By Ben Kaufman | March 6, 2020
LIBOR, the London Inter-Bank Offered Rate, was a benchmark interest rate underlying $800 trillion of financial assets. Then it came to light that LIBOR was being rigged by the bankers on whose expertise it depended—sometimes so that they could make millions defrauding struggling American cities, and sometimes just to score leftover sushi from their friends. Law enforcement got involved, Congress held hearings, a handful of people went to jail, and authorities across the globe issued more than $9 billion in fines.
When the dust from the scandal settled, regulators worldwide realized that the market previously underlying LIBOR had dried up, and that a new, safer index would need to serve as “the world’s most important interest rate.” In response, the Federal Reserve Board and the Federal Reserve Bank of New York formed the Alternative Reference Rates Committee (ARRC), a consortium of private and public-sector stakeholders tasked with finding a new global benchmark index.
The ARRC recommended the Secured Overnight Financing Rate (SOFR) as its preferred replacement to LIBOR in 2017. SOFR is based on actual transactions in the massive market for overnight loans backed by Treasury securities, making it more robust than LIBOR and less susceptible to manipulation.
But while recommending SOFR was an important step forward, the process of actually moving market participants away from LIBOR has been met with substantial foot-dragging from certain corners of industry, including from many firms involved in private student lending. This resistance has been especially pronounced where it relates to how the transition could impact companies’ bottom line, and several firms recently announced that moving away from LIBOR might adversely impact their profitability.
Private student loan borrowers are in the crosshairs of the LIBOR transition
Today, 3.3 million private student loan borrowers owe an estimated $80 billion in loans that reference LIBOR. These borrowers will face unique risks as the move away from LIBOR progresses, as they will have few protections to turn to if companies offload the cost of the transition onto them through an increase in interest rates.
This lack of protections is rooted in the fine print of existing private student loan contracts. Our review of these contracts suggests that they tend to give note holders broad discretion when it comes to picking a new index rate for loans that currently reference LIBOR, as well as the ability to readjust the loan’s margin upon adopting a new index. This opens the door for note holders to bump up borrowers’ rates to ensure that the transition from LIBOR doesn’t impact their cash flows, meaning that borrowers could ultimately pay thousands of additional dollars on their loans because banks blew up a far-off index rate.
Private student loan contracts sometimes require that the note holder’s chosen replacement index and the overall interest rate the borrower faces be “comparable” to what the borrower had before, but these contracts largely leave the term “comparable” undefined. For example, a recent student loan contract from Discover states:
If the 3-month LIBOR Index is no longer available, we will substitute an index that is comparable, in our sole opinion, and we may adjust the Margin so that the resulting variable interest rate is consistent with the variable interest rate described in this paragraph. If at any time the fixed or variable interest rate as provided in this paragraph is not permitted by applicable law, interest will accrue at the highest rate allowed by applicable law.
Only Discover’s “sole opinion” is given any weight, and no hint is given regarding what a new interest rate “consistent with” the borrower’s old one might look like. Similar language is present in several other LIBOR-based contracts we reviewed.
Private student loan borrowers need someone in their corner
At a time when borrowers desperately need a champion, the Consumer Financial Protection Bureau (CFPB)—the agency tasked with overseeing consumer financial protection laws—has failed to take several important steps to protect borrowers.
For example, the CFPB has failed to weigh in on what makes an interest rate or the index it depends on “comparable” to another. Should the CFPB continue not to act, note holders will be empowered to determine “comparability” on their own, affording them an unjust opportunity to offload costs onto borrowers.
Further, the CFPB has not made clear whether note holders will have to disclose changes to borrowers’ loan terms related to the LIBOR transition under the Truth in Lending Act. Should the Bureau remain silent, consumers will be left in the dark when consequential changes to their loans are made, leaving many to find out about the transition only after receiving an unexpectedly high student loan bill.
These failures would be bad enough on their own, but the scarcity of avenues borrowers will have in the event of harm stemming from the LIBOR transition makes them even more problematic. For example, private student loans already have fewer rights and protections than federal student loans, including lacking guaranteed access to alternative repayment options to mitigate financial shock. Private student loan borrowers are also denied access to the normal bankruptcy process. Further, student loan contracts frequently contain clauses that block borrowers from suing their lender under any circumstances, allowing companies to “sidestep the court system, avoid big refunds, and continue harmful practices.” With the CFPB on the sidelines, this lack of protections will ensure that borrowers have nowhere to turn in response to industry abuses around the LIBOR transition.
Meanwhile, industry voices—including many involved in student lending—are growing bolder in their touting of flawed arguments against SOFR adoption. This includes recent assertions that regulators should allow industry to adopt rates that fail to be based on actual transaction data or on a large, liquid market—meaning that they would suffer from the same flaws as LIBOR—as well as the claim that SOFR’s behavior in a stress scenario would make it unusable.
These arguments ignore the problems that led to LIBOR’s cessation, disregard realities of contemporary funding markets, and overlook the harm that would arise if interest rate risk were passed on to borrowers during economic shocks. But most importantly, they underscore the likelihood that industry will try to game the transition from LIBOR to their advantage—and to borrowers’ peril. Borrowers need someone in their corner to ensure that that won’t happen.
Demanding protections and answers for student loan borrowers
With each of these concerns in mind, the Student Borrower Protection Center, Americans for Financial Reform Education Fund, the National Community Reinvestment Coalition, and the National Consumer Law Center today raised concerns to the ARRC with various aspects of industry’s transition from LIBOR to spread-adjusted SOFR. In our letter, we urge the ARRC to protect borrowers from rate increases stemming from the transition from LIBOR, to demand greater transparency from industry during the transition, and to stand by the ARRC’s selection of SOFR as its favored replacement rate for LIBOR.
In addition, we are pushing for answers to the following critical questions:
- Will lenders adopt the ARRC’s recommended replacement rate (SOFR)? If not, what rate will they adopt, and why?
- When will lenders choose a preferred replacement rate?
- How will note holders determine whether a given replacement index is “comparable” to LIBOR?
- How will lenders ensure that any changes to borrowers’ rates “minimize expected value transfer based on observable, objective rules determined in advance ” in accordance with the ARRC’s guiding principles? Simply put, can borrowers be sure that they won’t pay more on their loans after the transition from LIBOR?
- When note holders choose a new replacement rate, how much notice will they give consumers before it is implemented, and how will they do it?
- Will the ARRC introduce a spread adjustment to SOFR gradually over a period of a year or more, lowering the possibility of rate shock for borrowers during the transition?
- Once a new rate is adopted, how will note holders and servicers communicate with borrowers regarding changes to their rates and monthly payment obligations?
- Will the CFPB finally provide appropriate guidance to industry on how transitioning from LIBOR may necessitate certain disclosures under the Truth in Lending Act, and/or around the definition of “comparable”?
- Will the ARRC stand by its commitment to SOFR by debunking flawed arguments against its adoption?
The story of LIBOR does not end with spread adjustments, nor with student loan borrowers. Instead, the transition from LIBOR stands to impact all American taxpayers through its role in the Special Allowance Payment program (SAPs), an interest rate subsidy for private holders of older, government-guaranteed student loans. The program has historically been the target of gamesmanship and illegal profiteering at the taxpayer’s expense.
The Higher Education Act stipulates that the Department of Education may use LIBOR to determine SAPs, leading certain industry players to recently disclose the possibility of losing SAP cash flows due to the LIBOR transition. This raises the significant question of how firms that previously enjoyed corporate welfare through SAPs will recoup their losses. If history is any indication, their solution is likely to involve an attempt to reach into the public coffers. Congress must step in to ensure that taxpayers do not bear the brunt of industry malfeasance. Congress must also vigorously oversee an industry that has exploited lax oversight of these payments before.
Overall, one thing is clear: student loan borrowers neither caused nor called for the end of LIBOR, but—as the institutions that hold their debts look to pad their profits—they are at a unique risk of being the ones who pay the price for its demise.
Ben Kaufman is a Research & Policy Analyst at the Student Borrower Protection Center. He joined SBPC from the Consumer Financial Protection Bureau where he worked as a Director’s Financial Analyst on issues related to student lending.