WASHINGTON — It’s an obscure statistic with an unwieldy name, but the furor over alleged manipulation of a key global interest rate is mushrooming into one of the worst-ever scandals to hit Wall Street.
The London Interbank Offered Rate, or Libor, is a benchmark used to set interest rates for trillions of dollars of consumer loans, including mortgages and credit cards. Criminal prosecutors in the U.S. and other countries are investigating whether major banks rigged Libor to boost profits.
Aside from potentially costing the banks tens of billions of dollars in penalties and legal settlements, the scandal is tarnishing the banking industry’s already soiled image. Analysts worry that it is further eroding the faith of investors and consumers whose confidence in Wall Street has been worn thin by repeated scandals and punishing stock-market losses.
“The basic business of banking is trust, and if we don’t trust banks their business model is broken,” said Karen Petrou, co-founder of research firm Federal Financial Analytics. “Do I invest in your mutual fund? Do I trade stocks with you? Or do I just keep my money under the mattress?”
The complex nature of Libor makes it difficult to determine the effect on individual consumers. But in a measure of the potential broad impact, prosecutors in New York and Connecticut are reportedly examining whether they suffered losses on financial products that states use to manage their debt.
“It’s a level of crime that’s almost hard to believe, even in light of what’s known about the egregious conduct of Wall Street,” said Dennis Kelleher, chief executive of Better Markets Inc., a nonprofit group advocating for financial reform.
“People throughout the United States are thrown in jail for decades for robbing convenience stores or mugging somebody,” he said. “Those crimes pale in comparison to what these people did here.”
The fallout from the scandal shifted to Washington on Wednesday when Treasury Secretary Timothy Geithner told lawmakers he acted appropriately as president of the Federal Reserve Bank of New York when he learned during the 2008 financial crisis that Libor could be manipulated.
Despite the concerns, Geithner said he and other Fed officials felt it was not a problem to use the rate to set the terms for the $182-billion bailout ofAmerican International Group Inc.and a $1-trillion emergency lending program called the Term-Asset Backed Securities Loan Facility.
“We, like investors around the world, had to take advantage of the rates available at that time, and we chose Libor at the time like many others,” Geithner told the House Financial Services Committee as he testified for the first time about the rate-rigging scandal.
Geithner said it was not clear whether taxpayers paid more for those bailouts because the interest rate could have been rigged. But Rep. Jeb Hensarling (R-Texas) said he didn’t understand why the Fed used Libor to set the terms of those bailouts given concerns that it was not legitimate.
“How can a number that you know has been manipulated, how can that possibly be the best choice?” he asked Geithner.
Geithner said that all the Fed knew at the time was that the rate was vulnerable to manipulation, but the agency decided it still was the best rate to use. “I think that was the right choice back then,” he said.
Libor is a measurement of the interest rates that banks charge one another for loans. The institutions report their rates, which are averaged together to calculate a single figure that is used as a yardstick for an estimated $350 trillion of loans and other financial products.
The problem is that there’s limited government oversight of the process, and banks have a financial incentive to artificially adjust their rates up or down to maximize their own profits.
Federal Reserve Chairman Ben Bernanke called Libor “structurally flawed” last week and suggested it should be replaced by other measures.
British investment bank Barclays in June agreed to pay $450 million to settle rate-manipulation charges filed by U.S. and British officials, and its chief executive resigned under pressure. The British banking giant was alleged to have submitted bogus rates, in part to make itself appear financially sound during the 2008 global financial crisis.
The House Financial Services Committee has launched its own investigation into allegations of Libor rate-rigging, requesting documents from the New York Fed.
Some of those documents released this month showed that the New York Fed learned from a Barclays employee in the spring of 2008 that the bank was under-reporting its borrowing costs to pull down Libor. The employee said other large banks were doing the same thing.
Geithner said Wednesday that he learned of the concerns at the same time and notified top U.S. officials, including the heads of the Treasury Department, Securities and Exchange Commission and the Commodity Futures Trading Commission. The agencies are working withBritain’s Financial Services Authority in investigating possible bid-rigging.
“We were aware of the risk that the way this was designed created not just the incentive for banks to under-report but gave them the opportunity to under-report, and that was a problem,” Geithner said of Libor. “I believe we did the necessary and appropriate thing very early in the process.”
The New York Fed also sent recommendations to the private British bankers group that sets the rate and to British regulators for improving the transparency of the Libor rate-setting process. It was their responsibility to fix Libor, he said.
Rep. Barney Frank (D-Mass.) noted that the top U.S. financial regulators in 2008 were Bush administration appointees.
“There’s been an effort to kind of blame you for all of this,” Frank said. “You were important, but not that important.”
But Hensarling said he didn’t think Geithner responded strongly enough to the concerns about Libor in 2008.
“It appears you treated it as a curiosity or something akin to jaywalking as opposed to highway robbery,” Hensarling said.