Here’s a fun Libor lawsuit: the ghost of problematic former hedge fund FrontPoint is suing the Libor banks for (1) selling FrontPoint some interest-rate swaps and (2) manipulating Libor in a way that hosed FrontPoint on those swaps. Here is the complaint and here is Alison Frankel on the legal issues, which are interesting and which we can talk about a little below.¹

Up here let’s talk about the trades that FrontPoint (and Salix Capital, which now owns these claims) is suing over. They’re interest rate swaps, of course, where FrontPoint received Libor, and where Libor was systematically manipulated lower by banks looking to enhance confidence in themselves by showing lower funding costs. But those swaps were part of a larger negative-basis package trade where (1) FrontPoint bought bonds (funded at a spread to Fed Funds), (2) FrontPoint bought CDS from a bank to hedge credit, and (3) FrontPoint entered into a swap with the bank to hedge interest rates. Schematically, when everything cancels, it looks like this:

If you asked FrontPoint what the trade was they might say “we are betting that the negative basis in these bonds will converge, making the bonds worth more relative to the CDS,” or alternately, that they would just ride the trade to maturity, getting paid that negative basis, and “earn a risk-free return by buying and selling the same credit exposure via alternative instruments in different markets.” That’s what the trade is primarily about: that orange thing in the lower-right-hand corner labeled “(Basis).” Read more »