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FrontPoint Partners Suddenly Remembered That Libor Manipulation Is What Caused Its Collapse

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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)."

But it's also about those other three boxes, which turned out to be more important than FrontPoint perhaps expected. The trade is not just a basis trade (bonds vs. CDS), it's a relative-funding-cost trade: FrontPoint paid its funding costs, and received, in the form of Libor, its bank's funding costs. They needed to have some rough relationship to keep the trade in business: if FrontPoint's funding blew out and the bank's didn't, then FrontPoint would lose money whatever the basis did. In a financial crisis FrontPoint's funding costs, unsurprisingly, increased; its bank's funding costs, surprisingly, did not. Or: they did, but they didn't flow into the thing - Libor - that was supposed to measure them.2

This led to poignant results: FrontPoint was paying fixed on the swaps, and as Libor collapsed in 2008, so did FrontPoint, as the mark-to-market on the swaps led to collateral calls. From the complaint:

Collateral support annexes attached to the Funds’ swap agreements permitted the party that was receiving net payments (here the Defendants) to request the party making net payments (here the Funds) to post cash collateral equal to the mark-to-market value of the swaps. Libor suppression caused substantial mark-to-market losses on the swaps. The resulting collateral demands would not have been made but for Defendants’ misconduct, and caused further harm to the Funds. Satisfying these collateral calls used up much of the Funds’ remaining liquidity. Redemption demands due to losses on the basis packages and the collateral calls led to forced sales of many of the bonds and early termination of many of the swaps on very unfavorable terms in November and December 2008. These forced sales locked in substantial losses for the Funds.3

One thing you could say against some Libor lawsuits is, well, I mean, okay, you would have had more money if Libor wasn't manipulated, but why should you have had more money? Libor was just a number, a variable that plugged into some contracts you had; the contracts just said you'd get paid whatever appeared on a certain Reuters screen at a certain time. Your bargain wasn't based on Libor being "right," as a reflection of where banks were lending to each other. In fact, in many cases you were probably using Libor has a rough-and-ready risk-free rate, which means that the manipulated Libor - manipulated to abstract away from bank credit risk - was more "right" than a "true" Libor would be. Why would you want your contract to reflect bank credit risk?

But that objection doesn't work for this trade! This was a trade that was, at least in meaningful part, about comparative funding costs: it was about Libor being the banks' cost of funding. If the banks systematically made Libor lower than their cost of funding, they really did screw FrontPoint, and about something that really was part of the point of its trade. FrontPoint's avenging ghost has a real grievance.

Salix Capital US Inc. v. Banc of America Securities LLC et al. [New York Supreme Court]
Shuttered FrontPoint hedge funds sue Libor banks for $250 mln fraud [Reuters / Alison Frankel]

1.Basically everyone was suing the Libor banks under the antitrust laws, for colluding to fix Libor, and those cases got dismissed on the theory that Libor setting was a collaborative process where they were supposed to collude. Roughly. I'm sympathetic to that decision, though not everyone is.

That was an attractive theory for lawyers because it meant that, like, every "consumer" of Libor could sue in a big class action, relying only on the colluding. But with the demise of that theory, and even before, people who actually had high-dollar Libor-based contracts (swaps etc.) with the Libor banks got the bright idea of suing the banks for breaching those contracts, because the contracts say things like "we won't break the law" and "we won't lie to you in connection with this swap," and arguably Libor manipulating (1) broke the law and (2) was a lie to the swap counterparty. That's basically FrontPoint's theory.

Freddie Mac filed a lawsuit on that theory and I was impressed by the cleverness but not exactly persuaded? It doesn't really seem like Libor manipulation was covered by the swaps contracts one way or the other. This may be fraudy but is it a breach of contract? Still that seems nitpicky; like, if you agree to make payments based on a financial quantity and then you illegally manipulate that quantity you really ought to owe your counterparty something.

2.An alternative way of thinking about that, from that paper ("Basis Package Relative Value") linked in the text, is to view the trade not as "hedge fund funding cost v. bank funding cost" but rather "bond issuer funding cost v. bank funding cost":

Credit default protection should never trade at a negative premium (i.e., at a sub-LIBOR level), as a negative CDS premium would imply that a protection buyer would be paid to own insurance against a credit event (wouldn’t it be nice if your insurance company paid you a monthly premium?). Cash bonds do not have any such limitation, and many cash bonds currently trade at or through LIBOR.

Given that default protection has a natural limit to spread-tightening potential, and that cash bonds do not have any such limitation, in some scenarios (particularly in a spread-tightening environment) the hedged cash position of a negative basis package may be able to increase in value more than the hedge itself. ... For example, consider a hypothetical basis package (buy protection/buy bond) where the cash bond trades at 10 bp and the CDS premium is also 10 bp (i.e., a basis of 0 bp). Suppose that in the future the demand for credit strengthens (improving credit quality, strong economic growth, little supply, etc.) and the bond rallies 20 bp (to LIBOR –10 bp). Credit protection will not be able to track this improvement fully, and, in this scenario, the package will have upside price potential despite being a hedged position.

That's from Fall 2004, so its scenario for "bond trades tighter than Libor" is "demand for credit strengthens." But in 2008, or now, you could think of it as "demand for corporate credit is less weak than demand for bank credit": why shouldn't an industrial company issue tighter than Libor, if Libor is just a measure of banks' cost of credit, and if the cost of credit for banks has skyrocketed? If that happens then bond spreads to Libor could move below zero, while CDS spreads (thought of, but not actually, spreads to Libor) can't move below zero, meaning that the bonds appreciate faster than the CDS and so FrontPoint makes money on the trade.

That scenario also falls apart if Libor is not "banks' cost of funding" but rather "just some nice number we wrote down."

3.As Frankel puts it in a parenthesis, "Others have linked the redemption demands to insider trading by FrontPoint principal Chip Skowron." Nobody's perfect.