Saturday, July 7, 2012

Will governments bail out banks for $1+ trillion in losses related to rigging Libor?

Given that the banks that rigged the Libor interest rate could be facing well over $1 trillion in losses, will governments bail them out by a) mysteriously finding no other bank guilty of rigging Libor in the current investigation or b) injecting equity into them to cover the losses?

Let's look at the potential for losses.

According to an Economist magazine article, during a two year stretch beginning in mid-2007, banks may have been understating their Libor submissions by enough to result in Libor being 30-40 basis points (.003 to .004) lower than it should have been.

This doesn't seem like a very large amount until you consider the notional value of the assets, including loans and interest rate swaps, that repriced off of Libor.  During that period your humble blogger estimates that there were $300+ trillion of assets that repriced off of Libor (by contrast, today we have $900 trillion).

By definition, anyone who was receiving a payment based off of Libor during these two years lost money as a result of the banks rigging a lower Libor interest rate.  Therefore, it is appropriate to use the total assets that repriced off of Libor.

So the potential loss from rigging the market for the two year period is $1.8 to $2.4 trillion (calculated by multiplying $300 trillion by 2 and then either .003 or .004).

Now, let's compare the potential losses against the current meaningless book bank capital levels.

On second thought, let's not and simply remember that financial regulators suspended mark-to-market accounting on structured finance securities over concerns that a smaller loss would show the banks had zero book capital.

These potential losses represent a sizable problem for governments that are desperately trying to keep bank book capital levels up as they pursue the Japanese model for handling a bank solvency led financial crisis.  They cannot be swept under the table with regulatory forbearance or suspension of mark-to-market accounting.

As Walter Scott said, 'oh what a tangled web we weave when first we practice to deceive'.

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