How Lehman, With The Fed's Complicity, Created Another Illegal Precedent In Abusing The Primary Dealer Credit Facility

Five months ago, Zero Hedge observed the nuances of the Federal Reserve's Primary Dealer Credit Facility (PDCF) and concluded that this artificial liquidity boosting construct was nothing more than yet another scam to allow banks to extract ever more money from taxpayers, with the complicit blessing of the Federal Reserve Board Of New York (as the original piece also provided an in-depth discussion of the triparty repo market which is now a parallel to the buzzword of the day in the form of Lehman's "Repo 105" off balance sheet contraption, it should serve as a useful refresher course to anyone who wishes to understand why while Repo 105 with its $50 billion in liability contingency may have been an issue, the true Repo market, with over $3 trillion of likely just as toxic assets, is where the real pain in the future will come from). The PDCF would allow assets of declining and even inexistent value to be pledged as collateral, thus making sure that taxpayer cash was funneled into sham institutions holding predominantly toxic assets, and whose viability was and is limited, yet still is backed by the Fed, which to this day continues to pour our money into them. Today, with a tip from the NYT's Eric Dash, we demonstrate just how grossly negligent the Federal Reserve was when it came to Lehman's abuse of the PDCF, and how the trail of slime of Lehman's increasingly obvious manipulation of its books goes to the very top of the Federal Reserve Bank of New York, and its then governor - a very much complicit Tim Geithner.

1. The Liquidity Conundrum And the PDCF

In our original piece, we posited the following observation on the Fed's constant involvement in liquidity provisioning, particularly in the context of the repo market:

Here is the liquidity crunch in its full flow-chart glory:

1. If can not obtain short-term (overnight or term) funding in repo market, go to Eurodollar market
2. If can not obtain short-term funding in Eurodollar market (LIBOR), go to asset sales
3. If asset sales are impossible due to lack bids, illiquid markets, and collateral consists of toxic MBS and CCC-rated junk bonds, yet margin calls are streaming and repo counterparties are demanding their cash back, go to bankruptcy
4. File for bankruptcy

This would be natural chain of events in a normal capitalist country. However, America in times of stress is anything but - which is why enter 3.5 (after 3 and before 4): the Federal Reserve. What the Fed did was to basically extend credit, first to Bear Stearns (through JP Morgan which ended up acquiring Bear's toxic asset mess, now better known as Maiden Lane as it continues to reside on the Fed's balance sheet), and second to Lehman Brothers (here JPMorgan was not the ultimate beneficiary of the "good bank," and instead it was merely the clearing agent of the triparty repo which had a very nervous Fed on one side, stuck with nearly $70 billion in worthless securities consisting of anything from defaulted CRE whole loans, to stock in hundreds of bankrupt companies.

Keep in mind this is not the first time the Fed has found itself in this situation: in 1998, when LTCM blew up, it was a dress rehearsal to the dot, along with the same feedback-loop driven evaporation of liquidity, as haircuts collapsed and nobody wanted to be on contingent to anyone else making rash decision. Yet there was one notable difference between 1998 and 2008: roughly $3.5 trillion (or 350% more) in outstanding repos: a number equal to about 30% of the US GDP, and a number sufficient to bring down the entire financial ponzi house of cards. Enter the Federal Reserve and the doctrine of encouraged moral hazard.

The Fed's response to point 3.5 - the emergence of the Primary Dealer Credit Facility.

The PDCF is mostly notable for the one fact that on the eve of Lehman's bankruptcy, the PPT officially came out to play. On September 14^th the original, "stricter", terms of the PDCF were modified to expand the collateral package from investment grade securities to pretty much anything that was not nailed down, including equities. In this way the Fed was basically acting as the Plunge Protection Team once removed: it would lend money to banks so they could buy equities. If anybody was confused about the existence of the PPT, it became completely evident on September 14^th. This was also previously discussed on Zero Hedge:

All through the spring and summer of 2008, the Fed was confident it had managed to glue the pieces together, and retain some semblance of stability. Then came that fateful weekend of September 13th about which so much has been written. In advance of the Lehman collapse, and what the Fed knew would quickly become a lock-up of not just money markets (which nearly occurred), but of the entire repo system, bringing practically all leveraged institutions to a halt and prompt liquidation, the Federal Reserve announced this little discussed amendment to the Primary Dealer Credit Facility:

The collateral elligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid. On September 14th, 2008 the gloves cames off, when the Fed, stated in a press release no less, that it would provide virtually free taxpayer capital to banks so that they could go to the market and purchase equities!

And while the gloves really came off after Lehman's failure, there was a sense that in the period between the PDCF's inception in March and the September crisis amendment, the Fed was acting with at least a borderline fiduciary obligation to taxpaying Americans, by at least being true to its words of accepting only "investment grade rated securities."

On March 16, 2008, finding itself in a quandary as to how to unclog frozen repo markets, the Federal Reserve Board announced the Primary Dealer Credit Facility. Most notably from the press release is the disclosure on collateral: "Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities." Note: not junk bonds, equities or any other toxic trash. At least at this point the Fed, while acting to preserve liquidity, still retained some semblance of fiduciary responsibility to the U.S. taxpayer.

We have now discovered that this was absolutely not the case.

When analyzing the Lehman failure, the Lehman Examiner spends a substantial amount of time on the PDCF, and the interplay between it, and Lehman's "assets":

On March 16, 2008, “at the height of the Bear Stearns crisis” the Board of Governors of the Federal Reserve granted the FRBNY the authority to establish the Primary Dealer Credit Facility (“PDCF”)...Under the PDCF, the FRBNY would make collateralized loans to broker-dealers, such as LBI, and in effect, act as a repo counterparty. Unlike a typical counterparty, though, with the creation of the PDCF, the FRBNY was generally understood by market participants to be the “lender of last resort to the broker-dealers.” Reflecting the fact that broker-dealer liquidity had become increasingly dependent on overnight repos to obtain short-term secured financing, the PDCF was structured as an overnight facility.

As to the acceptable collateral qualifier, Valukas notes:

Pursuant to the Federal Reserve Act’s requirement that a Federal Reserve Bank lend only on a secured basis, and according to the convention in repo lending, the FRBNY advanced funds against a schedule of collateral. Collateral accepted by the PDCF initially consisted of: Treasuries, government agency securities, mortgage-backed securities issued or guaranteed by  government agencies, and investment grade corporate, municipal, mortgage- and asset-backed securities priced by clearing banks.

Wall Street immediately greeted the arrival of the PDCF as the panacea that would bail out the world.

Citigroup’s Global Markets Equity Research division upgraded Lehman to “buy” on the back of the expansion of the PDCF. Referring to the PDCF, the Citigroup analysis states: “In our view, it’s tough to have a liquidity-driven meltdown when you’re being backed by government entities that have the ability to print money.” The Citigroup analysis elaborated on that point: “With $34b in liquidity at the parent company, [and] the ability to get access to over $200b in liquidity from the Fed’s primary dealer credit facility, . . . access to liquidity is a non-issue.”

To Lehman itself, the PDCF seemed like a Bernanke Ex Machina. To wit:

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,”5345 the facility “MAY BE THE ‘EXIT STRATEGY’ FUNDING SOURCE WE NEED TO GET NEW COMPETITION IN THE CORPORATE LOAN MARKET.

Amusingly, even Lehman realized the obvious: that the Fed was locked in its "enabler" mode and would now have to serve Ponzi heroin virtually in perpetuity, as it would have no ability to withdraw the extra liquidity:

Feldkamp hypothesized that banks would be able to take advantage of the PDCF’s warehousing potential over the long term, believing the FRBNY could not discontinue the temporary program in the near term, and that the program would eventually become entrenched:

Bernanke and co may have ‘saved the day’, and JPM has a great public affairs approach to make the Bear deal look extremely positive for everyone, by emphasizing how it will be looking forward to applying this new [CDO packaging]  technology to [the] resolution of this crisis. Once applied successfully, the Fed will not be able to end the facility. They’ll have to conti[n]ue it and manage it as a standard monetary policy tool.

Forget lender of last resort: everyone now saw the Fed as the "enabler of infinite resort."

The 'hope' reached to the very top, when Dick Fuld said on March 17:“The Federal Reserve’s decision to create a lending facility for primary dealers and permit a broad range of investment-grade securities to serve as collateral improves the liquidity picture and, from my perspective, takes the liquidity issue for the entire industry off the table.” [amusingly, this is taken from a quote by the now infamous Zachery Kouwe, Lehman Is Not Ready To Fuld — Chairman Bullish Despite 19% Drop, N.Y. Post, Mar. 18, 2008, at p. 37 - we wonder how many sources were trampled in the creation of this reference...]

Oh Dick, if only you knew then how wrong you are.

2. Lehman PDCF Land-Grab

The second PDCF was announced, it became Lehman's saving grace. The firm immediately took to packaging whatever questionable assets it could find, including completely worthless unsecured loans from Mozillo's defunct Countrywide Financial, securitizing them with a few rating agency kickbacks, getting a single A rating for these, and peddling them over to the taxpayers in exchange for cash, with the Fed's criminally negligent complicity:

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. he 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.

The rub here is that unlike any traditional "asset", there was no roadshow, no market, no way to determine the price for the CLO - it was all just Lehman's word. Yet the kicker is that the only reason the CLO was created was to abuse the PDCF's generosity.

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.

Where it gets much worse, and where alarm bells comparable to those in the AIG case should now start to go off, is that Lehman had every intention of manipulating its books to hide its intention of using the CLO exclusively for Fed collateral purposes. This has all the makings of another SEC-sponsored disclosure crisis, in which both the regulator and the Fed were criminally negligent and/or complicit in hiding the true state of Lehman's affairs from the broader public. And while Fuld can claim he was unaware of Repo 105, there is at least a written trail that exposes his order to make Lehman's PDCF participation hidden from the public's eye: this alone is grounds for a criminal and civil investigation.

Lehman may have also managed its disclosures to ensure that the public did not become aware that the CLOs were not created to be sold on the open market, but rather were intended solely to be pledged to the PDCF. An April 4, 2008 e-mail containing edits to talking points concerning the Freedom CLO to be delivered by Fuld stated:

"Given that the press has not focused (yet) on the Fed window in relation to the [Freedom] CLO, I’d suggest deleting the reference in the summary below. Press will be in attendance at the shareholder meeting and my concern is that volunteering this information would result in a story."

It is unclear, based solely on the e-mail, why a reference linking the FRBNY’s liquidity facility to the Freedom CLO was deleted. 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.

While it is immediately unknown if the SEC was aware, and thus at fault as well for the this public disclosure manipulation, what is clear is that the FRBNY was well too aware of the deal:

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."

Thus, the FRBNY was aware that Lehman viewed the PDCF as an opportunity to finance its repackaged illiquid corporate loans. The Examiner’s investigation has not determined whether the FRBNY also understood that these Freedom-style securitizations were never intended for sale on the broader market. In response to a question from FRBNY analyst Patricia Mosser on whether Voigts knew “if they [Lehman] intend to pledge to triparty or PDCF,” Voigts replied that the Freedom CLO was “created with the PDCF in mind.”

Recall that Jan Voigts, who was an Examining Officer in the FRBNY's bank supervision department, was woefully unaware of Lehman's Repo 105, as in the words of the Examiner, he had "no knowledge of Lehman removing assets from its balance sheet at or near quarter-end via a repo trade." Voigts disclosure that Lehman intended to use the PDCF as both a backstop and business opportunity" comes from a letter to none other than Tim Geithner from April 9. What is hilarious is that while the FRBNY itself acknowledges that merely the first part of the use of the PDCF, namely the use of the facility as a liquidity backstop, "could encourage risky behavior", thereby introducing "moral hazard" issues, the second part, i.e., the use of the PDCF as a "business opportunity" screams of gross FRBNY negligence when it comes to eliminating any risk on part of the borrower, explicitly guaranteed by taxpayer funds. And Tim Geithner was all too aware of not just this, but of Lehman's lack of public disclosure of this very critical component to its ongoing business model.

Yet after milking the PDCF for all it was worth, suddenly Lehman got cold feet, as it realized that there is a stigma effect associated with being seen as needing this very last recourse in the lender of last resort's toolkit.

Lehman complained internally, and to the FRBNY, about the stigma attached to PDCF borrowing. In an internal e-mail, Lehman personnel appeared to view the PDCF as a net negative, writing that Lehman could not use it due to its “stigma,”  owing to the fact that “should the Fed disclose the [PDCF] borrowers, it would likely further damage confidence in the institutions that tapped the facilities.” Yet, at the same time, Lehman personnel suggested that the mere existence of FRBNY facilities forced Lehman to “quell rumors and bad press,” presumably regarding whether Lehman was suffering liquidity problems or was forced to access the PDCF. Tonucci also complained of the stigma, elevating his concerns to the FRBNY. Tonucci relayed the rumor to the FRBNY, which he attributed to Standard & Poor’s, that “usage of the PDCF would cause [the rating agency] to change [Lehman’s] outlook from stable to negative.”

Here we uncover yet another stunner: in order to validate whether or not the last statement above was true, the FRBNYs Brian Peters notified the FRBNY's infamous Steven Manzari, notorious for his involvement in AIG disclosuregate, which already got Tim Geithner in hot water before Congress, that he had spoken to S&P's Diane Hinton, who had told him that the rumor was "not at all" true. This brings a whole slew of questions: how often does the Fed discuss rating criteria and policy with the rating agencies? Does the Fed exert pressure when S&P or Moody's determines a given rating? Is the Fed instrumental in "nudging" a rating agency to raise or lower a rating, as then-Tim Geithner/Ben Bernanke and now Bill Dudley/Ben Bernanke so desire? Obviously, with the fate of Greece tied to Moody's one notch downgrade, this question could not have come at a more opportun time.

Yet despite posturing about worries of being stigmatized, Lehman had really no qualms about pleding Freedom CLO as collateral to the FRBNY, and to US taxpayers. And not only that, but it once again materially misrepresented its liquidity needs and actual internal operations, the Examiner finds. Hey SEC: how much more blatant does it get?

Lehman drew on the PDCF facility sparingly prior to its bankruptcy. Lehman accessed the PDCF seven times in the liquidity stress period that followed the Fed-brokered sale of Bear Stearns to JPMorgan. Both internally, and to third parties, Lehman characterized these draws as “tests,” although witnesses from the FRBNY have stated that these were not strictly “tests,” but instances in which Lehman drew upon the facility for liquidity purposes.

After demonstrating a valiant effort in going after "psychics" and enforcing regulations when the amount of money involved is a few hundred thousands dollars (or less), The Scam Enrichment Cabal becomes very quiet when the perpetrator is someone who over the past several decades made over half a billion dollars based on repeated and gross misrepresentation and lies to the public. No, in this case the SEC is very much silent. One wonders just how complicit the SEC's Chris Cox and Mary Schapiro have been in all of this?

The above, in a nutshell, describes Lehman's repeated criminal misrepresentation to both investors, and the Fed's misrepresentation to taxpayers, about both Lehman's involvement in government backstopped programs, its intent in doing so, and the collateral the Fed would accept. We would certainly be more lenient on the Fed if it had indeed done some homework and realized the true value of Lehman collateral, which as is about to be shown, was in fact worthless.

3. The Fed's Criminal Negligence In Performing Any Collateral Diligence

Going back to the beginning, this whole debate would have been a moot point had the Fed done at least a little diligence to determine if the Lehman collateral in question was in compliance with the original PDCF terms of accepting only "investment grade" assets; if instead of blindly following the massively corrupt rating agency doctrine, the Fed's hundreds of overpaid analysts had done at least one hour worth of work; if the Fed had felt even a modest sense of fiduciary oblgiation to US taxpayers, to whom, much more so than Wall Street, it is supposed to be responsible.

This is not what happened.

In fact, what did happen, is that when Lehman attempted to use the Freedom CLO as collateral with Citi a few months down the line, it was classified as "bottom of the barrel" and "junk."

In early August, Lehman offered Citi the Kingfisher, Freedom, Spruce and Verano CLOs – recently rated tranches of asset-backed securities that were backed by corporate loans and structured by Lehman – as collateral in connection with the pledge agreement. Cornejo was concerned about Citi’s reaction to Lehman proposing these assets as collateral  and, according to Mauerstein, Lehman was not surprised when Citi ultimately rejected the CLOs as collateral. Citi personnel characterized the CLOs offered by Lehman in connection with the pledge negotiations as “bottom of the barrel” and “junk.”

There is far more but this is more than sufficient.

4. Total And Criminal Abdication Of Responsibility From Everyone

In conclusion what else can be said that the Fed was grossly irresponsible in its fiduciary obligation to US taxpayers, whose money it used to fund collateral which another bank (which itself would shortly need to be bailed out by taxpayers as well), made it all too clear that the Fed was playing Russian roulette with worthless assets, and admitting these to the PDCF, which at least on paper, was limited to quality collateral. The Fed basically lied to everyone, while behind the scenes allowing not just worthless collateral to be pledged, but worked in complicity with Lehman's management to misrepresent the true state of the firm's financial affairs. The Fed also conspired with rating agencies, and possibly was even instrumental in forcing the rating agencies to produce a credible threat of a major downgrade to Lehman, in order to accelerate the firm's death. Dick Fuld, in the meantime, was also willfully aware of financial misrepresentations, and that he was in violation of SEC reporting requirements, yet that did not stop him from repeatedly perverting the true nature of his PDCF involvements. And lastly, one may ask, where the fuck was the SEC in all of this? Aside from surely lamenting the fact that its only has a $1 billion budget a year, and engrossed in transvestite porn, did the agency do any work to figure out just how the common US investors was getting raped from all sides pretty much throughout 2008, and very likely, continuing to date?