LIBOR Pains: What's the Impact?
August 3, 2012
As legal eagles-including regulators, cops and attorneys-continue to swoop down for the kill in the wake of the LIBOR debacle, asset managers still struggle to gauge the scandal's impact on their investments.
Depending on who you talk to, this damage might be measured in the billions of dollars-ranging from at least $35 billion to $349 billion, according to one team of analysts. Or, according to others, it may be impossible to find any impact.
Consider these opposing opinions on the Libor scandal.
"This is a massive issue," says Elle Kaplan, chief executive and founding partner of Lexion Capital Management. "This is so large in scope that it, on some level, touches everyone."
"It really has not had an impact,...it just hasn't," says John Lekas, manager of the Leader Short-Term Bond Fund.
The stakes, of course, are enormous. It has already cost Barclays $450 million to settle charges related to the matter with American and British regulators. At least a dozen banks globally face escalating regulatory investigations, document seizures by police and potential lawsuits by investment juggernauts such as BlackRock, Fidelity Investments and the Vanguard Group. At least eight subsidiaries and funds of discount brokerage giant Charles Schwab & Co. have already filed two lawsuits on the matter against 11 LIBOR-participants last year.
In a statement sent to Money Management Executive, a BlackRock spokesperson wrote that "We are closely following the investigations as well as related litigation to assess the full implications and possible impact these events may have had on our clients and the cash markets."
So if there were damages, where would they be found?
First off, consider the size of the market potentially impacted. According to the Commodity Futures Trading Commission, over $800 trillion in securities and loans are linked to the Libor.
The most obvious victims would be mutual funds focused on debt securities, particularly short-term, says Michael Kraten, assistant professor of accountancy at Providence College. In particular, he says, fund managers using derivatives like interest swaps as risk hedges might be "significantly impacted."
"These 'hedgers' might well represent the saddest victims of the LIBOR scandal. After all, they were investing in these assets in order to reduce (i.e. hedge) their risk, and instead they would up magnifying their risk," he says.
How much could returns have been hurt? The Schwab suits allege that LIBOR rates may have been suppressed by as much 40 basis points.
Patrick Morris, chief executive of quant shop Hagin Investment Management in New York, says the scandal may have an impact on the ability of financial firms to sell debt instruments.
He says that the products that should be most negatively affected will be any high-leverage trade that is based on a carry, where you borrow and pay interest in order to buy something else that has higher interest.
Currency strategies could also be affected because many currency derivatives are tied to LIBOR.
The hardest to spot would be complex derivative trades, since the values of components of, say, an interest-rate swap could rely on a specific LIBOR rate. Moreover, volumes may drop and rate volatility could increase as it becomes more difficult to price some debt.
Morris doubts that the intent of the LIBOR fixing was true fraud and more likely was meant "to keep some liquidity around in more difficult markets." However, he said, "like all things it is a slippery slope and I am sure that some traders and funds acted much more maliciously with the intent to pad performance and returns."
"Keep an eye on the monthly returns of top managers to see if there is sudden dramatic slippage. If the fix was their only source of return then it could get ugly," he says. "Of course even if you see odd moves and sudden negative returns, no one will admit the cause."
An analyst team at the investment research firm Keefe Bruyette & Woods, led by Mark Phin, estimates the potential damage from the scandal to be at around $349 billion, based on outstanding notional interest-rate derivatives for the relevant time period of the LIBOR suppression.
The team came to that figure by assuming a four-year period, 2007 to 2011, for the alleged LIBOR suppression. They also assumed that the rate wasn't suppressed all the time, perhaps just 25% of the time. They also assumed a 20-basis-point suppression.
However, Phin's team noted that litigation on these matters could take several years, and in the end could lead to settlements much smaller in size than the claimed damages. If plaintiffs only get 10% of the damages sought, that would translate into $35 billion.
Also, the team said, plaintiffs will have their work cut out for them proving the Libor impact on investments.
"Correlations alone are not incontrovertible and we believe the burden of proof will be high," they wrote in a July report.
Indeed, Lekas, who manages the Leader Short-Term Bond Fund and whose team invests in a variety of Libor-products, says that if there was a big problem related to the alleged Libor-fixing, then these rates, "after the cat got out of the bag, should have gone up."
"That didn't happen," he said.
Lekas also believes that as investigations continue into the LIBOR scandal, a more complicated picture of what happened will emerge and that governments will also bear some culpability for what happened.
"The governments were well aware of what was going on. They were just trying to lower rates. They just don't have a Central Bank. They were using Libor," he says.