The Libor Scandal: Costs and Victims
David R. Kotok
July 17, 2012
Readers are seeing a series of Cumberland commentaries about the Libor Scandal. We do not intend to bore you. We do intend to explore it in detail, from various perspectives, seeking out the nuances, and asking as many questions as we answer.
Why are we doing this? We believe the Libor scandal is systemic and worldwide. It is not idiosyncratic to Barclays. The UK has seven other firms under investigation right now. Barclays was the first to reveal a settlement. The nature of the settlement itself indicates that the scandal is huge.
The implications of the Libor Scandal are significant in many ways. They will certainly alter the global direction and scope of regulation and supervision. The outcome will not be known for years. There are good reasons why Fed Chairman Bernanke used words like “weakens confidence” and “fundamentally flawed” in his testimony today. We was asked repeatedly about the Libor Scandal. Note how he could not give “full assurances” to Senators that Libor pricing today was trustworthy.
There are multiple questions and issues involving different national jurisdictions. My colleagues and I have already written about some differences between the US and the UK. However, the Libor-setting entities include banking institutions worldwide. Libor-type, rate-setting mechanisms are in place for the world’s major currencies. The investigation is underway in several countries, not just the US and the UK.
The amounts tied to Libor are monumental. That suggests the claims asserted by plaintiffs in class-action suits are likely to be enormous. We expect the alleged damages to be in the trillions.
What happens when those claims are resolved over time? Who pays whom? How much? Some estimates suggest the claims will be a severe blow to the banking system, require recapitalization of certain large banks, and lead to a new version of TARP. We think that is extreme but, of course, no one knows at this juncture. The worst-case estimate has Congress capping the liabilities of US-based banking institutions. Others suggest similar actions will take place in Europe and elsewhere. Who knows?
The best-case scenario is that there is no liability. We see many arguments being proffered to blunt the plaintiffs’ attacks. Some argue that the Libor-setting estimates were just that: estimates. There were warnings to that effect. They say that these were not fraudulent transactions. The trimmed-mean method means the high and low are not included in the final pricing, so a bad estimate is in the group that is thrown out. In due time, we will find out how valid these arguments are. At Cumberland, we doubt these defenses will prevail.
In the end, legal systems around the world will be making decisions on liabilities. They are different systems and their legal constructions are quite distinct as to the nuances.
Let me offer a thought-provoking calculation. Many estimates center on $350 trillion in derivatives, securities, and debt pricing tied to Libor. Assume that number is correct. Suppose a claim is asserted by a class action that ultimately results in a judgment of 1 basis point in damages. That’s right, for this example we will assume only a single basis point. One basis point on $350 trillion dollars is a very large sum. It is $35 billion. That is the damage for only one year. The Libor Scandal covered many years.
The highest estimates of total global exposure to US-dollar Libor are close to $850 trillion. Some claims are asserting that the Libor-rigging distortion was as high as 80 basis points. Remember, this was a multi-year scandal and these are the numbers for one year. Bottom line, the liability is potentially quite large. Also, remember: these are estimates for US-dollar Libor. What about the other currencies?
At Cumberland, we believe that this Libor scandal involves two elements. One of them is the retrospective of how the system operated in 2007-2009. We already see evidence of disclosure of things we did not know existed. My colleagues have been working on them, so I will not repeat them here. See www.cumber.com for the Libor-related commentaries.
Other issues with the Libor Scandal involve other asset classes. For example, we know billions in US housing-finance mortgages are tied to Libor. That number has been estimated as approximately $275 billion and covers an estimated 900,000 mortgages. Cumberland staff is among the potential plaintiffs. Do those borrowers have a claim? Were they overcharged? Were they undercharged? If they were overcharged, did the recipient of the payments have a windfall? Should it be returned? Is there a claw back provision that would be implemented by a judge in the settlement of the claim?
What about the foreign exchange market? Libor is instructive, indicative, and relied upon in order to set foreign exchange rates and the placement of funds. Global corporate treasurers look at two things (or at least they did): the Libor maturity schedule from one day to one year, and the foreign exchange market forward rates for the same period of time. The corporate treasurer has to decide in which currency he will deploy cash. Does he deploy monies in Currency A or Currency B; which way does he maximize his yield? He then goes to his commercial bank and puts on the position that is perceived to be the most beneficial to his company. In many cases, that bank is also on the Libor-setting committee for one of the currencies. Some of those banks are primary dealers with the Federal Reserve. The positions taken are transactions based on good faith. For years, they were “trusted.”
What if one of those rates is rigged? The whole game changes. Billions may have been deployed based upon assumptions that are now questioned.
Our Cumberland team will explore these issues over the coming weeks and months. We need to know what was real and what was rigged – that is obvious. We also need to know what indicators, what tests, what market-derived pricing was faulty. For example, if you depended on the TED spread to make your stock market investment decisions in 2007-2009, you may have made decisions on faulty information. Now you know that information is suspect. You are aware that activities in the UK were/are flawed. You also know that the system of governance has not been changed. Can you depend on these market-based indicators today? If not, you should be questioning other indicators as well.
Where does this end? None of us knows. This is an unfolding revelation. We are going to learn piece-by-piece as the onion layers are peeled back.
We will close this commentary with a personal note. We feel badly for some of our friends at Barclays and at other firms. Those individuals had nothing to do with the Libor Scandal. They are economists and analysts and they do excellent research. They publish some of the finest work in the world. They are now likely to feel some angst because their institutions have been tainted with reputational risk. From our conversations, we know that they carry psychological pain.
To them we add this note. You did not do anything wrong. You did your best in the research sphere. You assessed economics and finance. You reviewed published market data. You did so in good faith. Now, you have to carry a burden that you did not create. That is unfortunate. You, too, are a victim of the Libor Scandal.
To be continued…
David R. Kotok, Chairman and Chief Investment Officer