The potential victims of the Libor scandal are starting to estimate the costs to their bottom lines.
In its settlement with Barclays earlier this year, the Justice Department said that those who manipulated interest rates at the bank knew their activities hurt others.
The traders who rigged the London interbank offered rate “understood that to the extent they increased their profits or decreased their losses in certain transactions from their efforts to manipulate rates, their counterparties would suffer corresponding adverse financial consequences with respect to those particular transactions,†the Justice Depart ment said.
Now, a new report indicates that Fannie Mae and Freddie Mac, the mortgage entities that the government bailed out and now controls, may have suffered big losses related to the manipulation.
Rate-rigging may have cost the two firms more than $3 billion over just less than two years, according to a preliminary study from the inspector general's office that oversees the Federal Housing Finance Agency, Fannie and Freddie's regulator. The study was first reported by The Wall Street Journal.
What is especially interesting about the watchdog's report is that it lays out an easy-to-follow road map for calculating potential Libor losse s.
It starts on the assumption that the overall effect of Libor manipulation was to make the interest rate lower than it would otherwise have been.
When markets were declining from 2007 to 2010, banks benefited from a lower Libor because it made it look as if they could borrow cheaply from each other. The banks faked Libor to increase confidence in themselves. In addition, the banks' own individual trades often benefited from an artificially low Libor, though the manipulators also made money by fixing Libor higher.
The study by the inspector general's office starts out by estimating how much lower Libor would have been without rigging. It does that by comparing Libor with a very similar interest rate, called the Eurodollar deposit rate.
Before the market turbulence, the two rates had been very close, the study says. But then, during the financial stress, Libor became lower than the other rate, a lot lower for a short period in 2008.
In the repor t, the inspector general's office then tries to work out what Fannie and Freddie's cash flows would have been if Libor had continued to be in line with the Eurodollar rate. A low Libor meant that Fannie and Freddie were effectively underpaid on certain swaps and overpaid on others. They would also have been underpaid on Libor-linked bonds. The net result was that Fannie and Freddie experienced a cash shortfall of over $3 billion, according to the inspector general's office.
The office acknowledges the exercise is not exhaustive, and suggests other financial instruments owned by Fannie and Freddie that could have been affected by Libor manipulation.
Clearly, in this exercise, so much depends on whether the Eurodollar deposit rate is a strong proxy for Libor that was not manipulated. The comparison between the rates has been made in Libor-related lawsuits, the inspector general's office notes. “It's a perfectly good place to start out,†said John Sprow, chie f risk officer at Smith Breeden Associates, an asset management firm.
Of course, financial firms may have balance sheets that don't look like those of Fannie and Freddie. An overly low Libor may have meant they were overpaid.
Still, the inspector general has done the financial sector a favor. It now has a rough-and-ready template for assessing Libor losses.
Federal Housing Finance Agency's Office of the Inspector General memo on Libor
