Fed’s Preferential Treatment in Lehman BK Highlights Ambiguity of its Status

It must be nice to be like the Fed and be able to chose when you are public or private to suit your convenience.

Many readers like to rail that the Fed is a private institution, but it has a weird public/private structure that has the nasty effect of putting it beyond the reach of Constitutional processes, which is a legitimate reason to push for more transparency and accountability.

One of the interesting aspects of the Wall Street Journal story tonight on how the Fed got paid out by Lehman in full on its loans, while all the other creditors are fighting over scraps, is how the Fed is treated under the law. While (from what I can infer) the Board of Governors is subject of Freedom of Information Act requests, the twelve regional Feds, and that includes the New York Fed, are not, although they appear to be losing ground on that front. The Freedom of Information Act suit filed by Bloomberg seeking more details on the Fed’s emergency lending programs (which are held on the balance sheet of the New York Fed) has been approved by two courts. The Fed is now appealing it to the Supreme Court, which suggests it might have something to hide. But the Supreme Court is more political than lower courts, so the Fed may still prevail.

But the Fed, in the Bloomberg suit, is playing primarily on the idea that it would be detrimental to release the loan information. Ahem. Lots of big banks are seriously in hock to the Fed. The markets are going to fall over if we get the sordid details? It has already been established that no big bank is going to be permitted to fail. So what is the worst we can learn? That Citi is a garbage barge? All more disclosure might do is confirm some suspicions.

But we digress. Back to the matter at hand. The Lehman bankruptcy case is intriguing. First is the fact that the Fed got all its money back:

Billing records filed with the court show the examiner is investigating an issue that has angered many of Lehman’s creditors: how the Federal Reserve and the New York Fed — which lent Lehman $46 billion in cash and securities before its bankruptcy filing last September — were paid promptly and in full, while tens of billions of dollars in other debts were left to be sorted out in court. It remains unclear when and how much Lehman creditors will be repaid.

Yves here. And we get this later in the piece:

Details on the examiner’s work remain scant, and it is possible no actions will be brought. Should the examiner determine that the Fed got preferential treatment, bankruptcy administrators could pursue court claims to recover assets for Lehman’s creditors from the Fed, on the theory those assets should have remained with Lehman when it filed for bankruptcy last September.

Yves here. I love the artful wording: “should the examiner determine that the Fed got preferential treatment.” Um, let’s see. Lehman is bankrupt. That means it has a stay of all creditor claims. But the Fed asks to be paid and gets sent a check pronto. If this isn’t preferential treatment, pray tell what is it? Back to the article:

Such a finding would have little legal precedent and could turn politically fraught, bankruptcy lawyers say. Yet it could bring a focus to one of the unresolved questions of the financial crisis: just how much special treatment the federal government receives above private-market players when it becomes a direct participant in the markets…

Many legal experts said bringing claims against the Fed would be an uphill battle, because the Fed would qualify under a long-held standard of sovereign immunity. That concept generally holds that the government can’t be held legally accountable for its actions.

But Lehman’s estate could have an opening, because by the standards of bankruptcy law, the government isn’t supposed to receive immunity, said Richard Levin, a partner at law firm Cravath, Swaine & Moore LLP who helped write the U.S. bankruptcy code. “The Lehman estate could sue the Fed,” Mr. Levin said, adding that the Fed would likely argue it can’t be held liable.

So the Fed can claim sovereign immunity even though it is kinda-sorta private and subject to no checks of any type (well, its chairman and some of its officials can get summoned by Congress and prodded a bit). And that may mean that even if what it did was 100% illegal, it may be able to get away with it.

Willem Buiter has railed at how the Fed has become expert at regulatory arbitrage and loophole-exploitation, and is assuming a role that it at least inappropriate in a democracy, and possibly engaging in impermissible activities. The Lehman case supports his theory. Banana republic, here we come.

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  1. Charles

    I think people are hyperventilating here. If the loan was secured by T-bonds that were in the possession of the Fed, as in a repo, Fed’s priority on the asset seems quite established.
    It is only in the case of more sloppy collateral taken or problems with the lien registration process that issues may arise.

    Actually, if I was a legislator, I would structurally put the Central Bank with a priority on other creditors. Destroying Central Bank’s credibility is a game where everybody looses. It is akin to feeding the machine of a boat not with wood that is on the bridge, but with wood that makes up the hull below the flotation line !

  2. Delicious Pundit

    the Fed … is assuming a role that i[s] at least inappropriate in a democracy…

    The Fed is just trying to catch up to the national security apparatus, which is decades ahead in these kind of “quis custodiet” abuses.

    (Come to think of it, Juvenal, who gave us “quis custodiet ipsos custodes,” also talked about black swans. Maybe we are Rome. It would be a shame (but probably fair) if Jerry Jones’s stadium was all that future centuries remembered of us.)

  3. mannfm11

    I think you might benefit in going to the Fed website and downloading their loan documents. If I understand correctly, their loans are only for a few minutes a day, like at the end of the day and are callable on posted collateral. Marked to market and given a haircut to boot every day. Under this type of agreement, they merely don’t renew the loan and take the credit out of the account. They have a lot stronger hold on the assets of their customers than other entities.

  4. Yves Smith Post author

    I suggest you read the WSJ article. A Cravath partner who helped write the bankruptcy code suggests that the repayment was improper. That suggests the provisions of the bankruptcy code superceede whatever the terms of the Fed’s loans are.

    I would assume if the loans in question were repos, then yes, the Fed would be on pretty firm ground. But if so, a suit like this would be pretty close to frivolous, it would not pass summary judgement. And this did not sound like a repo, the Fed would not have needed to seek payment in that case. Given the already uphill battle of trying to sue the Fed, and the fact that the plaintiffs are probably not unsophisticated legally (as in they have good counsel), I have to believe there is some reasonable legal theory that supports this suit.

    It is also curious that the Fed got paid back so promptly on the loans to the broker-dealer. B/Ds are subject to very strict rules and a B/D failure is pretty much unheard of absent fraud (ie, even in a bankruptcy, the creditors and counterparties of the B/D proper come out whole). Thus the Fed was pretty certain to have any loans to the B/D repaid in the normal course of events.

  5. Faraz

    Doesn’t sound like a repo to me. If it was a repo, then the Fed would have sold the securities on its own and recouped the money and this would not be a preference. However, according to the article the Fed was repaid in cash so it must be a different kind of transaction or maybe it is not accurately described.

    1. Yves Smith Post author

      Agreed, the Fed would have securities/collateral, not have needed to seek payment from adminstrator.

  6. Sarons

    This is damn curious. Treasuries shot up after Lehman failed, so the portion of the collateral in Treasuries was excessive. My guess is someone at the Fed thought that a massive sale of the collateral would have confused the markets, and decided to exchange the (excessive) collateral with the estate for cash to draw less attention.

    If the other creditors can prove the Fed’s interest was not perfected, cool, but I don’t see how the Fed could have gotten a windfall exchange on the Treasuries at least. Perhaps other collateral was not as clean…but the Fed can certainly point to its statutory role and the attention focused on its actions in the aftermath of L’s failure as a defense.

    1. Faraz

      Exchanging cash for “collateral” would not be allowed by the stay provided by the bankruptcy court. If it was a repo, their remedy is to sell the securities in the market. If they want to insist on the estate sticking to the repo contract and buying back the securities then they have to get in line with everyone else.

  7. ds

    I am not sure where the 46 billion number comes from. Could it be the TSLF or PDCF opened in March 2008 after the Bear Stearns collapse? Either way, in the end, the Fed is different from other creditors in that it is not an investor in the true sense of the word. The Fed was not granting credit to Lehman in order to earn a risk-adjusted return — it was in fact lending money to Lehman in order to protect against a liquidity-fueled economic collapse and to buy Lehman time to restructure. Implicit in this agreement between the Fed and Lehman was that if the rescue effort was unsuccessful and Lehman did eventually fail, the Fed would be the most senior creditor and get paid back in full before anyone else. This is basically the same thing that happened with AIG — the Fed bought preferred shares and also became the most senior creditor. If, in the future, AIG is liquidated, most certainly the Fed will get its money first before any other creditor sees a dime.

    For creditors to complain about the Fed’s treatment is really sour grapes. The Fed used public money in an effort to help the company and its creditors survive. Who else was out there offering 46 billion in short-term lending to Lehman? Just because the Fed’s effort ultimately failed doesn’t mean it should be treated as an equal to other creditors. Alas, no creditor of Lehman complained back in March 2008 when the Fed changed the rule-book for their benefit.

  8. Alex

    To clarify- the Federal Reserve Board is appealing the District Court’s decision to the Second Circuit Court of Appeals, not the Supreme Court.

    Other then that, this post is spot on. The Federal Reserve Board and its Reserve Banks made a preposterous argument Board records in the hands of the Reserve Banks only include material produced while the Reserve Banks are ‘acting under delegated authority’ from the Board. Not only is this not really the standard, it typifies the regulatory arbitrage you are discussing.

    1. Alex

      Also, the Federal Reserve Board has NOT lost in an appellate court. In fact, two federal district courts were split on the issue. One affirmed the Board’s position with respect to each of its arguments and raised the possibility there will be no disclosure. The other court issued a decision, the subject of the Board’s appeal to the Second Circuit Court of Appeals, which rejected many of the Board’s arguments. Keep in mind these suits were brought against the Board and involve a FOIA request directed at the Board for Board records held at the Reserve Banks.

      I don’t blame you for being confused and I think legal murkiness is the intended result of the Board’s positions.

      To summarize the situation:

      – Two federal district courts came to different conclusions about whether the Federal Reserve Board of Governors must turn over documents within its possession relating to (New York) Federal Reserve Bank lending.
      i. One court held the records of the Reserve Bank lending are not Board ‘agency records’ subject to the FOIA and also found such records were ‘obtained from a person’ (namely the Fed’s borrowers) and confidential so exempt under from the FOIA’s disclosure mandate in any event.
      ii. The decision on appeal came to the opposite conclusion and ordered disclosure of much of the identified documents and an expanded search of the Reserve Bank for Board records subject to the FOIA. This court held many of the records of Federal Reserve lending are Board records which are NOT exempt from the FOIA.

      Under these circumstances the prospects on appeal are mixed. Two lower courts found sufficient legal support for entirely opposite conclusions and I suspect the court will decide whether it wants to order disclosure first and then back into a legal holding which achieves this result.

      If it ultimately reaches the Supreme Court we may yet see disclosure.

  9. Siggy

    Bit of a rush to judgement here. The appearance is that the FED received preferential treatment. What is critical, however, is what where the details of the repaid contracts?

    Lacking specifics as to what nature and terms of the repaid contracts were, all of the foregoing is speculation.

  10. Sasher

    Hey guys:

    Guess what? Bernanke is in BIG trouble! You missed the more important piece that that’s even bigger news for common folks like us:

    So THAT’S Where The Money Went!

    Karl Denninger at the Market-Ticker blog beautifully analyzes an even bigger cover-up that the Federal Reserve and Bernanke are involved in that you guys missed.

    That is this:

    And I quote:
    ” Why didn’t the NY Fed and Federal Reserve simply seize the collateral they had posted from Lehman for those “loans” and liquidate it?

    Remember folks, we are repeatedly told by The Fed that all loans they make are backed by sufficient collateral to prevent loss and are “haircut” to provide them with a margin against potential loss.

    If this is in fact true then there was no reason for The NY Fed or Federal Reserve to receive any sort of “preference” payment (unlawful though such a payment would be), as the proper and expected thing to do is simply to seize the collateral they have possession of and sell it!

    As such there are only two reasonable explanations for The NY Fed’s behavior:

    * They didn’t actually have collateral for those loans, in which case Bernanke is a damned liar, The Fed has been handing out money in violation of the law requiring proper collateral and haircuts, and the next question becomes “how many other times has The Fed done this and are they still doing it?


    The collateral they took was insufficient to cover the loan(s) balance, in which case Bernanke is also a damned liar, in that The Fed, contrary to The Federal Reserve Act and thus the law was effectively issuing unsecured loans. (Was that “collateral” worthless CDOs, as just one possibility?)”

    THIS IS A MAJOR PERJURY ALLEGATION against Mr. Bernanke if true!

    Guys: Stop Fiddling around while Rome is Burning!!


    I want to ask our dearly elected President this:


    If Marketwatch and others in the media are silent, then they are complicit in crimes against US by not reporting and investigating the misdeeds of the supposed “public servants” – those who are sworn to uphold the law!

    I ask all of us Honest Americans: PLEASE DO SOMETHING!!

  11. Hugh

    This brings up the question that if the Fed had a significant exposure to Lehman, which of course it knew about, why did neither Bernanke nor Paulson inquire into who else was exposed and what the effects of those exposures would be in the event of an uncontrolled Lehman bankruptcy?

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