Posted by Karl Denninger
The Jenner and Block report on Lehman just keeps on giving.
Today I am going to focus on FRBNY’s culpability in the apparent Lehman fraud – that is, the role that FRBNY (and thus Tim Geithner) played in keeping an insolvent institution afloat through the use of fraudulent artifices.
We must look first to what the PDCF, or “primary dealer credit facility” was created to be. The report does this for us:
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.”5332 Reflecting the fact that broker?dealer liquidity had become increasingly dependent on overnight repos to obtain short?term secured financing,5333 the PDCF was structured as an overnight facility.
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.5334
The FRBNY set the lending rate for PDCF advances equal to the rate charged by the Federal Reserve’s discount window, available to depository institutions.5335 In fact, the PDCF was frequently analogized to the traditional discount window, or viewed as expanding the discount window to securities broker-dealers.
In short, the PDCF was essentially an extension of the overnight repo market set up to deal with a very-specific circumstance – Bear Stearn’s near collapse, despite having valid and good, market-recognized marginable collateral that could be posted for overnight repos.
The problem is, as I noted at the time, that broker/dealers used the PDCF not as it was intended and announced but rather as a scheme to post illiquid or even trash collateral that nobody else would take in exchange for liquidity – that is, cash.
These banks could take dogsqueeze, put it in a box and slap a $1 million price tag on it, and given the utter lack of prosecutorial supervision of the law – existing law – they’d get away with it literally forever.
They could then make loans against this “value” and yet what they actually hold is worth zero.
When they ran low on cash they’d then tender that dogcrap to The Fed for a TAF or PDCF loan, and that’s ok too – our Congress simply doesn’t give a damn as the hundred million dollars in bribes, er, “campaign contributions”, insure that blatant violations of The Federal Reserve Act are not only tolerated but cheered whenever Wall Street needs more “slop” for its pigtrough – at your expense.
This was, at the time, an educated guess. Now we know it was much more – it was fact:
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.”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.5351
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.5352 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.”5353 Handwriting from an unknown source underlines this sentence and notes at the margin: “No intention to market.”
It gets better. Not only was Lehman aware that it was gaming the system it gamed public disclosure and FRBNY was aware what was going on:
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.
So we have the company intentionally avoiding public disclosure of “a material event.” Securities laws are supposed to prevent this sort of thing – if they’re enforced.
Did FRBNY know of this? It sure looks that way:
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.
But wait a second – that’s not what the PDCF was intended to be. So here’s a clear statement that FRBNY knew that Lehman (and perhaps others) were in fact gaming the system and yet they did nothing about it.
Who ran FRBNY at the time? None other than Tim Geithner.
It gets better.
Remember the “tests” of the PDCF from that time? Those were lies too:
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.5368 Both internally, and to third parties, Lehman characterized these draws as “tests,”5369 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.
And again, FRBNY and Tim Geithner allowed to be promulgated to the market false information about the character of the use of this facility.
Nor does it end there. FRBNY and Tim Geithner appear to have countenanced and sat silent while Lehman deliberately and intentionally was counting assets that were encumbered in its liquidity numbers! Specifically:
The FRBNY knew that Lehman included pledged assets in its liquidity pool, but as Lehman’s lender rather than its regulator, the FRBNY took no steps to compel Lehman to disclose the discrepancy between Lehman’s reported liquidity pool figure and the actual, smaller number.
FRBNY, however, is both a regulator and a lender. In addition the distinction may be immaterial; if you are a party to a violation of the law and do nothing about it, you can be held accountable as an accessory before or after the fact. In this case these false statements by Lehman appear to be nothing more than a garden-variety fraud, and it certainly appears that Tim Geithner and FRBNY were both fully-aware of what was going on and intentionally said nothing.
The report makes clear that the market was misled, and relied on the misleading statements. Specifically:
On the basis of Lehman’s reported liquidity pool, specifically its reported size and composition of easy?to?monetize assets, market participants formed positive opinions of Lehman’s liquidity profile. Certain influential participants, and rating agencies in particular, cited Lehman’s liquidity pool as the basis for concluding that Lehman’s liquidity position was sound.
“The basis for Moody’s assessment of Lehman’s liquidity,” the report continues, “is the strength of their overall funding framework, which includes an ample liquidity cushion of high-quality unencumbered assets.”
While private parties may have no obligation to “rat out” misperceptions of the market, it is my position that a government agency or actor, irrespective of what other hats they wear, DOES have such an affirmative obligation.
The SEC has concluded:
Post earnings announcement on September 9[, 2008], Holdings’ liquidity decreased . . . from $41 billion to $25 billion – $16 billion of which was required by clearing banks at the start of the day and approximately $7 billion of which was in liquid securities that became near impossible to monetize immediately in this extremely stressed market environment -primarily because of a loss of repo capacity.
As a result, . . . ”free cash” available intra day was less than $2 billion.
With LBIE facing a projected cash shortage of $4.5 billion on September 15, Lehman had no choice but to place LBIE into administration because of potential director liability. This resulted in a cross?default of and triggered the filing [of LBHI] on September 15.
In other words, essentially the entire liquidity pool was tied up in security agreements with various firms, and this was the proximate cause of the bankruptcy filing.
The paper makes a clear case that FRBNY was aware of both the encumbrance and Lehman’s lack of disclosure of this fact to the investment community and did nothing about it.
Here is the bottom line folks: Tim Geithner, then-head of FRBNY, is responsible as the chief executive for everything that went on there. Whether he had personal knowledge or not is immaterial, although it is extremely difficult to believe that he would not know about the most-important issue facing the markets in the summer and early fall of 2008.
The record is clear, however, that while the NY Fed knew that (1) Lehman was gaming the PDCF with assets that other banks refused to repo against (in fact Citi called one of them “garbage”) and (2) it was encumbering its so-called “liquidity pool” with security agreements and as a consequence there was in fact no liquidity available FRBNY did nothing to alert the SEC or investors of this fact.
This paper appears to set forth several prima-facie cases of violations of Securities Laws, both on a civil and criminal level.
The further question, however, is whether culpability extends to both FRBNY and the banks with which Lehman was doing business with. The paper also makes a prima-facie case that both FRBNY and these other banks were fully-aware of what Lehman was up to and intentionally looked the other way, deeming it “not their problem.”
This, I believe, is false.
I cannot have constructive or actual knowledge that you have the intention of robbing a bank (breaking the law) and yet drive you to the bank. If I continue with assisting you in the furtherance of your scheme once I become aware of it I am subject to being charged as an accessory or even as a primary criminal actor in the case.
How is this different?
Further, how is it that we can have a Treasury Secretary who, it appears, had either full or constructive knowledge of the gaming that Lehman was undertaking and yet did nothing about it, leading directly and proximately to the market meltdown in 2008.
Literal trillions of dollars were lost due to this malfeasance and misfeasance, along with millions of jobs. Yet one of the “watchdog” agencies involved in banking clearing and regulation knew about it, did nothing, and the head of that organization now runs Treasury.
It has been my contention that Geithner was largely responsible for willful blindness in the lead-up to this mess since it began. We now have a “smoking gun” making a clear and nearly-impossible to refute case.
I call upon prosecutors both at a State and Federal level to look into this for potential prosecution under both civil and criminal Racketeering statutes, including their counterparty banks and FRBNY.
Tim Geithner must be fired by The President. If he refuses, then following the election in November, when I fully expect that Republicans will re-take both the House and Senate, impeachment proceedings must be brought against President Obama for his willful and intentional refusal to remove the person who this paper makes clear could have put a stop to the collapse for nearly six months and yet failed to do so.