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As the financial crisis began to unfold in 2007, the New York Federal Reserve learned that some banks might have intentionally underestimated the rates they expected to pay for loans from other banks.
Documents the New York Fed released Friday, in response to a request from Congress, show that the banking regulator began to be concerned about the accuracy of LIBOR — or the London Interbank Offered Rate — late in 2007.
That's when the New York Fed began to hear anecdotal reports that some banks might be low-balling the rates they expected to pay for short-term loans from other banks. Their intention was to avoid appearing weak. A weaker bank would have to pay a higher interest rate.
A Very Big Deal
The manipulation is a very big deal, says Alan Blinder, a former vice chairman of the Federal Reserve, because the LIBOR is a benchmark for a huge number of contracts "ranging from mundane things like adjustable-rate mortgages all the way to complicated derivatives."
Those contracts are worth trillions of dollars and include bets about the direction of interest rates by investors from hedge funds to municipalities and pension funds. Manipulating the market could cheat investors out of billions of dollars. In fact, the city of Baltimore has already sued to recover alleged losses.
"I believe it's hugely damaging, if it's as bad as it might be," Blinder says. "We don't know yet the dimensions."
That's because some of the other 16 to 18 banks involved in setting the LIBOR could be implicated, too, including three U.S. banks: JPMorgan Chase, Citibank and Bank of America.
The documents released Friday indicate that after seeing evidence of manipulation in the market, a New York Fed official called Barclays in April 2008 and questioned a bank official. The Barclays employee said, in fact, the bank was underreporting its rate to avoid stigma. The employee also said Barclays believed other banks were underreporting, too.
Remember, this was in the early stages of the global financial crisis when concern was rising about the stability of banks, and none of them wanted to appear weak.
A couple of months later, then-New York Fed President Timothy Geithner, now the secretary of the Treasury, wrote to the head of the Bank of England. Geithner urged British regulators to eliminate incentives for banks to misreport rates and proposed changes to make LIBOR more credible. But neither Geithner, nor other officials like Fed Chairman Ben Bernanke who knew of the situation, went public.
Blinder, who's now an economics professor at Princeton, credits the Fed for uncovering the wrongdoing but says there were two ways the Fed might have handled the situation.
"One way is through internal reform of the market, which is the way that the Fed tried to push things; another way is to blow the whistle so that people know what's going on."
Blinder says Geithner and other officials might have legitimately worried that going public might add more fuel to the financial panic. In any case, he says, it's an immense issue, and the potential for lawsuits is "titanic."