LIBOR Related Lawsuits: How Do They Affect The Banks?

| About: Bank of (BAC)

Last week I wrote that Bank of America (BAC) seems to finally be putting one of its litigation related headaches behind it. This week brings headlines of a different litigation related risk in the form of the LIBOR related lawsuits. While not new, the implications of these lawsuits are only now starting to be understood by retail investors.

By now, everyone has read about the Barclays (BCS) settlement and watched Barclays CEO, Bob Diamond, testify in front of Parliament. However, I am not sure that investors recognize the impact this investigation is going to have on all the banks involved. Citigroup (C), Bank of America , JP Morgan (JPM), UBS, Royal Bank of Canada, and Lloyds Banking Group have already started getting sued in the U.S. and abroad.

These LIBOR lawsuits present a particular challenge for the banks because it is going to be extremely difficult for them to argue the facts. Each individual bank's settlement with government authorities is going to require them to admit wrongdoing. Most of these banks have already admitted to being under investigation. With UBS and Barclays already admitting wrongdoing and now co-operating with the authorities, the remaining banks will have little choice but to come to a settlement. Risking a criminal indictment is simply not an option for a bank.

As the New York Times described: "Settlements with the Justice Department require an admission of misconduct, not the more typical resolution in civil enforcement actions that come without any acknowledgment of violations." Further complicating the issue for banks, is the presence of whistleblowers who can confirm communication with other banks in setting the rates. Thus, its only a matter of time before we have settlements and admissions of wrongdoing. As more banks settle and documents are made public, the number of lawsuits is only going to increase. LIBOR is the reference interest rate for trillions of dollars worth of contracts. Anyone who has lent money out using LIBOR as a reference rate is going to claim damages.

Admitting wrong-doing to settle with the government however, opens the door to massive anti-trust and worse RICO lawsuits. Charles Schwab (SCHW) has already filed just one such suit against a bunch of banks. The City of Baltimore and the City of New Britain's Firefighters' and Police Benefit Fund has filed a class action lawsuit against Credit Suisse , Bank of America, JP Morgan, Citigroup and a host of others.

Banks are so far putting up a fight and asking the Judge to dismiss the class action lawsuit. This seems extremely unlikely to happen. An attorney (not involved in the case) is quoted as saying "Clearly collusion was going on. Clearly." What's worse for the banks is that now investors are thinking of opting out of the class to individually sue banks. This will drive litigation related costs much higher for the banks.

What's the big deal, you say? Banks always settle these lawsuit for pennies on the dollar? Well, RICO lawsuits are a little different. Because RICO lawsuits allow treble damages and for recovery of plaintiff's legal fees, plaintiff lawyers are going to be aggressive in their negotiations. Going to trial isn't an option because if the jury finds for the plaintiffs - each defendant can be held individually responsible for the total damages. Besides, when you are a big bank being sued by a firefighter's pension fund, I am not sure a jury trial is the best idea these days.

Retail investors are thus in for a wild ride with the LIBOR related suits.

For Bank of America investors, a small probability event is that Bank of America, which has not yet been implicated, somehow manages to have been the "honest" bank here. I am not holding out much hope on this one given the amount of trouble Bank of America was in during the crisis, I think the temptation to have done the wrong thing-- especially as they saw everyone else doing it-- will have been too great. Furthermore, a RICO lawsuit will probably result in Bank of America being held to the same standard as the rest of the banks.

Being long BAC, I am comforted by the fact that :

(1) I expect these lawsuits are going to take some-time to work their way through the system which will allow BAC to build some more equity cushion and begin reserving for the eventual payout.

(2) Management seems to have done a good job of handling the mortgage related lawsuits so can be trusted to make the right decisions on these lawsuits too for now.

(3) the bank continues to trade at a substantial discount to its earning power so has a substantial margin of safety built into it.

(4) It is TBTF.

Having said that, as we have heard numerous times, large banks are essentially unknowable. Outside retail investors are in a terrible position to accurately judge all the risk they are exposing themselves to when investing in one.

Disclosure: I am long BAC.