The Leading Edge of Bad Bank Behavior

The balance between risk and reward is one of the defining characteristics of investing. But what happens when risk seems unlimited while reward is severely curtailed? Barclays (NYSE: BCS  ) just released its third-quarter earnings, and while the bank lost some money, the bigger news was its announcement of two new investigations into its business. That realization came just days after Barclays was drawn into LIBOR fixing litigation in the U.K. Guardian Care Homes has accused the bank of false and fraudulent representation. Here's a rundown of the charges and what investors should look out for.

Barclays vs. Guardian Care Homes
On Monday, while the U.S. was holed up against one of the biggest storms ever to hit the East Coast, in the U.K., Barclays was holed up in a court room. The bank, which has been the first formally accused of rigging LIBOR, is now starting to see some trickle-down litigation. In its initial state, Barclays was fined by both the U.S. and the U.K. for manipulating the LIBOR to both make itself look stronger and to earn more money from its investment bank. But the LIBOR rigging didn't just affect governments, and with trillions of dollars in worldwide investments pegged to the LIBOR, it was only a matter of time until those smaller investors starting to fight back.

Guardian Care Homes was the first to step up and make its case. The company manages retirement and assisted living homes in the U.K., and it's suing Barclays for close to $60 million, alleging that the bank missold interest rate swaps a few years ago. The reason this is coming out now is that the swaps were related to the LIBOR.

How interest rate swaps work
The mechanics work something like this. A company needs to take out a loan from the bank, which means that it's going to be charged interest on the amount borrowed. Usually, the interest rate that it pays is tied to some metric, like LIBOR. So the business normally agrees to pay LIBOR plus 2%, and away they go. But there's a big problem there for the business. If interest rates go up, as they tended to do before the crash, then the company pays more and more. So the banks offer them an interest rate swap agreement with the loan. Instead of paying LIBOR plus 2%, the company pays a fixed interest rate (maybe something like today's LIBOR plus 2.5%). The bank charges them a fee for the swap, and then it can go on to sell that floating rate to a different party.

It seems like a great system to hedge against interest rate rises, and it is. But it doesn't protect against falls. What's happened to borrowers who took out these swaps is that they've watched interest rates fall down to near zero, while they're still paying 2007 LIBOR plus 2.5%.

Back to the action
Guardian is challenging the validity of these interest rate swaps, saying that because they were predicated on LIBOR, and LIBOR was rigged, the swap should be nullified. That would mean that Barclays would owe Guardian all of the excess interest that the company paid due to the fixed rate swap. Barclays initially argued that the case should be dismissed since the terms of the swap didn't specify how LIBOR was set, but the judge dismissed that idea.

If Guardian is successful, it opens Barclays up to litigation from all of the businesses that it sold LIBOR swaps to during the period leading up to the crisis. That's a huge sum of money, and the damages that could come through at the end of the day have the potential to seriously harm Barclays. Right now, the bank has set aside close to $725 million to cover losses from swap litigation, but that may not be enough. With this first case aiming to collect $60 million, and with thousands of small business potentially affected, the end cost could easily exceed the pot that the bank has put aside.

The extended fallout
Barclays was the first company to be held culpable for the LIBOR rigging, but the general consensus is that almost every bank involved in LIBOR setting was fudging the numbers to some extent. That means that Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and JPMorgan (NYSE: JPM  ) are all facing some sort of backlash. Whether that will extend to lawsuits from the private sector remains to be seen, but if the fate of Barclays is a parable for the other banks, they might want to start setting cash aside.

As far as I can see, none of the big banks has done anything to engender customer or investor confidence recently. But that doesn't mean that they can't turn things around. Even Barclays has a chance of survival, and its work with regulators has gone a long way to help its professional -- if not public -- image. So far, no American banks have been found guilty, but there's a long way to go before this is all over. To keep an eye on Bank of America, consider signing up for the Motley Fool's premium report on the bank. It lays out all its strengths and flaws in one place, and introduces you to the key areas that investors must watch. Click here to sign up for your copy today.

Fool contributor Andrew Marder has a retirement account with Barclays, but does not own any of the other stocks mentioned in this article. The Motley Fool owns shares of Bank of America, Citigroup, and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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