naked capitalism

The so-called Valukas report on the Lehman bankruptcy has put a harsh light on the final months of the floundering firm and the regulators who stepped up their oversight, in particular, the New York Fed.

Some of the NY Fed’s moves have been so indefensible as to in and of themselves warrant full bore investigation. In particular, the Fed devised two stress tests, which Lehman failed, then devised a less demanding version, which Lehman again flunked. So Lehman was allowed to create its own benchmarks, and mirable dictu, it passed! So why was the Fed bothering to hang out at Lehman if it had no intention of intervening?

But since the Fed is certain to continue stonewalling, those who want to find out what was behind these indefensible actions need to press forward on multiple fronts. And yes, Virginia, it does matter whether the root cause of Fed ineptitude was cronyism, incompetence, or a misguided effort to defend past Fed conduct), or some other institutional malady. The remedy will depend on the nature of the problem.

So the hue and cry over Lehman’s use of one of the Fed’s fancy “help the banksters” vehicles, the Primary Dealer Credit Facility, is useful, even if the concerns are misdirected.

To recap: the PDCF, which became operational right after the Bear collapse, allows primary dealers (big firms who bid at Treasury bond auctions) to obtain overnight funding by using a repo-type process (as in pledging collateral in return for the loan, with the value of the collateral greater than that of the loan). The collateral needed to be rated investment grade, meaning BBB- or higher.

A hue and cry erupted because Lehman appeared to have abused the facility, and the description in the Valukas report itself sent readers on a bit of a wild goose chase:

(c) In Addition to a Liquidity Backstop, Lehman Viewed the PDCF as an Outlet for Its Illiquid Positions

The PDCF not only provided Lehman with a ready response to those who speculated it would go the way of Bear Stearns, but also a potential vehicle to finance its illiquid corporate and real estate loans. A day after the PDCF became operational, Lehman personnel commented: “I think the new ‘Primary Dealer Credit Facility’ is a LOT bigger deal than it is being played to be . . . .” They mused that if Lehman could use the PDCF “as a warehouse for all types of collateral, we should have plenty of flexibility to structure and rethink CLO/CDO structures . . . .” Additionally, by viewing the PDCF as “available to serve as a ‘warehouse’ for short term securities [b]acked by corporate loans,” the facility “MAY BE THE ‘EXIT STRATEGY’ FUNDING SOURCE WE NEED TO GET NEW COMPETITION IN THE CORPORATE LOAN MARKET.”

Yves here. The report implies that Lehman using the PDCF “as an outlet for its illiquid positions” was contrary to its intended role and hence an abuse. This is not entirely clear. The Fed is remarkably oracular in its communications, and it created a huge menu of new vehicles for the sole purpose of letting dealers and banks get liquidity from then-illiquid positions. That is fancy speak for “park that stuff no one particularly wants to buy now at the Fed, we’ll give you cold hard cash.”

The potentially abusive aspect was that Lehman intended to leave its positions with the Fed, apparently for the foreseeble future, even though the facility was overnight. And the facility had a penalty fee built in for longer-term parking:

In addition, primary dealers will be subject to a frequency-based fee after they exceed 45 days of use. The frequency-based fee will be based on an escalating scale and communicated to the primary dealers in advance.

Yves here. One thus has to wonder whether the gleeful Lehman staffers missed this fee, had figured a way to game it (as in use the facility 40 days, somehow find another liquidity provider for a couple of days, rinse and repeat?) or figured this was still attractive even after paying the penalty fee. It would take more discover of the Lehman records and at the Fed to understand the motivations and actions better. Back to the report:

Lehman did indeed create securitizations for the PDCF with a view toward treating the new facility as a “warehouse” for its illiquid leveraged loans. In March 2008, Lehman packaged 66 corporate loans to create the “Freedom CLO.” The transaction consisted of two tranches: a $2.26 billion senior note, priced at par, rated single A, and designed to be PDCF eligible, and an unrated $570 million equity tranche. The loans that Freedom “repackaged” included high‐yield leveraged loans, which Lehman had difficulty moving off its books, and included unsecured loans to Countrywide Financial Corp.

Lehman did not intend to market its Freedom CLO, or other similar securitizations, to investors. Rather, Lehman created the CLOs exclusively to pledge to the PDCF. An internal presentation documenting the securitization process for Freedom and similar CLOs named “Spruce” and “Thalia,” noted that the “[r]epackage[d] portfolio of HY [high yield leveraged loans]” constituting the securitizations, “are not meant to be marketed.”

Handwriting from an unknown source underlines this sentence and notes at the margin: “No intention to market.”

Yves here. Oh, this sound really bad, right? Lehman created a new CLO and stuffed the Fed!

There is actually less here than meet the eye. First, Wall Street was stuffed to the gills with CLO paper. Firms were sitting on losses, albeit no where near as bad as on their real estate portfolios, and no one was particularly interested in getting any more long these exposures. CLOs were tranched, so placing an investment grade-rated tranche of a CLO with the Fed with “no intention to market” at that time is not as heinous as it sounds. What you would need to know is whether this CLO had peculiar features that would have made it markedly different than CLOs other dealers held in inventory.

Making this seem like even less of a dirty trick by Lehman was that the Fed was aware of Lehman’s plans BEFORE Lehman pledged the newly-created CLO to the NY Fed:

The FRBNY was aware that Lehman viewed the PDCF not only as a liquidity backstop for financing quality assets, but also as a means to finance its illiquid assets. Describing a March 20, 2008 meeting between the FRBNY and Lehman’s senior management, FRBNY examiner Jan Voigts wrote that Lehman “intended to use the PDCF as both a backstop, and business opportunity.” With respect to the Freedom securitization in particular, Voigts wrote that Lehman saw the PDCF as an opportunity to move illiquid assets into a securitization that would be PDCF eligible. They [Lehman] also noted they intended to create 2 or 3 additional PDCF eligible securitizations. We avoided comment on the securitization but noted the firm’s intention to use the PDCF as an opportunity to finance assets they could not finance elsewhere.

Yves again. So this again suggest that the problem with the PDCF was not necessarily Lehman’s use of it, but the Fed being somewhat less than candid with the public as to the apparent versus actual intent of the program (or as bad, there could have been differing interpretations within the Fed, leading to inconsistent signals).

The report notes that Lehman decided not to mention the use of the PDCF to investors, but again, there is less here than the report intimates:

One explanation could be that Lehman did not want the public to learn that it had securitized illiquid loans exclusively to be pledged to the PDCF. Another reason may have been to hide the fact that Lehman needed to access the PDCF in the first place, given that accessing the securities dealers’ lender of last resort could have negative signaling implications.

Yves here. The second reason is, as annoying as it may sound to readers, legitimate. Banks were reluctant to use the Fed’s discount window precisely because it would prejudice other firms against lending to them and could precipitate a death spiral. While the Fed’s obsession with secrecy is vastly overdone, the one area where it does have a valid argument is when financial firms are currently making use of special lending programs.

Now am I saying the Fed and Lehman are snow white in this affair? Far from it. But Lehman’s so-called Freedom CLO is a tempest in a teapot. And headlines like the one in the Huffington Post yesterday, “New York Fed Warehousing Junk Loans On Its Books: Examiner’s Report“, are just wrong. The Freedom CLO was rated single A, well above the threshold for “junk”.

The Valukas report and the critics are missing the real elephants in the room. First, one of the reasons the Fed was ostensibly was willing to lend is that the loans were made with recourse to the borrower, that is, the Fed was looking to the dealer for repayment, even though it also held collateral. With Lehman under special scrutiny, it would have seemed prudent for the Fed to exercise particular care in how Lehman made use of these programs. So if the Fed turns out instead to have been particularly lenient, that means the central bank misrepresented the aims and operations of the programs.

But second, and FAR more obvious avenue for abuse for both the PDCF and the Term Asset Backed Securities Lending Facility. The dealers could, and almost certainly did, mark the collateral they parked with the Fed at unrealistically high levels. This was a far easier, and no doubt more widespread avenue of abuse (and ultimate losses on Lehman exposures) than “junk loans.”

We pointed this out within days of the launch of the PDCF:
Ah, but how will the Fed assign values to the collateral? From the Fed’s FAQ:

What collateral is eligible for pledging?

Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.

How will collateral be valued?

The collateral will be valued by the clearing banks based on a range of pricing services.

That sounds objective and innocuous, right? Guess again. As an investor commented:

Note also that the Fed’s accepting the clearing banks’ valuations on the assets that the brokers present as collateral. That is so very understanding of them. Given that the clearing banks hold similar assets themselves, they are probably grading on a curve here, so as not to mark down their own assets simultaneously, I’m guessing. We’ll give the best student here an A—make that a triple A!—and hey, look, we’re all triple A on this bus. Yikes.

Willem Buiter, former central banker, now chief economist to Citigroup, came to the same conclusion:

This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?

For all collateral that is not priced in verifiable, liquid markets, the Fed should arrange its own auctions to discover the reservation prices of those offering the collateral. Leaving it to the clearers is a written invitation to be offered dross at gold valuations. The tax payer will be the loser. A bad and incomprehensible miss. This can be gamed by a bunch of reasonably smart high school kids.

It is also worth noting that former central banker Willem Buiter has argued that the valuations the Fed has published on its Bear and AIG related rescue vehicles look unrealistically high, and our own valuation work on the AIG CDO vehicle, Maiden Lane III, found glaring inconsistencies.

So there is ample reason to continue to demand more accountability from the Fed, even if some of the recent charges are overstated.