Libor Manipulation: Calculating Damages

Last week, in our blog posting entitled Libor and the Public Interest, we discussed what National Public Radio has called the biggest scandal in the world. Of course, NPR was referring to the Libor manipulation scandal, a scheme that dwarfs the other controversies that are now roiling the financial services industry.

And we don’t use the word “dwarfs” lightly. After all, within the past week, we learned that traders at JP Morgan Chase may have hidden losses from CEO Jamie Dimon that are now expected to exceed $7 billion. We also discovered that HSBC laundered several billion dollars for Mexican drug cartels. And we were told that the bankrupt Peregrine Financial Group misappropriated over $200 million in client investments.

Nevertheless, what of the news that over a dozen global banks have been manipulating the Libor rate that continues to be used around the world to establish interest charges on variable loans? It affects every citizen who holds a variable mortgage, credit card, line of credit, or small business loan. It also affects billions of dollars of corporate debt instruments, issued by global corporations, that utilize the Libor rate to calculate interest charges.

Extent of the Profits

By how much did the banks profit during this scandal? Well, a single bank with a $10 billion debt position (or portfolio) that successfully moves the daily interest rate 0.1% in a favorable direction could earn an incremental $10 million that day. If ten of the sixteen banks that define Libor earn similar profits on that day, the colluding group could earn a collective $100 million.

And what if the same group repeats the tactic one hundred times in a year? The annual collective profit of the group would equal $10 billion. And the counter parties on the “flip sides” of those transactions, i.e. individuals and organizations that are unfavorably influenced by such moves in the daily interest rate, would thus lose $10 billion per year.

As a point of comparison, the entire Centers for Disease Control and Prevention of the United States — the government entity that protects the American public against maladies from HIV / AIDS to influenza epidemics — received $10.6 billion in total funding last year (i.e. in fiscal 2011). It’s no wonder that Time Magazine has suggested that the Libor scandal may be considered the crime of the century because of its immense scale.

Proving Damages

With profits that are so significant, and with commensurate losses incurred by others, one would think that it should be easy for aggrieved parties to sue the banks and collect damages. Surprisingly, though, plaintiffs would be advised to proceed cautiously before filing lawsuits.

After all, the Libor mechanism serves to summarize the interest rates that each global bank estimates it would pay if it borrows funds from other banks in the City of London. Yes, Libor focuses on estimates that each bank would pay as opposed to the precise rate that each actually pays, and the hypothetical interest percentage if each bank chooses to borrow, as opposed to the real amount when each bank actually borrows.

In other words, each bank’s daily Libor quotation represents an educated guess, as opposed to an actual report. In order for a plaintiff to estimate damages, though, he would need to calculate the interest rate that each bank would have quoted if it had no incentive to manipulate the rate. But if the Libor quotations only represent rough estimates and educated guesses, how can any plaintiff establish what an unbiased “actual” rate would have been for a particular bank on a certain day?

The Trouble With Proxies

There are always “proxies” available for any statistic, including (perhaps) credit default swaps for unbiased Libor rate quotations. According to a Connecticut government report, “a CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs … the buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment …”

When independent investors believe that a global bank is more likely to default on its borrowings, they bid up the market price of the CDS that is designed to pay off in the event of a bank default. And because such a bank might expect to pay a higher risk-adjusted interest rate on its borrowings, some commentators believe that plaintiff attorneys can use fluctuations in CDS values as proxies for appropriate Libor estimates.

What is worrisome about this belief? Simply put, the CDS market itself is prone to manipulation by wealthy investors. A single large investor can drive up the value of a single CDS, at least temporarily, by making a large strategically timed purchase. So by using CDS values as proxies for Libor values, a plaintiff’s attorney would simply be substituting one manipulable statistic for another.

Clearly, it will not be easy for plaintiff attorneys to calculate damages. And without such calculations, it will be difficult for courts to require banks to pay awards.