Tim Geithner, Libor Manipulations, and the Bailout of AIG

At last week's hearings on Capitol Hill, Secretary Geithner was asked repeatedly about why the Fed used LIBOR even as it was purportedly trying to fix the LIBOR-setting process. If the Fed had really believed that LIBOR was fundamentally broken, presumably it would not have employed the benchmark in its own contracts. The Fed's use of LIBOR fit nicely into its efforts to make financial institutions look stronger than they were - which is exactly the same thing the banks were rumored to be doing when they underreported their borrowing rates for purposes of LIBOR.

Assuming that the banks actually were successful at manipulating LIBOR downwards, the Fed's use of the benchmark in its bailout loans was a conveniently subtle way to ease the terms of those loans. In contrast to most lenders, the government wanted to lend money on terms favorable to its borrowers. The government was looking to prop up failing institutions, not make a profit.

The AIG bailout, which the Special Inspector General for TARP reminded us last week is still a more than $30 billion item on the taxpayer tab, is a case in point. In September 2008, the federal government came in with a LIBOR-based $85 billion loan after failing to convince Wall Street firms to devise a private sector rescue of AIG. The appropriateness of the interest rate benchmark the Fed used in its rescue of AIG is less important than the question about the propriety of rescuing a company potentially worth less than the money needed to rescue it.

Nobody stepped forward to save AIG, because the private sector concluded AIG was not worth saving. A JPMorgan Chase employee who worked on the effort told the Financial Crisis Inquiry Commission staff in a 2010 interview that "the value of the company in its entirety was not necessarily sufficient to cover the liquidity need that the company had." He explained that "that was an assessment that JPMorgan, Morgan Stanley, Goldman Sachs, working alongside the company and representatives of the Fed and the Treasury all came to" and shared with relevant government officials, including Timothy Geithner, then the President of the Federal Reserve Bank of New York. The Fed poured money into AIG, despite the fact that the experts analyzing the company had come to the conclusion that AIG likely wasn't a creditworthy borrower.

The law under which the Fed extended its loan to AIG required the Fed to make sure it was getting adequate collateral before making a loan. The Fed justified its decision not to rescue Lehman Brothers on the grounds that Lehman did not have adequate collateral to obtain a loan. Yet the Fed loaned tens of billions of dollars to AIG after learning that the collateral AIG had to offer was potentially insufficient for the company's borrowing needs.

The Fed knew that it was making a loan to a company that was in severe trouble, and that such a weak borrower would not be able to handle tough loan terms. Accordingly, from the perspective of the Fed as a would-be rescuer of the flailing AIG, a benchmark that was being set intentionally low would be preferable to one that reflected true market interest rates.

As it turned out, even with a purportedly artificially low benchmark like LIBOR, the Fed's initial loan terms were too tough for AIG to handle. The loan was restructured multiple times to make it more workable for the company. Eventually, the Fed handed AIG over to Treasury's Troubled Asset Relief Program, which afforded the government greater flexibility in modifying the bailout to meet AIG's needs.

The moral of this story is that government regulators - which were complicit in trying to make financial institutions appear healthier than they were during the crisis - are not the right folks to be fixing LIBOR. If the British Bankers Association can't solve the problems with LIBOR, the markets will turn to substitute benchmarks.