mortgage lenders, use the U.S. Treasury market to price financial products. As a result, a change in the benchmark would have widespread effects.

Using LIBOR presents some challenges to lenders who already overwhelm many consumers with a complex mound of paperwork that comes with any loan application.

“A majority of the people don’t understand what LIBOR is and how it is computed. It is very difficult to get a customer to buy into the argument that your rate is indexed off of somewhere in London,” said Anand Bhattacharya, executive vice president at Countrywide Capital Markets.

ARMs are a small but critical piece of the mortgage loan market because they are favored by first-time home buyers who can qualify more easily for them than for 15- or 30-year fixed-rate loans.

In recent years, use of ARMs by consumers has fallen because fixed-rate mortgage rates--except for brief upward spikes--have been at record lows.

ARMs’ share of the mortgage market--now around 10%--was as high as 69% in December 1987 when the rate on U.S. fixed-rate mortgages was 10.64%.

In the week ended Feb. 2, 30-year fixed mortgage rates were 7.19%.

Meanwhile, some mortgage finance experts said other new benchmarks besides LIBOR will have to be developed for adjustable rate mortgage loans. One option might be calculating a synthetic rate based on the midpoint between the Treasury’s six-month bills and two-year notes.

A spokesperson for Fannie Mae, the nation’s largest provider of housing finance, said the agency “has not yet determined what index we will use but that is under consideration.”