• SmartMoney

Yes, the Libor Scandal Affects You

A liger is a cross between a lion and a tiger. Libor, on the other hand, is a daily approximation of what banks charge each other for loans.

It turns out only one of these things is real. Awkwardly, it’s not the one used to set prices on an estimated $800 trillion in global financial instruments, or $116,000 worth for each person on earth, ranging from complex derivatives to student loans. That’s a problem for holders of bank stocks – which includes just about anyone who owns a mutual fund or 401(k).

Barclays (BCS) agreed last week to pay $453 million to settle allegations that it manipulated Libor, which stands for London interbank offered rate. As The Wall Street Journal reported Thursday, it’s likely only the first: More than a dozen banks on three continents are under investigation.

Libor is compiled by asking up to 18 banks what they think they would pay if they needed money. Some banks may have submitted artificially low responses during the global financial crisis to give the appearance of high creditworthiness. Others may have tinkered with the reading to profit from trades, or avoid losses.

The Barclays settlement is affordable, at less than 7% of the company’s projected profits this year, but the size of legal claims it and other banks face is difficult to imagine. Trial lawyers will do their best to work out the sums, of course. Libor may have been subject to rigging for more than five years.

In Thursday trading, Bank of America (BAC) lost 3% of its stock market value, and JP Morgan (JPM), more than 4%. Investors are worried about more than possible legal claims.

The financial crisis, with its bank failures and taxpayer bailouts, led to regulatory attempts to rein in risky bank activities, even at the expense of profits. JP Morgan is now sorting through a massive trading loss–estimates range from $4 billion to $9 billion–that has raised calls for even stricter reforms.

Picture the public’s mood if the next round of losses stems, not from rogue trading gone bad, but from widespread dishonesty that pretty much had its desired effect.

Bank stocks already trade at a discount to offset some of their warts. The banking sector of the Standard & Poor’s 500-stock index sells for 12 times this year’s projected profit, versus 13 times for the broader index. The problem is that banks have gotten so complex that relying on those estimates takes deep faith.

Consider: Most analysts have trimmed their earnings estimates for banks of late, not because of the Libor scandal, but rather, because of weak investment banking trends. But on Thursday, Wells Fargo analysts boosted estimates on several big banks. Why? Because Moody’s slashed their credit ratings. See, lower bond ratings mean lower bond prices, which in turn mean that banks will record accounting gains for the hypothetical lower cost of buying back their debt.

Financials, which make up 14% of the S&P 500, have had a good year, all things considered. Before Thursday, ones in the S&P 500 were up 14% year-to-date, versus 9% for the broader index. Investors should now consider reducing their exposure to these stocks until more is known about possible liabilities connected with Libor.

For central bankers, rate-rigging may be part of the mission. For Wall Street bankers, it’s the clearest sign yet that the industry isn’t well.

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