Last week while watching Bloomberg TV early in the morning, I noticed a headline scrolling across the bottom of the screen. The headline reported that tiny Berkshire Bank (BERK) had filed a lawsuit against some of the worlds largest banks including Bank of America (NYSE:BAC), Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Barclays (NYSE:BCS). BERK is contending that they suffered material financial damage as a result of suppressed libor rates.
Talk about David versus Goliath. Berkshire Bank has a market cap of about $120 million. When compared to the size of the defendants named in the case that appears to be about as fair a fight as a mosquito taking on a grizzly bear.
Initially, I dismissed the lawsuit as somewhat frivolous; however, upon further reflection I believe that BERK and thousands of other tiny regional banks can successfully argue that they were adversely affected by suppressed libor rates. Further, it seems to be a slam dunk that federal prosecutors will be able to establish that the money center banks colluded to falsify rates in light of Barclay's (NYSE:BCS) recent admissions. That would pave the way for liability suits. To quote James Cox, a law professor at Duke University in Durham, N.C: "Libor could well be the asbestos claims of this century."
Libor and its Effect on ARM Interest Rates
Libor (London Inter-Bank Offer Rate) can be defined as the interest rate that banks charge each other for loans. The rate is generally determined in euro dollars and is applicable for large loans with a duration of anywhere from one day to five years.
Libor rates are instrumental in calculating the interest rates on many adjustable-rate mortgages (ARMs). Many ARMs consist of a small fixed rate plus a libor adjustment. The higher the libor rate the higher the interest rate and vice versa. Approximately one half of all ARMs are tied to libor rates.
Are you starting to get the picture? The suppression of libor rates materially affects the interest income of thousands of small banks like BERK. Lower libor rates mean lower interest payments on adustable-rate mortgages which directly damage the profits of a lending institution.
The following graph depicts the history of one-year libor rates in the last ten years:
The downward libor-rigging is alleged to have occurred during the height of the financial crisis in late 2008 and early 2009. The above graph reveals that libor rates dropped precipitously in late 2008 when the credit crisis was at its paramount. Ironically, the alleged false reporting of actual lending rates between banks during the credit crisis was a gift from heaven for many U.S. home owners who had tied their mortgages to adjustable rather than fixed rates.
Investing and the Libor Scandal
What exactly does the lawsuit filed by tiny BERK mean for the regional banks? It means that thousands of small regional banks now have a potentially large intangible asset on their balance sheets. More importantly, it means that the mega banks have an extraordinary potential liability on their balance sheets, although the breadth of that liability will not be known for years.
Should investors rush to sell their shares of the large banks or indiscriminately buy up the tiny regional banks? Obviously not. What investors should do is take the opportunity to search for potential bargains in the tiny thrifts and regional banks throughout the country; particularly ones which are selling at historically low price to book ratios.
The market has been less than kind to many of the smaller banks based upon their minuscule spreads which has resulted in historically low returns on equity. The low returns on assets and equity have resulted in low price to book ratios in many of the small bank stocks.
Catalysts for the Small Banks
The small banks have several catalysts which have nothing to do with the potential the windfall of the libor scandal which exists well out in the future. Those catalysts include a return to profitability and a recovery in the U.S. housing market.
As the U.S. housing market improves, many small banks have been able to reverse their loan-loss reserves while returning to operational profitability. As rental rates increase, the benefit of home-ownership for consumers who are able to attain financing will magnify. Eventually new home starts will accelerate as regional inventories are cleared, aging houses are eliminated from the market and the U.S. population increases.
Small banks which possess sound balance sheets while trading at historically low price to book ratios offer extraordinary value for patient investors. Many of these small banks will reinstate dividends after TARP money is repaid and their operational profits accelerate.
In the case of BERK, I anticipate that they will reinstate their dividend in the near future. The bank remains extremely overcapitalized and its majority owner Moses Marx currently holds about 70% of the outstanding stock. Marx has not collected any dividends since Oct. 31, 2011, when his preferred shares converted to common stock.
The recently filed lawsuit makes a sale of the bank unlikely; therefore I believe that shareholders will soon be rewarded by a reinstatement of the dividend in the not-too-distant future.
Disclosure: long BERK