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Buyout CLOs Used for Fed Loans

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Just when you think you’ve heard everything about how low the Fed has stooped to rescue an industry that really ought to be left to twist in the wind a bit, another squirmy critter crawls out from under a rock.

Investor Scott directed us to a Bloomberg story that cites a Morgan Stanley report which argues that investment banks are taking their hung leveraged buyout loans and bundling them into collatearlized loan obligations so they can use them as collateral for loans fromt the Fed.

Now admittedly, AAA-rated CLOs are permitted collateral at the discount window, valued at 93% to 98% of par depending on their duration. However, the discount window used to be an overnight, in extreis facility for banks under duress, while the alphabet soup of new central bank enabled loans to Wall Street increasingly look like a subsidy.

The article winks as hard as it can, but carefully avoids saying that Lehman assembled a CLO to put to the Fed.

Scott also passes along the following:

1. A rumor is circulating that Lehman sold $2.5 billion in CLOs, but the buyer insisted Lehman retain 25% of the worst tranches. Oh, and that buyer was the Fed.

2. The quality of Lehman’s first quarter earnings was terrible. It recorded a gain on widening debt spreads. That means the marker value of its debt fell because the market thought Lehman was less creditworthy. That reduction in market value of debt was a gain that flowed though its income statement.

In addition, “LEH recorded a gain of $695 million in the category of level 3 Corporate equities. That’s ten times the levels recorded in the last 2 quarters of 2007, and it’s not some first quarter of the year aberration either—the year-ago quarter yielded a gain of $13 million. This during a quarter when the major equity indexes took significant hits.”

Aren’t unaudited financial statements just wonderful?

From Bloomberg:

Wall Street firms may be bundling high-yield, high-risk corporate loans into securities to use as collateral to borrow from the U.S. government, according to a report by Morgan Stanley analysts.

Securities firms can borrow against collateralized loan obligations at the Federal Reserve’s Primary Dealer Credit Facility, the analysts said. The Fed set up the facility last month, its first extension of credit to non-banks since the Great Depression.

The creation last month of CLOs comprised of loans for private-equity buyouts or other leveraged loans to larger companies totaling $11.4 billion ended “the deep freeze” in the market, and many arose from unusual motives, today’s report said. “At least one” recent CLO was probably done to take advantage of the Fed’s new facility, it said.

“It’s not cheap to finance loans today in the market,” Vishwanath Tirupattur, a Morgan Stanley analyst in New York, said in a telephone interview.

Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, last month created the $2.8 billion Freedom CLO, the largest this year, out of loans that couldn’t be readily sold to investors, such as for buyouts of payment processor First Data Corp. and power producer TXU Corp. JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc also underwrote CLOs in March, according to data complied by Bloomberg.

Issuance of collateralized debt obligations, a subset of which repackage company loans into new securities with varying risks, totaled $16.7 billion last quarter, tumbling from $165 billion a year earlier, according to the report. CLOs created last month — including $2 billion comprised of high-yield loans to “middle market” companies — represented 80 percent of all the CDOs created in the first quarter.

Only about a third of the CLOs issued this year have been created for the traditional reason, the analysts including Tirupattur and Sivan Mahadevan wrote in the report. The typical model is for a CLO “equity” investor to profit by selling off its safest classes, keeping the difference between the coupons on those securities and on the underlying loans.

The pipeline of unsold debt from leveraged buyouts has shrunk to $118 billion from more than $230 billion in July, Bank of America Corp. analysts said in a report yesterday. High-yield loan prices climbed 1.3 cents in the past week to 90.14 cents on the dollar yesterday, according to Standard & Poor’s. Prices are still 4.67 cents below the beginning of the year, according to S&P, which tracks loan prices.

Recent CLO deals have been “eating into the massive overhang of leveraged bank loans and alleviating some of the stress in the capital markets,” said Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York.

They’re also “an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors,” Plaut said.

Morgan Stanley’s Tirupattur declined to say which firm he believed recently repackaged buyout loans into CLOs with investment-grade rated classes to enable Fed borrowing. Randy Whitestone, a spokesman for New York-based Lehman Brothers, declined to comment.

Borrowing through the Fed facility rose 16 percent to $38.1 billion in the week ended April 2. The Fed accepts “all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available,” along with safer debt, according to the Federal Reserve Bank of New York’s Web site.

Andrew Williams, a Fed spokesman, declined to comment…..

U.S. lawmakers such as Senator Charles Grassley, a Republican from Iowa, and investors such as First Pacific Advisors LLC Chief Executive Officer Robert Rodriguez in Los Angeles have said the central bank has been taking unusual risks that may cost taxpayers.

Another atypical motivation for the creation of CLOs in recent months has been to restructure “market-value” CLOs, a type that can be forced to liquidate when their collateral’s prices fall by a certain amount, according to Morgan Stanley.

“A few other CLOs that priced during the past few weeks are hung warehouses from mid-to-late 2007,” or loans sitting on the lines of credit granted by banks and securities firms to CLO arrangers, the analysts wrote.

The ten U.S. commercial banks with the most mortgage-backed bonds boosted holdings of securities that lack guarantees from government-linked entities such as Fannie Mae by $48 billion in the fourth quarter, partly because they were making the loans for consumer customers anyway, Barclays Plc analysts Ajay Rajadhyaksha and Derek Chen wrote in February.

The 12 Federal Home Loan Banks, the government-chartered cooperatives that lend to U.S. banks, thrifts, insurers and credit unions, generally extend more against AAA bonds than loans. The Fed also last month began to temporarily swap U.S. Treasuries for non-guaranteed mortgage bonds, a form of lending meant to restore liquidity to financial companies.

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21 comments

  1. TallIndian

    Not surprising that the investement banks would now structure securtizations to optimize the cash obtained from the discount window.

    Years ago, structures were based on how much they could sell to Memphis and Florida bond daddys.

    Wow, the NY FED in a few short weeks has become a retail broker that takes the tailings from Wall Street securitizations and loads it to the taxpayer.

    Doesn’t the FED now need to register with FINRA or something?

  2. RK

    The next step for the Fed is to re-package these CLO’s
    into $1000 units, and put them on Home Shopping
    Network for 3 easy payments of 333.33. Maybe Ron Popeil could do the selling.

  3. Frank Ruscica

    Why are high(er)-profile bloggers not catalyzing/coordinating efforts to minimize taxpayers’ exposure to gratuitous moral hazard?

    Doesn’t it get frustrating to just note the goings-on?

    My first pass at catalyzing such an effort is here:

    http://www.loveatmadisonandwall.com/petition/

    Feel free to adopt/adapt/overhaul…

    Best,

  4. Anonymous

    A neophyte with a question.

    Share your concerns about the nature of the collateral being accepted by the Fed, as well as your distaste for bailing out those who have benefited most from the credit bubble. And I would guess that the Fed would prefer to do neither.

    The blogospere seems to be attributing their actions to incompetence or to cronyism. What if it’s simply desperation on their part based on legitimate concerns about the banking system being able to fund its operations because of the continuing freeze-up of the securitization process? Consider how much our banking system has come to rely on laying off each month hundreds of billions of dollars of paper through securitization in the “shadow banking system”. And with that cut off, where do they go? An isolated bank or two would go to the interbank market; but where do they all go if they are all having funding problems?

    And if the desperate actions in fact reflect a system-wide funding problem, surely they realize they are not large enough to replace the entire securitization process that has developed. Hence the panic.

  5. clem clements

    Anon: what you say makes good sense, but instead of letting these horrible mistakes FAIL the Fed is enabling further destruction as this Bloomberg article shows.

    VP Cheney at some point during the Iraq invasion said “budget deficits don’t matter” which is accurate while you’re the big dog around town, but with the Fed “enabling” more off-balance-sheet genius we keep seeing on Wall Street, it’s only a matter of time before educated people around the globe walk away from the artificial “capitalism” we’ve promoted.

    All that’s happening is a delay of the inevitable – and with each delay it gets worse and bigger. When this rumbling financial volcano finally breaks through the endless pile of helicopter-drop dollars, our country will either be owned by China or indebted permanently to another nation. I think Russia in 1990-1995 is a good example. AND THEY WERE WAY MORE PREPARED…

  6. S

    Lehman takes assets on balance sheet after funds fail ($1B). Lehman total assets RISE in the Q. Analysts talking another $2 billion writedown in Q2. Is it not the height of ironic that they are taking equity gains in the Q as market is down and yet crying in the press with a welcome ear by the way anbout dreaded short sellers. Then they had such a “creative” offer by placing it with non shorters. To borrow a John Mccain phrase: Lehman is like the 40 year old model still trying to get by on her looks.

    The Fed is becoming a victim of its own “success” with the moronic MSM happy to blather on with euphamistic bailout talk.

    End of Empire

  7. Anonymous

    “The evidence was fast accumulating: the Administration’s great experiment in ‘business elf-rule- had come into full collision with the ingrained determination of business executives to hold down their cost of doing business, to push up prices if they could, and in general to run their companies as they pleased, come hell, high water, or General Johnson. Where they could turn the machinery of the NRA to thier own ends, they did so–and it was they, not labor or the consumers, who held the initative inframing the codes. Where they could not turn this machinery to their own ends, some of them complied, others fought the law or nullified it…

    “Intermittently throughout the year 1933 the Senate Committee on Banking and Currency, whith the aid of its inexorable counsel, Ferdinand Pecora, had been putting on one of the most extraoridinary show ever produced in a Washington committee room: a sort of protracted coroner’s inquest upon American finance…

    “The investigation showed how pool operators in Wall Street had manipulated the prices of stocks on the Exchange, with the assistance of men inside the companies with whose securities they toyed. It showed how they had made huge profits (which represented the exercise of no socially useful function) at the expense of the little speculators and of investors generally, and had fostered a speculative mania which had racked the whole economic system of the country–and this not only in 1928 and 1929, but as recently as the spring of 1933, when Roosevelt was in the White House and Wall street had supposedly been wearing the sackcloth and ashes of repentance… Again and again it showed how men occupying fiduciary positions in the financial world had been false to their trust.”

    Frederick Lewis Allen, “Since Yesterday”

  8. Anonymous

    “Now admittedly, AAA-rated CLOs are permitted collateral at the discount window, valued at 93% to 98% of par depending on their duration.”

    This statement is incorrect. The Fed lends 93% or 98% of the market value of the securities, not the par amount. That is an important distinction. A 2% haircut is still outrageously low compared to what is available on the street but the Fed isn’t lending more than the market value of the bonfds.

  9. Steve Waldman

    “A rumor is circulating that Lehman sold $2.5 billion in CLOs, but the buyer insisted Lehman retain 25% of the worst tranches. Oh, and that buyer was the Fed.”

    Sold, or borrowed against on loose terms and indefinite duration? The economic distinction between the two is fuzzy, but if the Fed has bought anything outright other than as part of the Bear deal, that is big news. I’d like to know more… (Perhaps the “sale” was a repo, which is after all, legally change of ownership? Then Lehman could get away with chirping about its deal without technically lying, and the Fed could be the lucky purchaser, without technically buying…)

  10. Molten_Tofu

    Let me see if I’ve got this right:

    “Recent CLO deals have been “eating into the massive overhang of leveraged bank loans and alleviating some of the stress in the capital markets,” said Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York.They’re also “an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors,” Plaut said.”

    High yield because they’re high risk. So lets see: Banks/etc can’t sell they’re sketchy loans, so they transfer said loans to what essentially amounts to a shell company (a CLO), buy the sketchy loans off themselves using money from bonds sold to the Fed, and sell stock in their new shell company to investors for a quick profit.

    Exact technicals aside, am I getting the gist?

  11. Anonymous

    I was under the impression that this has already been the practice for some months already in Europe: packaging stuff expressly for presenting to the ECB. Also, I believe the ECB has all along had the latitude (in terms of counterparties it deals with and the financial instruments they present to it) that the Fed has just recently given itself.

  12. Anonymous

    “I was under the impression that this has already been the practice for some months already in Europe: packaging stuff expressly for presenting to the ECB. Also, I believe the ECB has all along had the latitude (in terms of counterparties it deals with and the financial instruments they present to it) that the Fed has just recently given itself.”

    This is correct, the ECB has always repo’d a wide variety of collateral types for wide variety of counterparties.

  13. Anonymous

    Re: “The proposal to give new tax breaks to homebuilders and banks is yet another example of the pernicious trend of privatizing profit and socializing losses, which is gnawing away at faith in the system. Dilute the shareholders, not the taxpayers.”

    Visits to The Fed/Treasury clinics:
    http://en.wikipedia.org/wiki/Methadone

    Methadone has traditionally been provided to people who are opiate dependant in a highly regulated methadone clinic, generally associated with an outpatient department of a hospital, though this varies country by country. For example in Australia, Methadone maitenance treatment (MMT) is delivered by private pharmacies for a nominal fee to the client (regardless of the fact it is free as it is subsidised by the Federal government).
    In many Western countries, new patients are required to visit the clinic daily so that they may be observed taking their dose by the dispensing nurse, but may be allowed to leave the clinic with increasing supplies of “take home doses” after several months of adherence to the clinic’s regulations, including consistent negative drug-screen results. The way that MMT is delivered in some countries create barriers to scaling up access to the treatment. For example, in Australia, people who are on MMT are dosed in designated area in front of other pharmacy customers. This can inhibit people’s willingness to access treatment due to a lack of confidentiality and anonymity. In some countries or regions, law stipulates that clinics may provide at most one week’s worth of methadone, (up to 30 days in the USA) except for patients unable to visit the clinic without undue hardship due to a medical disability or infrequent exceptions made for necessary travel to areas without clinics, and this level is only reached after a few years of proper results.

    >> IMHO, any bank or builder begging for taxpayer cash should have every detail of fraud accounting brought before a bankruptcy court and they should sit in fron of a public jury and be crucified!

  14. S

    CNBC is seriously in need of goijng off air. Steve Liesman should be posted to the GE parking lot. He is officially dangerous

  15. Anonymous

    See we all were wrong and the monolines were right ! It turns out the sub-slime gooboo is AAA after all !

  16. Anonymous

    There have been questions concerning the collateral the Fed is accepting and the Fed-chief assures that the Fed is being cautious and has “intimate knowledge” of what they are taking in. The impression is that he is confidant that the tweaking of the system the Fed has carried out is working and, even as more shoes keep dropping (with the sting of each apparently losing velocity), the rewiring of the system will skirt further trouble.

    Re: “intimate”, does that imply a long romance?

  17. Richard Kline

    ‘Intimate’ as an exchange of precious bodily fluids.

    The Fed is only now doing what the ECB has been doing since August: that’s called follow the Leader.

  18. Anonymous

    Examples of something similar, which has already been happening in Europe for some time?

    “European banks are issuing asset-backed securities in massive amounts and pledging them to the European Central Bank as collateral on its term repo funding. Since September, more than 50% of European ABS issuance has been used as ECB collateral.”

    “Thus, we have found out that European banks have continued to issue billions of euros-worth of residential mortgage backed securities (RMBS) that are never sold to any investor. After securing the rating, the securities, which are simply paper representing actual mortgages in the books of various banks, are pledged as collateral to the ECB and liquidity lines are drawn.”

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