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Libor-RMBS suits: A ticking time bomb

RMBS investors pushback after losing on lower interest rates

September 3, 2013

U.S. banks could find themselves facing a slew of new litigation if investment companies begin accusing banks en masse of conspiring to keep Libor benchmarked interest rates low from 2007 through 2010.

Investors nationwide could have a bone to pick with all of the Libor-participant banks accused of setting the Libor benchmark interest rate too low—a situation that lowers an investor's ability to earn appropriate returns on residential and commercial-mortgage backed securities.

The risk of this type of litigation resurfaced this week.

A series of investment companies filed suit against Bank of America (BAC), Citi (C), JPMorgan Chase (JPM) and countless others involved in Libor, claiming banks conspired to keep the benchmarked Libor rate low, compressing returns for investors in RMBS and CMBS.

So what is Libor and could it really hit the banks hard considering the tens of billions in liability surrounding Libor participants based on some analyst estimations?

To understand the scandal, the market has to understand Libor. Libor is used as a benchmark rate for simple loans, derivatives and impacts an array of financial instruments from RMBS, CMBS, interest-rate swaps and short-term paper.

Principal Funds and other investment entities recently sued the mega banks and others over Libor in the U.S. District Court for the Southern District of Iowa Central Division.

The plaintiffs’ claim is simple in this case:

Unknown to investors like plaintiffs, from at least August of 2007 until at least May of 2010, defendants conspired to manipulate Libor and fix it at artificially low levels in order to reap billions of dollars in ill-gotten profits.

But a banking insider says don’t expect the banks to lose their shirts over Libor. It would be virtually impossible for banks to pay out on all of the alleged claims if market participants decided to sue on Libor-related investment losses. Not to mention, that despite disappointments over Libor, it’s history as a benchmark is rather nuanced.

"What happened? Obviously, there was manipulation and bad things happening, but the trouble is Libor is really not a market rate," an industry insider told HousingWire.

The Libor rate started out as a simple offer between banks in which they set the rate for extending credit between each other.

The insider added, "It’s an indication, not a firm price." But in modern times, he says lawyers, the public and bankers have come to consider it a market rate. The contractual construction may make this suggestion as well, but Libor, he notes, is not a solid offer price.

So is there a tailrisk that banks could face an influx of Libor litigation that will threaten their balance sheets? Maybe not. That would almost be impossible. The system simply would not allow it, the insider suggested.

"It’s not like these claims are without merit," he explained adding that, "if every buy-side investor who relied on Libor brought a claim, the banks could never pay it."

It is likely to be handled at a high-level and then tossed a bit aside.

"I think when this is all said and done, the banks will be disciplined," he assured.

The principals involved in the price fixing are already in trouble, but beyond that, it’s uncertain where Libor claims could go from here. The lingering question is whether judge's will let these cases sit and fester, considering the level of potential liability and the impossibility of allowing the banking system to repay it all.

"You could come up with judgments in the tens of billions of dollars, the banks don’t have the funds to pay that," the market insider said.

So for now, Libor claims sit on the sidelines with lawyers and plaintiffs waiting for a shot at the banks? But it’s unknown how a judge would really take on such a convoluted, risky issue.

A more likely outcome, the banking insider says, would be the banks either not paying at all or dishing out a smaller amount than expected.

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