Guest Post: Monetary Miscalculations From A World Captive To Models

Tyler Durden's picture

Submitted by Atlantic Capital Management

Monetary Miscalculations From A World Captive To Models

Looking through the Federal Reserve’s newly released Discount Window data fills in some missing pieces surrounding the credit crunch in 2008.  We now know why Senator Chuck Schumer was so concerned about IndyMac.  In the three business days after June 19, 2008, IndyMac had to double its discount window borrowings from $200 million to $400 million.  Four short days later, Schumer’s leaked letter forced IndyMac to ask the Fed for $1 billion.

Beyond some of these little details that end up providing granularity to the whole picture, there is still one piece of data that stands out as a singularity.  Although it had become public knowledge over a year ago, the Lehman Brothers activity on September 15, 2008, still flashes a deepening warning as our economy and markets depend more and more on central banks.

On the surface, Lehman’s use of the Primary Dealer Credit Facility (PDCF, the investment banker’s discount window) seems to be insignificant.  It was a momentous day, after all, with turmoil in every corner of the global marketplace.  Why shouldn’t Lehman borrow $28 billion from the Fed on that Monday?  It had filed for bankruptcy at about 1:30am that morning, so clearly it was in need of financing.

A lot has been published already about that volatile week.  However, I still believe there is a hole in the “official” story as it relates to overall monetary policy.  What is truly striking is not that Lehman used the Fed that Monday; rather the significance was that it was Lehman’s first use of the PDCF since April 16, 2008.  Lehman Brothers did not use the Fed’s liquidity until after it had declared bankruptcy.

Conventional wisdom has seemed to settle on some version of the government allowing Lehman to fail as an example against moral hazard.  But access to the PDCF would not have been viewed as a “bailout” any more than IndyMac’s $1 billion discount window activity.  It is a fact, shown by internal JP Morgan documents, that $24.6 billion in fresh financing for Lehman would have been enough to avoid bankruptcy had it been done on Friday, September 12, 2008. 

As it turns out, Lehman Brothers is not an exclusive term.  The Lehman Brothers that went bankrupt was the holding company for the bank, LBHI.  The rules of the PDCF state that holding companies are not eligible for “primary dealer” status.  So LBHI’s US investment bank subsidiary, LBI, was the legal entity designated as a primary dealer.

But this should not have hindered access to the PDCF either.  As I mentioned above, LBI did access the Fed’s program on five occasions in early 2008:  $1.6 billion on 3/18, $2.73 billion on 3/24, $2.13 billion on 3/25, $2.13 on 3/26, and $2 billion on 4/16.  All five were overnight loans. 

Lehman even went so far as to make a dramatic spectacle of its first transaction.  It put its CFO, Erin Callan, on CNBC on March 18 to declare to the world that it was going to use the PDCF in an effort to take some of the stigma out of it.  It had clearly used the borrowing program and did it in plain sight.

Even the venerable Brian Sack (then the senior economist at Macroeconomic Advisers LLC, now the New York Fed’s head of open market operations) speculated to Bloomberg News on September 10, 2008 that:

“The PDCF could be used to keep Lehman operating until a broader solution was found.  The challenge is figuring out what that broader solution is.”

So why did they wait until after the bankruptcy to finally borrow? 

In short, it seems that the New York Federal Reserve got impatient.

In the weeks before Lehman’s end, the bank had pinned its survival hopes on the Korea Development Bank (KDB).  As KDB ran through its due diligence process, some of Lehman’s counterparties began to get nervous, especially JP Morgan. 

JP Morgan acted as Lehman’s clearing bank, meaning JP Morgan had some minor risk associated with that relationship, as well as extensive inside knowledge.  But because the clearing capabilities were absolutely essential to LBI, Lehman kept JP Morgan up to date with all of its survival plans, including KDB.

On September 5, KDB emailed several executives at JP Morgan, including Jamie Dimon, to notify them that no deal would be done by Lehman’s September 10 deadline.  That same day JP Morgan forced Lehman to post additional collateral for additional perceived clearing risk.

On September 9, KDB officially and publicly ended its interest.  The stock tanked and Lehman’s management decided to pre-announce the third quarter’s results, a hefty loss, on September 10.  Lehman’s credit default swaps spiked 200 basis points, and JP Morgan again got more collateral from Lehman (as did Citicorp). 

At the outset of September, Lehman’s management declared a $40 billion liquidity pool for the company.  Because of these collateral calls and the ongoing loss of short-term financing, Lehman’s actual, available liquidity pool was only $2 billion by September 10.  Informally and quietly, the company began investigating bankruptcy options.

By the weekend of September 13 & 14, the Federal Reserve and the US Treasury were already actively seeking a solution.  Treasury Secretary Hank Paulson was working with the Federal Reserve Bank of New York (FRBNY) President Tim Geithner to gather Wall Street CEO’s and get them to find a private solution.  Paulson was adamant that no Federal guarantees were going to be used this time in a clear departure from the Bear Stearns episode (though Paulson later admitted that the Treasury would have financed some of the deal, he only wanted the CEO’s to come up with a solution ex-Treasury first).

Lehman itself was fully investigating a sale to Barclays.  That sale came very close to fruition on September 14, except that the FRBNY wanted Barclays to guarantee Lehman’s obligations until the sale was finalized.  Barclays agreed in principal but was rebuffed by the FSA (the UK’s equivalent of the SEC).  The FSA stated that the guarantee would require shareholder approval first, and since there was no precedent it would not waive that requirement.

Dick Fuld, Lehman CEO, wanted Paulson to call British Prime Minister Gordon Brown to press the FSA, but Paulson denied the request.  Fuld even tried to contact Jeb Bush, then a consultant for Lehman, to get his brother President Bush to pressure Brown.

It was clear that a deal was very much reachable at that moment, the “broader solution” that Brian Sack alluded to.  All that was needed was some more time – time that could have been provided by the PDCF. 

Apparently the FRBNY was unwilling to give any.  It was decided by Sunday, September 14 that Lehman Brothers was to either have a concrete deal in hand or declare bankruptcy.  The FRBNY’s directive was that Lehman would not open for business on Monday.

From the Valukas Report, we know that Lehman’s outside bankruptcy council, Harvey Miller, received a phone call on the way to meet with FRBNY that Sunday and was told by another attorney at his firm that “Citibank had been told that Lehman was being liquidated”. 

Shortly after that, FRBNY issued a press release changing the terms of the PDCF to accept a much broader range of collateral.  Again from the Valukas Report, “Upon learning of the expansion of the PDCF window, Lowitt [Lehmans’ CFO] and Fuld [Lehman’s CEO] initially believed that Lehman’s problem was solved and that Lehman would be able to open in Europe by borrowing from the PDCF.”

Lehman’s team responded to the change in PDCF as if it was a lifeline, but FRBNY only changed the terms for the other 16 primary dealers.  For Lehman, it placed special restrictions on its ability to access the window – now known as the “Friday criterion”. 

Not long after the press release Herbert McDade, Lehman’s President, with Miller at the FRBNY meeting, called Fuld to tell him that “the Fed has just mandated that we file for bankruptcy.”  FRBNY’s general council, Thomas Baxter said that the filing needed to happen before midnight.  McDade and Miller tried to protest but were told simply, “that it was decided and there were cars available to return them to the Lehman building.”

During its investigation, the Financial Crisis Inquiry Commission (FCIC) asked Baxter about the “Friday criterion”.  He responded that the Lehman board minutes from that fateful Sunday essentially established LBHI was insolvent and its own bankruptcy council had advised, “it was likely the corporation ultimately have to file for protection under Chapter 11.” 

Since LBI was the only entity allowed to access the PDCF, Baxter relayed that FRBNY believed the “Friday criterion” was needed.  First, LBI’s collateral would be discounted by a steeper haircut regime than the other primary dealers due to LBHI being in bankruptcy – FRBNY believed that it had to discount the value of the parent’s support.  Secondly, FRBNY required that LBI certify that any securities pledged were actually owned by LBI as of September 12 and that they were not subsequently transferred from LBHI.  Again Baxter clarified that this was a necessary legal protection for taxpayers, ensuring that there would be no legal recourse to the collateral by the parent in bankruptcy.

These two restrictions effectively closed the PDCF to LBI without a bankruptcy filing for LBHI.  FRBNY knew that Lehman was somewhat uniquely structured so that any securities or collateral were, in fact, “owned” by LBHI.

Baxter also states later in his response to the FCIC that, “after LBHI filed for bankruptcy, the FRBNY did extend on September 15 an aggregate amount of credit of approximately $60 billion to LBI, which enabled LBI to continue in business…To keep all of Lehman operating as a going concern, rather than only the U.S. broker dealer, would have required a vastly greater amount of credit and collateral.” [emphasis added]

That is quite a statement to make knowing full well that FRBNY had just expanded the range of collateral accepted.  And even bolder considering the worthless junk that we now know was actually accepted from the other primary dealers as they got caught up in the panic.

We know that FRBNY had a radically different philosophy when it came to Morgan Stanley (MS).  By September 29 Morgan Stanley was drawing $61.2 billion from the PDCF alone, and $100 billion from the Fed in total.  That accounted for 10% of MS’s total funding needs and 25% of its short-term fundings.

We also know that as early as September 17 Morgan Stanley was already in trouble and drew a massive $27 billion in financing from the PDCF.  There were unsubstantiated rumors that MS’s CEO John Mack told Citigroup’s CEO that same day “we need a merger partner”, and then he actually circulated a memo to employees blaming short sellers for the company’s problems.

From FRBNY’s perspective, it seems clear that the difference in treatment was the perceived insolvency of Lehman.  But was that FRBNY’s call to make? 

The timing of that call was also suspect, particularly in light of Barclays’ interest in merging.  If Lehman and Barclays just needed more time to work out a deal and get the right approvals, why was FRBNY so against giving it?  It had already established the means.

I think the answer lies in the exact timing of the bankruptcy filing.  FRBNY wanted Lehman in bankruptcy that Sunday night – before the Asian markets opened for business.  Remember that in the week of trading leading up to this point, the markets (particularly short-term credit) were pounded by ceaseless rumors and news about Lehman.  Investor fear was rising due to the unending uncertainty.

So it seems the FRBNY went into that weekend with the idea that there would be a resolution by Sunday night, no matter which way it went.  They believed, in my opinion, that getting Lehman off the front pages was the answer to the uncertainty problem, and by extension the short-term fear.  If Lehman could be unwound in an orderly fashion, it would surely calm the markets.

It was a colossal miscalculation.

The fact that PDCF collateral terms were loosened for the 16 non-Lehman primary dealers shows that FRBNY expected some kind of funding tightness in the wake of Lehman’s bankruptcy.  But despite that apparent loosening of monetary policy, FRBNY was still sterilizing its liquidity efforts.  We know that the Fed shut its repo desk completely in mid-September just when liquidity levels were getting serious.

I believe these miscalculations are the obvious result of too much adherence to monetary models.  I think that FRBNY ran many simulations that weekend and determined that Lehman’s bankruptcy would cause a quantifiable amount of disruption, and that the Fed would easily absorb the difficulties.  It seems that the Fed believed that any short-term trouble would be more than balanced by the longer-term benefits of Lehman’s orderly demise (which was, in fact, orderly).  Because of these mathematical, random walk constructs, a 1% probability is no concern at all. 

We know that the Fed models were so far off in 2008 that the estimated probability of the Fed funds rate being near zero was at least a six standard deviation event – an impossibility in their minds.  Even if they had updated their models for the building crisis (which I am fairly certain they did not) how much more accurate would they have been?  A five standard deviation event?

The Fed is a creature of ineffective models.  Every single monetary decision is based on them.  But we have yet to see its full explanation for the actions taken on September 14, 2008.  Counterfactuals are mostly unhelpful, but in this case could it at least admit that it was unequivocally wrong, and that its modeling assumptions fatally flawed?  Any benefit from taking Lehman out of the news was absolutely overwhelmed by the abrupt, outright panic the bankruptcy filing created.  It is not coincidence that Morgan Stanley needed emergency funding on September 16, nor that several more institutions failed in short order thereafter.

I am certainly not suggesting that Lehman bore no responsibility for any of this, or that FRBNY was the only problem here.  Certainly JP Morgan and Citigroup should accept some blame for their blatant, extortive collateral demands.  And the entire concept of credit creation through investment banks and securitized means were major contributors.  Rather, I am simply trying to isolate this overall adherence to the mathematical modeling of financial behavior at the center of repeated monetary miscalculations. 

In the current context of quantitative easing (QE), I have no doubt that the Fed has run the numerous random walk simulations to quantify any effects of ending or extending QE.  I also have no doubt that those calculations will be as “effective” as they were in March 2010 and, unfortunately, September 2008.

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Dr. No's picture

I can understand there is a desire to bring clarity to a chaotic event.  There are theories about moral hazard and not enough money and this and that.  The fact is someone wanted to get rich.  Someone important determined letting Lehman fold would make them richer than if they were bailed out.  This important person then told Hank Paulson to not try so hard finding a solution.  How else you explain why some are bailed out and others are not.  Simple.

Smu the Wonderhorse's picture

Bullseye.  Miscalculation my foot.

Harlequin001's picture

I think it was a screw up. I think the Fed and the Treasury did not want to be seen backing up the entire US economy and so wanted Lehman bankrupt to show this. However, so swift was the attack then on AIG and then Merrill that they knew it was a mistake, so they moved to bail AIG, Merrill and others but once filed, Lehman was too late.

I think had they been able they would have bailed Lehman retrospectively.

Major, major error.

alexanderstollznow's picture

some suggested answers:

*the bailing was done by Treasury, and they didnt have power to do so till TARP was passed, which occurred after Lehman's collapse

*those that were bailed were all banks, with viable businesses, and none of them actually was pushed to the point of funding crisis.  the bails ie TARP were precautionary. 

*as the article makes clear above, there are plain issues about the legal identities which went bankrupt, vs the entity which could have borrowed from the PDCF.  given the unending ranting about the Fed which occurs here, and everywhere else, including capitol hill, perhaps the prospect of the Fed illegally lending might have been a factor for the Fed? 

i know it is a real bitch of a fact if you want to blame the fed - again - for everything, but contrary to the common wisdom, it is actually directed and limited by legal requirements, and as anyone who has ever read the news, or watched the address formerly known as humphrey hawkins, will understand, is under a lot of scrutiny and pressure to act legally.

*contrary to the suggestion the most theories have it that Lehmah was not bailed out to make an example of avoiding moral hazard, Bernanke has stated a number of times that the Fed didnt not have the power to lend to an insolvent company.  as you would hope.  no doubt many here will dispute that, but that is the Fed's position, and presumably that of their legal advisors.

*one can criticise the (insert name of bank or governement entity here) for allegedly acting illegally, or you can critcise it for acting legally and not pragmatically, but you cant have it both ways.

Dr. No's picture

So the laws which govern the FED prevent it from bailing out insolvent companies, allow it to bail out AIG as well as buy toxic assets at face value?  huh.  doesnt really surprise me I guess.  What is surprising is people actually believe they follow the spirit or letter of the law.

Harlequin001's picture

Dr No, to be blunt, if they hadn't bailed AIG you would have no economy. Goldman would have failed as would all the banks one after another and the entire derivatives complex.

I remember the panic and late Sunday notices designed to move markets through Asia. Right or wrong, we would be living in a very different place today if they hadn't, and that doesn't just apply to the US.

tickhound's picture

..."and as anyone who has ever read the news..."

"Bernanke has stated a number of times that the Fed didnt not have the power to lend to an insolvent company"


Wasted breath... You offer nothing I can't find from filtered msm.  Your entire "thesis" should've been summarized by simply stating, "The msm and federal reserve told us so, therefore it is."

Headline should read... "Extraordinary Popular Delusion"


Dr. No's picture

contrary to the suggestion the most theories have it that Lehmah was not bailed out to make an example of avoiding moral hazard, Bernanke has stated a number of times that the Fed didnt not have the power to lend to an insolvent company.  as you would hope.  no doubt many here will dispute that, but that is the Fed's position, and presumably that of their legal advisors.


I dont beleive Lehman was allowed to fall as to make an example.  I beleive they were allowed to fall (rightfully so) because someone determiend they would be more rich with Lehman banckrupt.

Dr. No's picture

those that were bailed were all banks, with viable businesses, and none of them actually was pushed to the point of funding crisis.  the bails ie TARP were precautionary


Note to CIT shareholders: things are fine!

tickhound's picture

""It" (everything that happened then, now, and in the future) was a colossal miscalculation."

Err... Or it was all right on schedule and by design.

NotApplicable's picture

Let's see. At every step of the way, FRBNY was acting to take-down Lehman, yet the author blames it all on adherence to models? Really???

Give me a fucking break.

This article is nothing more than damage-control whitewash.

Whoever wrote this shit should be ashamed.

Raynja's picture

Exactly, there was no miscalculation or mistake, and they were not sacrificed for moral hazard. Someone wanted them gone, or at least not bought by barclays.

Maybe someone finally had all their shorts in place?

Ricky Bobby's picture

+1 The Stakes is High. To sit atop the empire is to be a GOD.

Res publica mortuus est, vivat imperium

I think I need to buy a gun's picture

Well the final 4 was packed last night,,,,these games and events continually sell out as i prepare for the worst what is going on?

Shell Game's picture

The under belly of infamy..  Lehman's old HQ should be cemented over, a sort of 'sarcophagus' if you will, and made into a memorial to dead capitalism.  Long live capitalism.

NOTW777's picture

banker creed - file BK get $

77411147's picture

Bottles and models are what we need....oh wait wrong thread.



Duuude's picture

Oh Bullshit.

Substitute PaulsonSpawn Geithner every time you read FRBNY.

Then think Squid.


nah's picture

numbers can speak truth that noone will understand


and we think afghans are disinterested retards with a global agenda

bank guy in Brussels's picture

Great article.

For those who haven't seen it, the terrific movie -

« The Last Days of Lehman Brothers »

Amazingly, you can see it online here. Totally riveting.

hedgeless_horseman's picture

Looks like we will soon see if $140 oil has something to do with crashing the economy. 

Interesting times, version 2.

tek77blu's picture

Everything QE means................................higher floors for gold and silver.

tony bonn's picture

yeah that's it - the model made me do it.....

Caviar Emptor's picture

People have already forgotten one key piece of the Lehman bankruptcy puzzle: the extreme degree of faith in orthodox market fundamentalism that was present at that time. "Markets are self-correcting, mean-reverting and rational". "The fundamentals of our economy are sound". And Paulson and Bush were the high-priests of market fundamentalism. Markets ran on freedom, according to the gospel.

What is still shocking and hard to understand from today's environment is that the prevalent mode back then was "hands-off". After LTCM, market risks were cushioned by complex layers of derivatives and hedging techniques, people believed. And technology only reduced risk. And the Fed and regulatory bodies encouraged theses practices. It's not that they were asleep at the switch so much as they regarded all the leverage and risk-taking as routine, safe practice given "the new paradigm"

We're in the topsy-turvy, through the looking glass reverse reality now where there is no official confidence in markets not to keel over and puke for almost any reason. The near-death experience of 08 changed it all. 

10kby2k's picture

Is Benny playing with his  hasbro erector set again?  or his easy bake oven?

linrom's picture

Has the Fed modeled yet the possibility that Ahmadinejad is the 12th Iman? Your supposition that you can effectively model financial outcomes has been proven repeatedly to the contrary and merely reinforces the lie that you can create something out of nothing and swindle billions for tomorrow's promises.

New American Revolution's picture

This was all and only about consolidation of 2B2Fails into fewer hands that would make those that remained standing stronger.   Survival was all about connections.    They not only ripped off America, they were ripping off one another,... up to a point.    The men that participated in this crime, beginning at the March 11, 2008 luncheon at the NY Fed; they, and those that aided and abetted the actions of these 'unprincipaled men', and their actions right through the end of 2008 were ALL involved in an 'on going criminal organization' and in violation of Federal RICO laws.    Each and everyone of them need to be indicted and brought before a court on criminal charges.    This includes Baranke, Geithner, Paulson, Dimon, Blankenfein, Fuld, et al.    In the New American Revolution, these men will be brought to justice, and I would suggest that anyone in the current Administration that would consider attempting to circumvent these coming events, consider these acts as their inclusion in these RICO charges as well as obstruction charges.    And once the Revolution has commenced, their obstruction could be construde as 'Treason'.    If I were them, I'd watch my step.

Milton Waddams's picture

So similar to Tim blaming Turbo Tax for his mistake, Ben is going to assign blame to SimCity when the global financial system collapses?

Widowmaker's picture

That's weird, shady Lehman dealings in subprime mortgages and Paulson and Geithner doing absolutely everything to eliminate true price discovery -- dripping with collusion from well before the organized "crisis."

Goldman Sachs won big front running Lehman failure, and loyaties at that place deep - right through the US treasury (tax forfeiture for everyone's fortunes).

I'd say it was much about competition, and the rest of the criminal syndicate of fraud, big-money fraud, being exposed - using the Fed as a weapon and government as a front for the opportunity to take Lehman out.  There has to be a fall guy (just one) to blame everything illegal on so that the rest could say "no one saw it coming," and always have uncertainty.

The joke is on your grandkids, their asses were bet on it and are paying the record bonuses.

Just a theory.

People need to start asking the right questions, like "Where are all the doctors that are needed?"

AldoHux_IV's picture

"The Fed is a creature of ineffective models.  Every single monetary decision is based on them."

That's it in a nutshell.

Still Life Living's picture

In March I attended the Val-Con conference sponsored by the American Bankruptcy Institute where the Chief Bankruptcy Officer (or similar title) for Lehman was on a panel (I can't remember his name and he is not listed in the program-I believe he now works for Alverez).  He discussed a number of issues associated with the bankruptcy and how he had been on the phone with Fuld, Paulson, Bernanke, etc. the night the deciders said that they were going to let Lehman go down. 

He made a statement that he said he has never seen in the press to date: that the government was very concerned that JPM would liquidate Lehman's book of $140 billion, which the feared would depress the market.  So, according to the speaker, the government purchased the Lehman book from JPM for $140 billion cash. (Note that JPM thought the book was a pile of crap because they required credit enhancements before dumping it on the government.)

And this was "long before" there was any talk of a $700 billion system-wide bailout. 

So JPM got made whole to the tune of $140 billion, and they still needed billions more from the Fed to avoid thier own insolvency?  I can't help but think that this is just the high-rollers version of survival where Lehman got voted off the island.  And the survivors got to keep the spoils.


nostromo17's picture

So if it "models" to blame then is no one accountable???

And why do these "models" somehow seem to comfort the commenters that go "yah its the models?"

If there were humans involved Lehman went because they were deep into the mortgage mess...that's who it seems the fed went about eradicating or transplanting in the case of BOAC. --Except for Goldman who was as deep as any into the mortgage mess curiously enough.


thames222's picture

Lehman was definitley set up to fall pre-emptively.  Capitalism is dead, true capitalism anyways--today's American people don't want it.