The special inspector-general for the Troubled Asset Relief Program, the bailout vehicle launched during the financial crisis, recommended that the Treasury and the Fed change some initiatives to ensure participating U.S. firms use alternatives to the London inter-bank offered rate in pricing billions of dollars in loans.

Libor is intended to measure the rate at which banks lend to one another and is used as a benchmark to set borrowing costs on financial instruments, including derivatives and mortgages.

It has faced heightened scrutiny since Barclays agreed to pay more than $450 million in fines to U.S. and British authorities to settle charges its employees rigged the rate to increase profits.

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."

Libor was set as the base interest rate in many government bailouts from 2007-2009. More than three years after the launch of TARP, the federal government still has bailout programs in operation, some of which will last as long as 2015 and 2017.

"The scale of what has erupted over Libor is significant," the special inspector general, Christy Romero, said in an interview. She said that in addition to putting taxpayer money at risk, the reliance on Libor could undermine confidence in the TARP program.

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.

The watchdog's report focused on two TARP programs. One, known as the Term Asset-Backed Securities Loan Facility, or TALF, was started to jumpstart the securitization market for credit cards, auto loans and small business loans.

The second, the Public-Private Investment Program, or PPIP, was intended to use both taxpayer money and private capital to get bad assets off the books of major banks.

There is $598.6 million in outstanding TALF loans and $5.685 billion in outstanding PPIP debt with interest tied to Libor, the report stated.

"If we sought to renegotiate the rate, it is likely that borrowers either would not agree to a rate change or would agree only to a change that would result in a lower payment to the taxpayers," Treasury Assistant Secretary Timothy Massad said of the TALF loans in a letter to Romero Dated October 9.

Massad also said that changing the benchmark rate for the PPIP program now "may in fact harm, rather than benefit, taxpayers." He said fund managers overseeing those investments have developed investment strategies over the years that could be adversely disrupted.

"It's not as hard as Treasury and the Federal Reserve make it out to be," Romero said. She cited the bailout of insurer American International Group as an example in which a benchmark rate was renegotiated.

As for TALF, the Fed wrote that neither it nor the Treasury had the "authority to unilaterally change the interest rate."

In the Fed's letter to the watchdog dated October 3, William Nelson, the deputy director of the central bank's Division of Monetary Affairs, said that the borrower would either not agree to a rate change or would only agree to an alternative that would result in a lower payment to the U.S. taxpayer.

The report also recommended that AIG be designated as a systemically important firm, which would subject it to greater scrutiny and higher capital liquidity requirements.

(Reporting by Margaret Chadbourn; Editing by Dan Grebler)

• A Permanent Economic Emergency