NEW YORK ( TheStreet) -- After stronger-than-expected earnings reports from U.S. banking giants JPMorgan Chase ( JPM) and Citigroup ( C), it's tempting for investors to question whether the worst is over for the banking sector after recent headwinds like Federal Reserve stress tests, ratings downgrades and a Eurozone slowdown. While the prospect of a banking and housing recovery augur well for the likes of JPMorgan, Citigroup and Bank of America ( BAC), financial sector investors may still be underestimating risks to earnings - as they have in the past. A rate fixing scandal that started with Barclays ( BCS) may extend to some of the largest banks in the U.S. and Europe, and stands out as a new and potentially titanic risk. However, amid those concerns and uncertainty over sector-wide earnings, pure-play investment banks like Goldman Sachs ( GS) and traditional lenders like Wells Fargo ( WFC) -Warren Buffett's largest bank sector stock investment - may avoid the next shoe to drop in the banking industry. Since Barclays settled a rate fixing probe with U.S. and U.K. regulators on June 27, the prospect of regulatory fines and civil litigation hangs over banking giants like Bank of America, Citigroup, Deutsche Bank ( DB), UBS ( UBS) and Credit Suisse ( CS), who also are involved in the setting of key short-term interest rates, otherwise known as Libor. Diversified european consumer and investment banking conglomerates like Barclays, Deutsche Bank and Credit Suisse are most exposed to revelations of manipulation in the rate setting process, according to a Tuesday analysis by bank research firm KBW. In the U.S., similarly structured banks like JPMorgan, Citigroup and Bank of America face the same risks. Among major banking conglomerates, KBW estimates that losses could range from $3 billion to roughly $6 billion, eroding capital and future earnings. The probe is significant because of the size of the market for Libor, which is used to set over $350 trillion in financial contracts, and for the reputational damages that the regulatory inquest may wreak on the industry. Already, the process of setting the rates has been criticized as being too opaque and giving far too much power to the world's largest banks. Meanwhile, a manipulation of the rates may have unfairly impacted the borrowing costs of homeowners, municipalities and corporations, as Barclays and others allegedly tried to manipulate rate fixings during the financial crisis. Nevertheless, it is investment banks like Goldman Sachs and Morgan Stanley ( MS) and consumer-focused lenders like Wells Fargo and US Bancorp ( USB) that don't face Libor related losses since they aren't among the institutions that set the rate, signaling that an escalating Libor probe could raise winners and losers among the most watched bank stocks. For financial sector investors, who've weathered a wrenching six months of industry-wide pessimism entering 2012, excitement after first quarter earnings and a recently muddied outlook for the remainder of the year, the probe may mark yet another unanticipated earnings drain. In fact, on Tuesday, KBW analysts led by Mark Phin estimate that banks involved in the process of setting Libor face an estimated $35 billion in total regulatory and civil fines.
The potential for billions in Libor-related losses looms large as a risk to capital and earnings for european banking giants, which are already threatened by an escalating Eurozone debt crisis and an economy that's set to contract in 2012 and grow at less than 1% in 2013, according to new estimates from the International Monetary Fund. Meanwhile, in a Tuesday hearing with lawmakers, Federal Reserve chairman Ben Bernanke, after being peppered with questions regarding the process of setting Libor and ongoing regulatory investigations, conceded that alleged manipulation is a big problem for the financial sector. Already, Barclays top brass including ex-chief executive Robert Diamond and COO Jerry del Missier have resigned and testified in front of British lawmakers. In the U.S., Congress is now also gearing up for an inquiry after the New York Fed revealed 2007 correspondence with Barclays traders alleging systemic manipulation. KBW's Phin estimates that Barclays, the Royal Bank of Scotland and Deutsche Bank face over 3 billion British pounds in liability, accounting for between 20% to 50% of each banks' respective Basel III capital build in coming years. In the U.S., KBW analyst Frederick Cannon estimates that JPMorgan and Bank of America face over $4 billion in prospective damages, while Citigroup's Libor losses may come in at $3.1 billion. For Citigroup and JPMorgan, that would wipe out roughly a quarter's worth of earnings after both banks beat earnings . Cannon estimates a $4.8 billion loss, or roughly $1.25 in earnings per share, while Bank of America's $4.2 billion loss would eat up 39 cents in EPS and a $3.1 billion loss at Citigroup would roughly match its second quarter EPS of $1, in losses that would cut capital by between 2% and 3.5% of each bank's tangible book value. "We believe any such settlements are years away," notes Cannon. A settlement over a span of years for the likes of JPMorgan and Bank of America may be both a blessing and a curse. On the one hand, Libor is unlikely to be an issue in 2012 and may only hit EPS years away. Still, the inquiry could remain an overhand in coming quarters and years. More importantly, investors may grow complacent to litigation risks only to be surprised when an earnings drain finally hits. "Remember the early days of the mortgage putbacks requests to banks by the GSEs and private label investors? In our view, the fallout from the LIBOR scandal is reminiscent of early days of the mortgage putback losses and reps & warranty worries that infected the banking sector and our gut is the news flow and subsequent volatility related to Libor will continue to weigh on the stocks for a while," wrote Nomura Securities analyst Glenn Schorr in a July 12 note to clients. While Barclays shares have tumbled since revelations of its manipulation emerged, Schorr added, "we're not sure this potentially large problem is "fully priced in" just because it's received a bunch of press so far," highlighting possible downside risks to JPMorgan, Bank of America and Citigroup shares. Still Schorr's conclusion is that like with mortgage putbacks, a high variance in expected Libor costs could weigh on financial sector stocks until actual costs are announced. In the case of putbacks, an estimated $54 billion in costs comes below worst case estimates of nearly four times that size. "We think there are a handful of reasons that the ultimate financial exposure could be less than worst fears," Schorr states. Although it's hard to handicap exactly how Libor related lawsuits and regulatory, civil and criminal inquiries will play out, investors may be wise to simply recognize that some of the largest investment banks and U.S. lenders like Goldman and Wells Fargo will remain untouched by the probe. For more on the contrasts between U.S. bank earnings and business models, see why Warren Buffet shuns investment banks. See why Barclays' scandal was born out of a derivatives bet for more on Libor litigation. -- Written by Antoine Gara in New York