The Special Inspector General for TARP, Christy Romero, has recommended that the Federal Reserve and the Treasury Department stop using LIBOR, the benchmark interest rate derived in such a slipshod way that it was rigged for years. But the Fed and Treasury aren’t taking Romero up on the request.

The Treasury and the Fed should “cease using Libor in TARP programs,” the special inspector general said in the report. “American taxpayers who funded TARP may have been at risk and continue to be at risk from the manipulation of Libor.” [...]

“The scale of what has erupted over Libor is significant,” Christy Romero, the special inspector general for TARP, said in an interview.

The Treasury and the Fed have said they had no choice but to use Libor in designing the lending programs that propped up the financial sector when credit seized up. In letters to Romero, both argued it was not in the taxpayers’ interest to pursue changes now.

In particular, Romero focused on two TARP programs, the TALF (Term Asset-Backed Securities Loan Facility) and the PPIP (Public-Private Investment Program), both of which have significant amounts tied to Libor, about $6 billion all told. She recommended that alternatives to Libor be pursued for the programs, as a different way to construct the benchmark. Both Treasury and the Fed basically said that the contracts have been written, they lack authority, and that changing the benchmark could result in taxpayer losses. That’s the kind of thing regulators say when they don’t want to do something and they don’t really want to explain it. Indeed, Romero questioned the objections, saying that both regulators have “broad discretion” to replace the Libor with the prime lending rate, for example.

British regulators overhauled the Libor, previously derived through 16 banks sending the rate at which they get charged to borrow money over to the British Bankers’ Association. This proved susceptible to rate-rigging, as traders would call in favors to the rate-setters, asking them to raise or lower the Libor, depending on what they needed for their derivative trades. Later, during the cusp of the financial crisis, banks submitted deliberately lower Libor rates to pretend that their bank remained in good financial health. The Libor is used as a benchmark for trillions in structured finance products, and small shifts in the rate magnify as a result, costing one side of the trade billions at a time.

There is no current replacement for the British Bankers’ Association in setting Libor, though they have announced tighter regulation on the rate-setters who will supplant the BBA, including making Libor-rigging a criminal offense. More banks will be involved in submitting rates to smooth out any spikes.

But there’s plenty of reason to believe that Libor is a convenient fiction for the financial sector, one which cannot be “saved” through a better process of derivation. But Treasury and the Fed refuse to amend the contracts based on Libor, putting the taxpayer money for those programs at risk.

More from Shahien Nasiripour.