Credit Crunch Digest

Credit Crunch Digest
July 2013

This issue of the Credit Crunch Digest focuses on the future of Libor; a large settlement between Citigroup and Fannie Mae; another lawsuit against the ratings agencies; the duties of custodial banks to investors who lost their investments with Madoff; non-bank designations of systemically important financial institutions; and the CFTC’s oversight of overseas swaps trades.

Libor Scandal

Litigation and Regulatory Investigations

Fraud and Ponzi Schemes

Government and Regulatory Intervention


Libor Scandal

LIBOR to Be Overseen by NYSE Euronext

The U.S. owner of the New York Stock Exchange, NYSE Euronext, will take over the running of Libor from the British Bankers’ Association, a trade body that had administered the rate since the 1980s. The focus for NYSE Euronext will be to restore credibility and integrity to Libor, as well as to ensure that it remains one of the most important global rates.  However, London will not lose oversight of the benchmark for the time being because the benchmark will continue to be regulated for now by Britain’s Financial Conduct Authority.  NYSE Euronext will begin administering the benchmark interest rate beginning in early 2014.  Although NYSE Euronext has not yet stated how it plans to restore credibility to the benchmark, one source said it would involve “a very strong governance and oversight regime,” which will include an oversight committee, as well as a code of conduct that would prohibit the sort of behavior that led to the Libor scandal of the past couple of years.  (“NYSE Euronext to take over scandal-hit Libor,” Reuters, July 9, 2013)

Litigation and Regulatory Investigations

Citigroup Resolves Claims With Fannie Mae in $968 Million Settlement

Citigroup has agreed to pay mortgage-finance giant Fannie Mae $968 million to settle claims on 3.7 million home loans that either defaulted or were at risk for defaulting as a result of the housing crash. The agreement covers not only those loans that are already troubled, but also any potential future claims that relate to mortgages issued between 2000 and 2012 and purchased by Fannie Mae. As part of the settlement, the bank will continue to service the mortgages included in the deal.  While a majority of the settlement amount is covered by Citigroup’s mortgage-repurchase reserves, Citigroup will be required to set aside an additional $245 million to cover the remaining amounts of the settlement.

Aside from the Citigroup settlement, the Federal Housing Finance Agency is independently urging banks to reimburse Fannie Mae (along with its twin, Freddie Mac) for losses incurred as a result of purchasing bad mortgage-backed securities in connection with lawsuits the agency filed two years ago against 17 large banks in a single day for selling $200 billion in subprime mortgages to Fannie Mae and Freddie Mac.  Several of those cases are still unresolved. (“Citigroup pays Fannie Mae $968M to settle mortgage claims,” The Seattle Times, July 2, 2013)

Ratings Agencies Targeted by Bear Stearns Liquidators

During the five years since the collapse of Bear Stearns, liquidators of two Bear Stearns hedge funds have sued Standard & Poor’s Rating Services (S&P), Moody’s Investors Services and Fitch Ratings in New York State court seeking to recover $1.2 billion in losses.  In targeting the three largest credit rating agencies, the liquidators allege misrepresentations surrounding the accuracy of their ratings on collateralized-debt obligations and residential mortgage-backed securities.

The principals of the two funds, now represented by the liquidators, were previously sued for securities fraud by the U.S. government, but were acquitted. The funds collapsed in 2007 and Bear Stearns fell apart the following year, at which time it was acquired by JPMorgan Chase & Co.

Although a full complaint has not been filed, the liquidators’ action against the ratings agencies mirrors the allegations brought by the U.S. Department of Justice in its action against S&P. The liquidators  filed their action shortly before the six-year statute of limitations for state-based fraud claims was to expire. (“Bear Stearns Liquidators Sue Credit Ratings Firms,” The Wall Street Journal, July 10, 2013)

Fraud and Ponzi Schemes

Madoff’s Trustee Lacks Standing to Sue Banks for $30 Billion

On June 20, 2013, the U.S. Court of Appeals for the Second Circuit ruled that Irving Picard, trustee for Bernard Madoff’s victims, may not attempt to recover approximately $30 billion from banks, including JPMorgan Chase & Co., HSBC Holdings Plc, UniCredit SpA and UBS AG, because he lacked standing.  Picard attempted to bring a claim alleging that certain financial institutions aided Madoff by ignoring red flags of fraud arising out of Madoff’s Ponzi scheme.  Picard sought approximately $19 billion from JPMorgan, $8.6 billion from HSBC and UniCredit, as well as $2 billion from UBS.  Applying the legal doctrine of in pari delicto, the Second Circuit ruled that Picard could not assert claims on behalf of Madoff’s investment firm and recover damages for fraud caused by the firm itself.

This 3-0 decision, unless successfully appealed, now limits the collective damages amount Picard has available for distribution to Madoff’s victims.  According to Picard’s website, he has recovered $9.35 billion of the alleged $17.3 billion of customer principal lost, but is still pursuing other avenues to recover an additional approximate $4 billion.  (“Update 3-Madoff Trustee Cannot Sue Big Banks, U.S. Court Rules,” Reuters, June 20, 2013)

Custodial Bank That Invested With Madoff Owes No Fiduciary Duty to Pension Fund Members

After 14 hours of deliberation, a federal jury in Hartford, Conn., found that the Westport National Bank and its parent company, Connecticut Community Bank, were not liable for Madoff investors’ losses where the bank served as just a custodian.  If found guilty, the bank’s liability could have amounted to as much as $70 million or $80 million in damages. 

This lawsuit was one of the first to focus on the duties of custodial banks in connection with Madoff’s Ponzi scheme.  During the trial, the bank argued that its contractual relationship with the plaintiffs only required the bank to perform ministerial duties, and it lacked any fiduciary relationship with the plaintiffs.  Moreover, because even the SEC did not catch Madoff’s Ponzi scheme, the bank argued that it would be impracticable to hold it to a higher standard.

Although the jury decided that the bank breached its custodian agreements when calculating its fees based on Madoff’s reports, rather than using the actual values of the assets, the jury ultimately determined that the plaintiffs did not prove they suffered any financial loss as a result.  The investor plaintiffs plan to file a motion to request a judgment in their favor, alleging that the jurors’ findings are inconsistent.  (“Bank in Madoff Case Settles With Some Plaintiffs and Gets Favorable Jury Ruling,” The New York Times Dealbook, July 18, 2013)


Government and Regulatory Intervention

AIG and GE Accepting “Systemically Important” Label; Prudential Appealing

On June 3, 2013, the Financial Stability Oversight Council (FSOC) proposed American International Group, Inc. (AIG), GE Capital and Prudential Financial Inc. be labeled as “Non-Bank Systemically Important Financial Institutions,” believing these companies have a direct effect on the United States’ financial stability and are deemed too big to fail.  Under the Dodd-Frank Act, being labeled as systemically important subjects the corporation to greater regulatory scrutiny.  Upon receiving this designation, companies have 30 days to appeal.

Without receiving a challenge from a company at the end of the 30-day mark, the FSOC then votes again to finalize such designations.  Both AIG and GE have already publicly remarked that they will not contest the FSOC’s decision.  Alternatively, Prudential stated that it is contesting the designation and plans to request a hearing.  FSOC must announce its final decision within 60 days of the appeal hearing.  (“Update:  AIG, GE Capital Won’t Appeal ‘Systemically Important’ Label,” Wall Street Journal, July 2, 2013; “Prudential Financial Challenges Its Label As Systemically Important; Nasdaq; July 8, 2013)

Potential Six-Month Phase-In Period for Swaps Trades Regulations

The U.S. Commodity Futures Trading Commission (CFTC) is contemplating implementing a six-month phase-in period for new rules under Dodd-Frank regarding overseas swaps trades.  Regulators around the world continue to debate the extent of the CFTC’s oversight into global markets despite the implementation deadline of July 12, 2013.  While international regulators allege the CFTC’s regulations imply that the United States cannot trust other international systems, Chair Gary Gensler proposes broad global regulations over swaps trades due to the risk placed on taxpayers when the trades flow back into U.S. companies.

Amid the debates, the CFTC scheduled a meeting for July 12, 2013 to vote on the rules that would regulate overseas swaps trades.  According to people with knowledge of the ongoing deliberations, the CFTC plans to announce a six-month phase-in period, rather than a sweeping overhaul of regulations, in order to test the boundaries of the agency’s international reach. Some banks affected by the new rules, such as JPMorgan Chase, have been critical of them arguing the new rules put them at a disadvantage when trading overseas.  (“U.S. Derivatives Regulator Weights Delay in Cross-Border Rule,” Bloomberg, July 9, 2013)