The recent decision to phase out the London Interbank Offered Rate has left banks that issue adjustable rate mortgages tied to the benchmark with plenty of uncertainty. But it is still unclear whether that uncertainty will turn into a quick headache that fades or a full-blown migraine.

Banker & Tradesman spoke with several community banks in Massachusetts that have issued a significant number of ARMs in recent years, according to data compiled by The Warren Group.

Some were more concerned about Libor’s imminent demise than others. But there was a consensus that ARMs are still effective products for the right borrowers, and that banks would keep issuing ARMs tied to Libor until it is phased out, or until regulators land on a new index.

“It’s going to be a significant matter for us as well as other banks that peg to Libor,” said Charles Nilsen, executive vice president and national director of residential lending at Boston Private, which ties its residential ARMs to Libor, as well as some commercial loans. “It’s four years away, but four years can go by quickly with something like this.”

The Changes

Libor, a daily rate set in London based on what banks think is the cost of borrowing from other banks, has been around since the mid-1980s and is used as a benchmark for the price of mortgages, loans and other financial transactions.

Shortly after the financial crisis, it gained unwanted attention when banks were caught manipulating the rate by submitting false data.

Regulators from the United Kingdom announced in late July that they would phase the rate out and transition to an alternative benchmark by the end of 2021.

Black Knight Financial Services Inc., a mortgage data and technology firm, says ARMs account for $1.33 trillion of mortgages outstanding, nearly 14 percent of the total market, according to a report in the Wall Street Journal.

Nilsen said banks will likely have to adjust the margin on new loans previously tied to LIBOR after the change, depending on the new index.

No one is certain what this new index will be, although various media outlets have reported that the broad Treasury repo rate and the Sterling Overnight Index Average are possibilities.

Banks were prepared for a situation like this, as most ARMs have a provision that reads something like the one on a uniform Fannie Mae/Freddie Mac adjustable rate note: “If the Index is no longer available, the note holder will choose a new index which is based upon comparable information.”

The switch could cause some commotion for ARMs initially tied to Libor through their first adjustment period. If the new rate is higher than Libor, banks win because they could potentially receive higher returns from borrowers on loan payments. If it’s lower, consumers win, because their loan payments could be lower.

Banks will also need to undertake a coordinated effort to educate borrowers about potential mortgage payment changes, as well as updating origination and servicing systems.

“The global market of loans tied to Libor exceeds $350 billion and is so liquid there will have to be coordinated acceptance of what is originated,” said Nilsen. “This goes beyond just having systems reset to change existing loans and loans held in securities. The holders of the mortgages and the borrowers will have to be on the same page understanding the changes and why.”

Don’t Freak Out Yet

David Gaffin, a senior loan officer at Fairway Independent Mortgage Corp., said he expects the new index to closely mirror Libor because the “last thing the regulators want is for consumers to have a payment shock and find out that they can’t afford to make payments due to the change in index.”

Patrick Sylvester, vice president of secondary markets at Arlington-based Leader Bank, which sells ARMs tied to Libor on the secondary market, said his biggest worry right now is educating the consumer so they are not surprised by a potential rate change or payment change.

But Sylvester and Gaffin both said that if the new index is not too far off from Libor, they don’t expect to see huge pushback, as the consumer tends to be more interested in the starting rate of an ARM and may sell or refinance prior to the first adjustment.

Gaffin said after the starting rate of an ARM, the next question is typically about rate cap adjustments – rarely do people ask specifically about Libor.

Since the financial crisis, ARMs now have greater protections in place to determine if the borrower can repay their loans when qualifying. ARMs continue to have interest rate and annual adjustment caps, but most lenders now qualify borrowers based on the worst-case maximum interest rate scenario.

If anything, Gaffin said, the consumer concerned about the ambiguous Libor situation may seek out an ARM tied to the U.S. Treasury Index instead.

Cape Cod Five Cents Savings Bank is another big originator of ARMs in Massachusetts, according to data from The Warren Group. Senior Vice President David Brennan said the bank ties all of its residential ARMs to the U.S. Treasury rate and has had very low delinquency rates.

“It’s been a good product,” he said. “We just felt that we wanted to stick to an index that the consumer would be able to understand.”