Lehman and the Primary Dealer Credit Facility: Audit the Fed Push Right, Arguments Wrong

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.

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  1. i on the ball patriot

    We need an audit the government push for the right reasons … election night promises to sucker voters always morph into legislative output that matches lobbyist spending …


    Yes, you reveal some big elephants in the room, but the fallback rationale will always be that we had to abuse the system a bit so as to not let the system fail and we did a great job (the phony Timmy defense) considering the circumstances.

    I think the biggest elephant in the room, closely related to these machinations, is that the central banks have intentionally burned the global house of finance down to collect the insurance money and build a new one that does not include the middle class.

    Deception is the strongest political force on the planet.

  2. Francois T

    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”.

    Given how accurate, timely and useful have been the ratings in this decade, this argument seems to be planted on rather shaky ground, no?

    1. Yves Smith Post author


      Yes, the rating agencies have been wrong very often. But that is a different issue. “Junk” has a very specific meaning in investment land. It refers to paper rated below BBB. And unlike subprime-related, where the rating agencies models were grossly deficient, on CLOs, they are seen as being not too bad. So the Fed used a methodology that inherently relied on ratings, and in that scheme, this paper was not junk.

      The Fed has LONG relied on ratings in deciding what paper to accept. That now looks dubious. So yes, this is a problem, but it pervades the entire Fed approach to picking which collateral to accept and extends WAY beyond the Freedom CLO. You aren’t wrong here, but there are much better poster children for illustrating this problem, starting with AAA asset backed CDOs.

      And even thought Citi later called some of the Lehman CLOs, including this one, “bottom of the barrel”, that was five months later (August 2008 v. March), after financial firms had continued to decay. Five months was a very long time in 2008, so while the Citi remark is troubling, it isn’t conclusive.

      I’m not saying this looks great, mind you, but if you are going to go after the Fed and have it stick, you need to be on solid ground. There are better lines of attack.

      1. lizzy

        So, you argument seems to be based on which POS collateral is a “better poster children for illustrating this problem” Which implicitly acknowledges that their was a problem with the rating of Freedom CLO. Which would then refute your primary position which was this headline was wrong. “New York Fed Warehousing Junk Loans On Its Books: Examiner’s Report.

        While, Citi’s contention that the was “bottom of the barrel” came 5 months after the initial creation of Freedom CLO (aren’t the rating agencies models supposed to take into effect the deterioration of financial conditions?), isn’t that missing the point: nobody other than the FBRNY would allow this particular CLO to be used as collateral, regardless of the rating (hard to believe considering that it included unsecured country wide financial loans).

        One would believe that this the inability to price this particular CLO (bloomerg per the Valukas report), the fact that it was created exclusively for use at the PDCF (regardless of how many times LEH actually used the PDCF. intent is more important here), that Citi would not accept it as collateral, would seem to lend credence to the theory that in fact the Fed was in fact accepting Junk Loans and the evidence was the mere existence of Freedom CLO.

        1. Yves Smith Post author


          You are missing the point here.

          First, there is no smoking gun here. Valukas basically went off half baked based on that quote from the Lehman e-mail re “EXIT STRATEGY FUNDING SOURCE.” Guess what, this was an overnight facility with escalating penalties! Lehman only used it a grand total of seven nights! The report also clearly states Lehman used the facility “sparingly”.

          Sorry, the actions were not consistent with the idea cherry picked out of that e-mail. In fact, that message reads to me more as further confirmation of Lehman desperation than anything else.

          Second, no you are wrong re ratings. Rating agencies are not supposed to have a crystal ball. They are supposed to make reasonable forecasts. And perhaps MOST important, their ratings of CLOs have not been shown to be wildly deficient, unlike CDOs. A single A credit is decent, not great, certainly not in imminent danger of failure. Rating agencies downgrade corporate credits when they decay (a bit after the market starts to get nervous, typically but not too much afterwards, they lose cred otherwise). If a rating agency had perfect foresight, there would never be a bankruptcy because they’d see it in advance, never give it an investment grade rating, and no one would lend it money.

          Third, you are ignoring the elephant in the room. Why did the Fed create the PDCF at all? This was devised PRIOR to the Bear collapse and came into being right afterwards. So PRIOR to Bear, they was a clear problem with a contraction in bank willingness/ability to fund each other overnight generally. And this facility was not just for US investment banks, but primary dealers, which included foreign banks. And it isn’t even certain no dealer would have refused this paper. In fact, Lehman had to have funded it all those nights it didn’t fund it via the PDCF. Saying it was not designed to be SOLD (to third parties) does not mean it was not able to be repoed to parties other than the Fed. Or alternatively, it could have been repoed, but the haircut was too high, not worth the fuss.

          I am not saying the Fed should not be made to reveal much more re its conduct during the crisis. But mounting attacks on issues where it can has credible defenses for its decisions serves the Fed. It makes the critics look ill informed and simply out to collect a scalp.

          By contrast, there is NO defense for the Fed letting Lehman fail a stress test three times and letting Lehman devise its own test so it could pass. That sort of failing is a sound basis for going full bore after them.

          1. lizzy

            Thank you for your reply.

            I think we are both in agreement with the basic premise that the Fed needs to be scrutinized much more closely.

            I think where we differ is that I believe that Freedom CLO was junk (regardless of how it was rated as i believe that is just semantics). As per the Valkous report:

            “Lehman packaged 66 corporate loans to create the “Freedom CLO.” 5347 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.5348 The loans that Freedom “repackaged” included high‐yield leveraged loans,5349 which Lehman had difficulty moving off its books,5350 and included unsecured loans to Countrywide Financial Corp.

            That Freedom CLO was created specfically for use at the PDCF.

            “Lehman did not intend to market its Freedom CLO, or other similar securitizations, to investors. Rather, Lehman created the CLOs exclusively to pledge tothe PDCF.”

            Moreover, the only attempt by LEH to repo the Freedman CLO to anyone besides the Fed (that we know of) meet with out right rejection and not merely a haircut. Further, doesn’t the fact that Citi was unable to obtain Bloomberg pricing for the Freedom CLO go to one of your main issues about how the colleteral being pledged to the Fed was being priced?

            “[l]ike Freedom CLO and Spruce CLO . . . is just creating securities to take to the Fed
            window”). Further evidence that Freedom CLO‐style transactions had limited liquidity value outside of
            the PDCF is found in Citibank’s rejection of Freedom and similar CLOs when they were offered by
            Lehman as collateral to secure Citi’s intraday clearing exposure. E.g., e‐mail from Anthony Lieggi,
            Citigroup, to Michael Mauerstein, Citigroup, et al. (Aug. 1, 2008) [CITI‐LBHI‐EXAM 00082156] (quoting
            exchange among Citigroup analysts and Mauerstein about pricing Lehman CLOs). Lieggi noted that
            Citibank was unable to obtain pricing data from Bloomberg for the collateral offered by Lehman
            (“Freedom,” “Spruce,” “Pine,” “Verano” and “Kingfisher” CLOs). Id. Lieggi also noted that a Citibank
            risk manager assigned to Lehman, Tom Fontana, “expressed strong concern” about this collateral. Id.
            According to Mauerstein, these CLOs were “bottom of the barrel” securities that Lehman could not repo
            out. Examiner’s Interview of Michael Mauerstein, Sept. 16, 2009, at p. 8. Mauerstein said that the
            securities “may have been investment‐rated, but we know what that means now.” Id”

            I believe the PDCF was contemplated in the weeks leading up to the demise of BSC as it became obvious that the fed was unable to stem the BSC liquidity crisis by offering them funding via JPM. So, clearly the Fed knew there was a problem prior to the implementation of the program on March 16, 2008. As to the why it was implemented, well that is easy: to allow all those with access to the PDCF to basically pledge cats (i jest that change didn’t occur until September 14, 2008)to the Fed for 100 cents on the dollar. Is the mere existence of the program worthy of investigation? Absolutely. As is those securities that were created specifically to abuse the program. As is the manner in which those securities priced.

            With all due respect, I still have not heard a credible defense to the assertion that the Fed was accepting “junk collateral”. How does one explain the fact that a security rated A was ONLY accepted as collateral at the PDCF, and was not only rejected by third parties but unable to even by priced by them

  3. tim

    Question about explaining the risks to the masses re: The Fed being out of control.

    Fed will stay opaque.
    Financial Reform will be bullshit.

    Activity with the Fed by banks:

    Banks get “free” money to play with.
    They can create “any asset” and park it at the Fed indefinitely.

    Therefore the risks to the economy/masses are:

    1. The banksters being able to act foolish, make big easy money taking insane risks and “hiding” it at the Fed unless they blow up.
    2. No confidence in our regulatory system.
    3. Expansion of the money supply – since the “worth less” collateral is traded for cash.
    4. Further risks the Fed will never be able to roll back all these programs “correctly” whether it’s due to incompetence or cronyism or fraud or whatever.
    5. Countries being motivated to “take action” against us due to the Fed’s activities.
    6. Banksters being able to use the extra “cash” from pushing “assets” off to the Fed to, as an example, speculate attempting to bring down countries or other companies. [Or is this irrelevant?]

    Any other risks ?

    I’m attempting to translate the most elementary risks to the average person so they understand why the hell they should be demanding transparency, reform, etc.

    Thank you for indulging me.
    You can also email me from my site, or tsolanic at gmail dot com.

    Thank you.

    1. Yves Smith Post author


      I agree 100% with your first two assumptions. That makes it CRUCIAL to be on solid ground in making attacks and not overstate one’s case. That’s my beef here. If you accuse the Fed of doing stuff in a way that lets the Fed duck the attack, it creates the impression that the critics just want a scalp and don’t care about accuracy. That serves the Fed.

      The banks NOW get free money, or close to it. That is supposed to be an emergency remedy. So why are they getting all these bennies and not being made to change their ways? (also note the PDCF was not free money, we need to be clear re then v. now).

      They can’t “create” any asset. It needs to be investment grade. Yes, that is subject to gaming, but there are some forms that have to be adhered to.

      This program was only overnight. That was a big limit on how badly it could be abused. And despite all the hoopla re Lehman, it used this facility all of 7 times, meaning a mere seven nights.

      1. b

        What would have been the repercussions to Lehman if it hadn’t used this facility 7 nights?

        Perhaps there need to be distinctions drawn between what should be viewed as a reasonable response to the crisis by the fed and any gaming of the system that is now apparent (which I think you do flesh out slightly in the post in this particular instance).

      2. Rich

        Truly? Was the PDCF truly an overnight window? I thought the banks could extend that to 45-days without penalty, and I also recall that some of the Fed’s overnight lending facilities (TALF?) were extended to 60-days recently. I tend to believe that if a PD called up the Fed and said, “We need an extension” that the Fed is so adverse to taking actions that might injure a big bank, they’d relent. Quietly, in the middle of the night.

        1. Yves Smith Post author


          No, please read the Q&A on the Fed’s website. It was overnight. Effectively, you could go to it overnight for 45 days in succession before the Fed would start imposing penalties, and then they would escalate, as in get worse the longer you kept using it.

          This is far from an “exit strategy funding source.”

  4. JCH

    The Fed 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.

    Did that definition apply at all to Lehman Brothers, or is that the change made after the Lehman Brothers bankruptcy?

    The Fed indicates loan balances and collateral balances are all zeroes. What was parked forever?

    1. Yves Smith Post author


      That is what I have been saying. The facility is only overnight. It has to be renewed, and the Fed has disincentives v. long term use. It was scheduled to terminate Feb. 1, 2010 “or longer if conditions warrant.” On a quick pass, I see no evidence that it was extended (as in a press release) but that isn’t definitive.

  5. Ginger Yellow

    “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.”

    Some additional data points to address this question. Here in Europe, it’s extremely common (especially post-crisis) for banks to construct securitisations, including CLOs, exclusively for the purpose of accessing central bank liquidity. Lehman Brothers International Europe did this as well, leaving the ECB nursing some painful (mark to market so far) losses when it collapsed. What’s interesting is that while everyone was doing stuff along these lines, Lehman’s ECB-specific deals, unlike everyone else except a handful of Icelandic banks (notice a pattern?) were constructed so as to just meet the minimum rating requirement, ie single-A. Even though other banks were and still are putting together deals with no intention of bringing them to market, they still structured them so as to get a triple-A rating, giving the ECB more protection in the event of borrower insolvency. Not Lehman. Now to me this doesn’t so much suggest malice as desperation – obviously they could use less collateral to get the same amount of funding if they don’t provide as much credit enhancement, but they paid a higher price to do so. They were obviously scraping together every bit of collateral they could find in the months ahead of the bankruptcy filing.

  6. Rich

    Yves, Thanks again for excellent analysis. Sadly, I think you overestimate the political will to correct the problems at the Fed when you say: “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.”

    Remedy? Let’s not deceive one another. Besides us, the blogosphere of objectors, the basic approach is not simply “extend and pretend”, it is hide the facts (remarkably, just like an undercapitalized bank) take some big risks (also, just like and undercapitalized bank) and hope that idiot consumers will once again max-out their credit cards and start buying unaffordable houses. This is so Ponzi it is beyond belief – that “dang, the market jumped up and bit us on the ass, but we got it sussed this time, let’s put it all on red” approach to risk (mis)management.

    I have wholly lost faith with U.S. law enforcement. Frankly, you are among the people I would hope that the FBI would be pestering constantly to do some forensic accounting, to ferret out the miscreants. Are you? Nooooo, instead we get Bernanke as Man of the Year, we get Timmy Taxcheat assuring us that the economy is improving even as evidence of his extreme deriliction comes out. And where pray-tell is Eric Holder? Seriously, has he left the country or what? Frankly, I am now wondering why Andrew Coumo hasn’t indicted half of Wall Street’s execs himself. The bottom line of the Valukas Report is that our system of financial governance has failed. From the revolving door, to outlandish campaign contributions, to dismantled protections, to insane court rulings extending the Bill of Rights to corporations and enslaving us all, we must admit that the democracy experiment has failed in the U.S.. The oligarchs rule – just like in Mother Russia. Eventually, I suspect they will find a way to silence us – the dissenters.

    1. psychohistorian

      Nice posting and clarification in the comments Yves!

      That said I want to add my thanks to Rich for his comment. Yes, this may currently be textual white noise to the elite that run the world but they need to know that there is a tipping point beyond which their ability to exert control ends.

      May that point be reached in what is left of my lifetime.

    2. Sundog

      “the basic approach is not simply “extend and pretend”, it is hide the facts….”

      Except, the facts are hidden in plain sight. As Yves makes clear, all the rules were on the table and it was obvious to Buiter and others how they would be put to use. Reminds me of Michael Lewis and the guy who made many hundreds of millions for his investors just by reading the docs on subprime securitizations and betting they would fail. Everything was in plain sight.

      Yves’s first point (was Lehman treated exceptionally favorably for those seven overnight loans) relates to the opaqueness of the process. A Fed audit might well discover Lehman was treated leniently; on the other hand it seems most market participants believed Lehman was next in the line of dominoes after Bear Stearns so this could be excused as acting to prevent systemic crisis IF and only if at the same time Fuld and his board were being pressed to the limit to find outside investors or sell the firm, and I do mean (in the spirit of TED) going as far as threats that the IRS would soon be having close encounters with all C-levels and board members.

      Lend against somewhat dodgy collateral, and force an outcome in which management is replaced and creditors take a hit. Would Bagehot approve?

      Yves’s second point relates to asset valuation in general and brings up the MtM pro-cyclical hornets nest. This is the real issue, it seems, when it comes to a rare and extreme Mess such as the one we’re in. I suspect that creditors (pension funds, insurance companies, sovereign wealth funds) have been shielded too closely. The Japanese have got away with similar policy so far thanks to a positive trade balance; the US cannot contemplate such luxury. Or can it? Should it?

  7. Andrew Bissell

    It’s sort of funny to watch central banking supporters like Buiter raise a hue and cry when the central banks fulfill their raison d’etre of ripping off the public during solvency panics. How in the world was the Fed supposed to meet the Bagehot-ian mandate to provide “liquidity” without allowing the banks to overvalue the collateral they were pledging to the Fed’s various facilities?

    The intellectual supporters of central banking like Buiter helped create this monster, and should share at least some of the blame for its worst abuses.

    1. Yves Smith Post author


      The ONLY financial system intervention that the Fed has taken that conformed to the Bagehot rule was, believe it or not, the first AIG bailout. The rule is “lend against good collateral at a penalty rate.” None of these fancy programs even remotely adhered to that principle. That $85 billion loan was at a suitably costly private sector rate and the assets of AIG would have over time (in a 2-3 year liquidation scenario) been sufficient to pay back the loan. But AIG kept hemorrhaging (which raises all kinds of ugly questions re Fed competence and AIG candor that we do not need to go into here) and the first loan (appallingly) was made more lenient and new credit kept being extended. The bloody company should have been liquidated, the ONLY reason for the backup was to prevent a systemic crisis. AIG’s continued existence should not be a consideration at all, and yet it has come to shape how its bailouts were handled.

      The facilities did not conform to the rule, and Buiter has been one of the few in the circle of Respectable Economists with Real Cred to criticize them roundly.

      1. Andrew Bissell

        The problem, Yves, is that the Fed couldn’t say in the summer and fall of 2008 that the assets it was accepting were “bad collateral.” Doing so would have been tantamount to admitting that the entire financial system was insolvent.

        Buiter (and Bagehot, originally) believed central banks could be trusted not to blink or bend this rule in order to preserve their clients at the major banks. On that point they were clearly, catastrophically wrong. The moral hazard implicit in the Bagehot rule was spelled out by his critics even as Bagehot was writing the Economist editorials that laid the foundations of modern central banking. The warnings were ignored and now that moral hazard is coming home to roost.

        The cries of men like Buiter, who whine, “but I didn’t want this kind of central banking!” ring sort of hollow now.

  8. Socratic

    Fascinating discussion here, and one that is central to reform. However, I think Yves is way too optimistic in thinking that we could force enough transparency from the Fed to ever ascertain whether the “root cause of Fed ineptitude was cronyism, incompetence, or a misguided effort to defend past Fed conduct, or some other institutional malady.” My vote is certainly cronyism, or perhaps better termed “regulatory capture”. Because let’s face it, the whole system was based on some seriously false premises that nobody in the system had an incentive to question. The bonuses were being paid, the citizens were taking equity of their houses, taxes were being collected, etc.

    In reagrds to the Freedom CLO, does anyone truly think that Lehman was the only one “gaming” the Fed? First of all, I am nearly certain that I saw Bloomberg headlines at the time that explained that Lehman was creating a CLO in order to post to the PDCF. So I don’t think this was new news.

    What difference does it really make whether Lehman created a new CLO to post to the Fed? ALL of the banks held CLOs that could not be priced during the crisis, and as Yves points out, they held far more “junk” in AAA asset-backed securities that they could (and most likely did) post to the PDCF. The Fed could get away with saying that they would only accept investment-grade securities, but let’s face it, the whole ratings system on tranched paper was completely corrupted! Almost the entire asset-backed market was junk, wrapped in a lot of marketing/ratings BS to transform it into AAA – this was the big fraud.

    Let’s face it, the PDCF was not created so that dealers could post Treasuries. Banks were having problems financing their illiquid positions, they weren’t having problems financing their investment-grade corporates or equities. If the Fed didn’t find some way to allow the banks to fund their illiquid positions, all of the large banks probably would have failed due to an inability to maintain financing.

    What seems to me to be the BIG question is why exactly did Lehman and Bear fail? I didn’t read Sorkin’s book, but my best guess (and I am very interested to hear if others have more clarity) is that the Street/global banks/Fed simply refused to keep financing the illiquid positions of Bear and Lehman, but continued to finance the illiquid positions of Citi, Merrill, and perhaps MS, GS, and JPM. Why? For whatever political reasons, that was the decision.

    If the PDCF was open to Lehman, then why would they have had to declare bankruptcy? They could have just posted their illiquid positions there and slowly unwound their book, just as all the other banks are doing. Likewise, the PDCF was created the day after Bear was forced to fold – if Bear had had access to the PDCF, then wouldn’t they have been able to continue?

    Simply seems to me that the Fed was able to choose who to finance and who to throw to the wolves, as it were.

    My question is – did the Fed turn off the PDCF to Lehman in order to force their hand?


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