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.