Bank derivative areas benefitted from Libor manipulation

According to a Reuters' article, Libor rate-fixing amplified the losses investors suffered on CDOs and, surprise, benefitted the banks.

This highlights a very important, unappreciated fact:  derivatives are a zero-sum product.  If the banks win, then someone else is losing.

By submitting artificially low rates, banks benefitted not only from creating the impression they were borrowing at a lower rate than they were, but from the impact the artificially lower rate had on their derivative books.

The manipulation of Libor rates increased losses for investors saddled with toxic assets in the financial crisis, say lawyers and analysts evaluating the prospects for litigation over the scandal. 

Many collateralized debt obligations (CDOs) were hedged with interest rate swaps, they say, and inflated payments on those swaps siphoned away money that should have gone back to investors. 

Moreover, many CDOs are structured so that counterparties to those swaps are paid first, even ahead of investors in the most senior tranches of the structures -- many of which were already performing badly in the throes of the financial crisis. 

"Especially for CDOs whose underlying pool of securities had to be 100% hedged, lower Libor meant ridiculously large payouts each quarter to bank counterparties -- up to $8 million to $10 million per year for some deals," said Guillaume Fillebeen, a director at PF2 Securities Evaluations, a consulting group focusing on CDO evaluations for hedge funds and other asset managers. 

"The burden of having this payment is essentially like having an extra senior tranche in the CDO. We are already engaged on a CDO-related Libor case with a law firm, trying to quantify how much the manipulation in the rate increased losses," Fillebeen said. 

"These are just the early stages. There will definitely be more litigation around this topic -- possibly a class action." 

The swaps contracts were widely used to hedge against interest rate mismatches between fixed-rate assets and floating-rate liabilities, or vice versa. 

In the typical fixed-to-floating interest rate swap embedded in many CDOs, the CDO structure agreed to pay out a fixed strike rate over the life of the contract, while the counterparty, typically a bank, paid back a floating-rate amount based on Libor. 

Investors complain that the CDOs' hefty fixed-rate quarterly payouts -- generally set at 5% or higher in 2006 and 2007 -- have far eclipsed the unfairly diminished Libor-linked floating-rate payments the structures received in return from the counterparties.

Legal experts say even a small increase in Libor from 2008 onward would have cut the CDOs' net payments significantly, freeing up more money for investors, many of whom were already badly burned when their securities turned sour in the crisis.

Many CDOs are still shelling out exorbitant quarterly payments, experts say, and senior noteholders probably suffered the most. 

"If the CDO was on the receiving end of payments based on Libor, and it was paid Libor plus 1% instead of Libor plus 3%, that's a major problem, because over several years the CDO got less than it should have," said Craig Wolson, a structured finance lawyer and consultant who specializes in CDOs. 

"Depending on the size of the interest rate swap, it could be real money lost," Wolson said. 

Or, in the case of the bank, real money gained.