Treasury Secretary Timothy Geithner was grilled by the House Financial Services Committee this morning about why he did not immediately alert Congress or the Justice Department about evidence that banks were manipulating one of the world’s most important financial benchmarks in early 2008, while he was president of the Federal Reserve Bank of New York.The London Interbank Offered Rate affects everything from the interest paid on credit cards and home loans to complex financial derivatives.
Evidence has surfaced recently that the NY Fed knew that banks were understating the rates at which they could borrow, and thus distorting LIBOR, in the lead-up to the financial crisis. According to documents released by the Fed, traders were submitting lower-than-realistic rates in order to raise the perception of their creditworthiness.
N.B.—Such manipulations appear to have had little connection to those perpetrated by Barclays traders on individual trades in 2006 and early 2007 revealed by Britain’s financial regulator in late June. For more on this, read our explanation of why there were really two different LIBOR scandals >
Why didn’t the Fed seek criminal investigations of LIBOR fraud right away?
Neither Geithner nor Fed Chairman Ben Bernanke would ever publicly admit it. But they probably didn’t go after LIBOR violators—or “get rid of LIBOR”—in 2008 because doing so would probably have led to the collapse of an already stressed financial system.
What most people fail to understand about LIBOR is that the basic securities it governs—Eurodollar futures—are the basis for the global financial system. This system allows banks to borrow money from one another and conduct international lending.
This system descended from an early system which used certificates of deposit (CDs) back in the mid-1980s, but since then evolved to dominate the way the world’s biggest lenders exchange money. While there are other rates that may be determined more accurately by a similar system, LIBOR is the dominant standard.
So there’s no way the Federal Reserve could just have told banks to stop using LIBOR, a solution that a handful of House Representatives suggested. There’s simply no back-up way the money system can function right now.
The world’s central banks are currently looking into ways to change this system—and we’ll probably hear about some of those methods after a meeting of such bankers in September—but for right now, we’re stuck with LIBOR, faulty as it can be.
More important, however, is the reason why the Fed did not immediately report that banks were manipulating this rate to criminal investigators. In reality, it is unclear that the Fed at the time had any truly concrete evidence that specific traders were submitting bad rates (Geithner and Bernanke have testified that they learned this later).
But even if they had known about such manipulation, pursuing immediate trials—or even reporting such abuse to Congress—could have collapsed the system at a time when banks’ creditworthiness was already under fire. Even whispers that a criminal investigation was beginning against one bank could have led wild investor speculation against it—not only because it would face litigation but because it would signal that the bank was more stressed than anyone believed.
Further, Fed finger-pointing would have alerted investors to the frailty of banks—the exact kind of weakness that the government soon after struggled to mitigate.
The banking system in the lead-up to the financial crisis was a tinderbox, and confirmation that stresses in the financial system had gotten so bad that banks had to deliberately lie about the rate at which they could lend could have ignited it.
Not to mention that artificially low rates had much the same effects as official policy easing would have had, something the Fed was already doing and arguably not quickly enough.
In short, the Fed probably accurately recognised LIBOR manipulation as a sideshow at that point, and left a more thorough investigation for after the crisis had subsided.
NOW READ: LIBOR EXPERT: The Fed Has Destroyed LIBOR >
If you can help us better understand this, are connected with LIBOR and related securities, or are involved in any current investigations, please contact Simone Foxman at [email protected] or call +1-646-376-6016 (U.S.).
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.