Fed Ends Bank Exemption Aimed at Boosting Mortgage Liquidity: Bloomberg

By Craig Torres

March 20 (Bloomberg) — The Federal Reserve Board removed an exemption it had given to six banks at the start of the crisis in 2007 aimed at boosting liquidity in financing markets for securities backed by mortgage- and asset-backed securities.

The so-called 23-A exemptions, named after a section of the Federal Reserve Act that limits such trades to protect bank depositors, were granted days after the Fed cut the discount rate by half a percentage point on Aug. 17, 2007. Their removal, announced yesterday in Washington, is part of a broad wind-down of emergency liquidity backstops by the Fed as markets normalize.

The decision in 2007 underscores how Fed officials defined the mortgage-market disruptions that year as partly driven by liquidity constraints. In hindsight, some analysts say that diagnosis turned out to be wrong.

“It was a way to prevent further deleveraging of the financial system, but that happened anyway,” said Dino Kos, managing director at Portales Partners LLC and former head of the New York Fed’s open market operations. “The underlying problem was solvency. The Fed was slow to recognize that.”

The Fed ended the exemptions in nearly identical letters to the Royal Bank of Scotland Plc, Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Deutsche Bank AG, and Barclays Bank Plc posted on its Web site.

Backstop Liquidity

The Fed’s intent in 2007 was to provide backstop liquidity for financial markets through the discount window. In a chain of credit, investors would obtain collateralized loans from dealers, dealers would obtain collateralized loans from banks, and then banks could pledge collateral to the Fed’s discount window for 30-day credit. In Citigroup’s case, the exemption allowed such lending to its securities unit up to $25 billion.

“The goal was to stop the hemorrhaging of risk capital,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Investors were being forced out of the securities market because they couldn’t fund their positions, even in higher-quality assets in some cases.”

Using mortgage bonds without government-backed guarantees as collateral for private-market financing began to get more difficult in August 2007 following the collapse of two Bear Stearns Cos. hedge funds.

As terms for loans secured by mortgage bonds got “massively” tighter, haircuts, or the excess in collateral above the amount borrowed, on AAA home-loan securities rose that month from as little as 3 percent to as much as 10 percent, according to a UBS AG report.

Lehman Collapse

By February 2008, haircuts climbed to 20 percent, investor Luminent Mortgage Capital Inc. said at the time. After Lehman Brothers Holdings Inc. collapsed in September 2008, the loans almost disappeared.

“These activities were intended to allow the bank to extend credit to market participants in need of short-term liquidity to finance” holdings of mortgage loans and asset- backed securities, said the Fed board’s letter dated yesterday to Kathleen Juhase, associate general counsel of JPMorgan. “In light of this normalization of the term for discount window loans, the Board has terminated the temporary section 23-A exemption.”

The “normalization” refers to the Fed’s reduction in the term of discount window loans to overnight credit starting two days ago from a month previously.

The Fed eventually loaned directly to securities firms and opened the discount window to primary dealers in March 2008. Borrowings under the Primary Dealer Credit Facility soared to $146.5 billion on Oct. 1, 2008, following the collapse of Lehman Brothers two weeks earlier. Borrowings fell to zero in May 2009. The Fed closed the facility last month, along with three other emergency liquidity backstops.

Discount Rate

The Fed also raised the discount rate a quarter point in February to 0.75 percent, moving it closer to its normal spread over the federal funds rate of 1 percentage point.

The one interest rate the Fed hasn’t changed since the depths of the crisis is the benchmark lending rate. Officials kept the target for overnight loans among banks in a range of zero to 0.25 percent on March 16, where it has stood since December 2008, while retaining a pledge to keep rates low “for an extended period.”

Removing the 23-A exemptions shows the Fed wants to get “back to normal,” said Laurence Meyer, a former Fed governor and vice chairman of Macroeconomic Advisers LLC in Washington. “Everything has gone back to normal except monetary policy.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: March 20, 2010 00:00 EDT



This in combination with A.K. Barnett-Hart’s Thesis make’s one hell of a Discovery.

Jennifer E. Bethel*
Allen Ferrell**
Gang Hu***

Discussion Paper No. 612


Harvard Law School Cambridge, MA 02138



This paper explores the economic and legal causes and consequences of recent difficulties in the subprime mortgage market. We provide basic descriptive statistics and institutional details on the mortgage origination process, mortgage-backed securities (MBS), and collateralized debt obligations (CDOs). We examine a number of aspects of these markets, including the identity of MBS and CDO sponsors, CDO trustees, CDO liquidations, MBS insured and registered amounts, the evolution of MBS tranche structure over time, mortgage originations, underwriting quality of mortgage originations, and write-downs of investment banks. In light of this discussion, the paper then addresses questions as to how these difficulties might have not been foreseen, and some of the main legal issues that will play an important role in the extensive subprime litigation (summarized in the paper) that is underway, including the Rule 10b-5 class actions that have already been filed against the investment banks, pending ERISA litigation, the causes-of-action available to MBS and CDO purchasers, and litigation against the rating agencies. In the course of this discussion, the paper highlights three distinctions that will likely prove central in the resolution of this litigation: The distinction between reasonable ex ante expectations and the occurrence of ex post losses; the distinction between the transparency of the quality of the underlying assets being securitized and the transparency as to which market participants are exposed to subprime losses; and, finally, the distinction between what investors and market participants knew versus what individual entities in the structured finance process knew, particularly as to macroeconomic issues such as the state of the national housing market. ex ante expectations and the occurrence of ex post losses; the distinction between the transparency of the quality of the underlying assets being securitized and the transparency as to which market participants are exposed to subprime losses; and, finally, the distinction between what investors and market participants knew versus what individual entities in the structured finance process knew, particularly as to macroeconomic issues such as the state of the national housing market. 

 continue reading the paper harvard-paper-diagrams



Michael Lewis’s ‘The Big Short’? Read the Harvard Thesis Instead! “The Story of the CDO Market Meltdown: An Empirical Analysis.”

March 15, 2010, 4:59 PM ET

Michael Lewis’s ‘The Big Short’? Read the Harvard Thesis Instead!

By Peter Lattman

Deal Journal has yet to read “The Big Short,” Michael Lewis’s yarn on the financial crisis that hit stores today. We did, however, read his acknowledgments, where Lewis praises “A.K. Barnett-Hart, a Harvard undergraduate who had just  written a thesis about the market for subprime mortgage-backed CDOs that remains more interesting than any single piece of Wall Street research on the subject.”

A.K. Barnett-Hart

While unsure if we can stomach yet another book on the crisis, a killer thesis on the topic? Now that piqued our curiosity. We tracked down Barnett-Hart, a 24-year-old financial analyst at a large New York investment bank. She met us for coffee last week to discuss her thesis, “The Story of the CDO Market Meltdown: An Empirical Analysis.” Handed in a year ago this week at the depths of the market collapse, the paper was awarded summa cum laude and won virtually every thesis honor, including the Harvard Hoopes Prize for outstanding scholarly work.

Last October, Barnett-Hart, already pulling all-nighters at the bank (we agreed to not name her employer), received a call from Lewis, who had heard about her thesis from a Harvard doctoral student. Lewis was blown away.

“It was a classic example of the innocent going to Wall Street and asking the right questions,” said Mr. Lewis, who in his 20s wrote “Liar’s Poker,” considered a defining book on Wall Street culture. “Her thesis shows there were ways to discover things that everyone should have wanted to know. That it took a 22-year-old Harvard student to find them out is just outrageous.”

Barnett-Hart says she wasn’t the most obvious candidate to produce such scholarship. She grew up in Boulder, Colo., the daughter of a physics professor and full-time homemaker. A gifted violinist, Barnett-Hart deferred admission at Harvard to attend Juilliard, where she was accepted into a program studying the violin under Itzhak Perlman. After a year, she headed to Cambridge, Mass., for a broader education. There, with vague designs on being pre-Med, she randomly took “Ec 10,” the legendary introductory economics course taught by Martin Feldstein.

“I thought maybe this would help me, like, learn to manage my money or something,” said Barnett-Hart, digging into a granola parfait at Le Pain Quotidien. She enjoyed how the subject mixed current events with history, got an A (natch) and declared economics her concentration.

Barnett-Hart’s interest in CDOs stemmed from a summer job at an investment bank in the summer of 2008 between junior and senior years. During a rotation on the mortgage securitization desk, she noticed everyone was in a complete panic. “These CDOs had contaminated everything,” she said. “The stock market was collapsing and these securities were affecting the broader economy. At that moment I became obsessed and decided I wanted to write about the financial crisis.”

Back at Harvard, against the backdrop of the financial system’s near-total collapse, Barnett-Hart approached professors with an idea of writing a thesis about CDOs and their role in the crisis. “Everyone discouraged me because they said I’d never be able to find the data,” she said. “I was urged to do something more narrow, more focused, more knowable. That made me more determined.”

She emailed scores of Harvard alumni. One pointed her toward LehmanLive, a comprehensive database on CDOs. She received scores of other data leads. She began putting together charts and visuals, holding off on analysis until she began to see patterns–how Merrill Lynch and Citigroup were the top originators, how collateral became heavily concentrated in subprime mortgages and other CDOs, how the credit ratings procedures were flawed, etc.

“If you just randomly start regressing everything, you can end up doing an unlimited amount of regressions,” she said, rolling her eyes. She says nearly all the work was in the research; once completed,  she jammed out the paper in a couple of weeks.

“It’s an incredibly impressive piece of work,” said Jeremy Stein, a Harvard economics professor who included the thesis on a reading list for a course he’s teaching this semester on the financial crisis. “She pulled together an enormous amount of information in a way that’s both intelligent and accessible.”

Barnett-Hart’s thesis is highly critical of Wall Street and “their irresponsible underwriting practices.” So how is it that she can work for the very institutions that helped create the notorious CDOs she wrote about?

“After writing my thesis, it became clear to me that the culture at these investment banks needed to change and that incentives needed to be realigned to reward more than just short-term profit seeking,” she wrote in an email. “And how would Wall Street ever change, I thought, if the people that work there do not change? What these banks needed is for outsiders to come in with a fresh perspective, question the way business was done, and bring a new appreciation for the true purpose of an investment bank – providing necessary financial services, not creating unnecessary products to bolster their own profits.”

Ah, the innocence of youth.

Here is a copy of the thesis: 2009-CDOmeltdown

‘Hail Mary’ to Warren Buffett: Untold Details of Lehman’s Fall

March 11, 2010, 6:15 PM ET

‘Hail Mary’ to Warren Buffett: Untold Details of Lehman’s Fall

By Matt Phillips

Doubtless, historians will be going over the mammoth 2,200 page report from the Lehman bankruptcy examiner for years to come.

But we bloggers are writing the first draft now. And there’s plenty of good fodder on Lehman’s final days, including fresh details on its effort to get support from billionaire investor Warren Buffett.

Now, it’s well known that Lehman reached out to Buffett in its final months. The Journal’s Scott Patterson wrote about the Oracle’s decision to pass on Lehman in a story back in December.

But the level of detail provided by this report is pretty astounding. It offers a pretty amazing snapshot of Buffett’s conversation with Lehman CEO Dick Fuld as well as a remarkable window on how the Oracle negotiates during times of crisis.

The report really reads like a novel, so we’ll just give you the sections here:

Fuld and Buffett spoke on Friday, March 28, 2008. They discussed Buffett investing at least $2 billion in Lehman. Two items immediately concerned Buffet during his conversation with Fuld. First, Buffett wanted Lehman executives to buy under the same terms as Buffett. Fuld explained to the Examiner that he was reluctant to require a significant buy‐in from Lehman executives, because they already received much of their compensation in stock. However, Buffett took it as a negative that Fuld suggested that Lehman executives were not willing to participate in a significant way. Second, Buffett did not like that Fuld complained about short sellers. Buffett thought that blaming short sellers was indicative of a failure to admit one’s own problems.

Following his conversation with Buffett, Fuld asked Paulson to call Buffett, which Paulson reluctantly did. Buffett told the Examiner that during that call, Paulson signaled that he would like Buffett to invest in Lehman, but Paulson “did not load the dice.” Buffett spent the rest of Friday, March 28, 2008, reviewing Lehman’s 10‐K and noting problems with some of Lehman’s assets. Buffett’s concerns centered around Lehman’s real estate and high yield investments, lending‐related commitments derivatives and their related credit‐market risk, Level III assets and Lehman’s securitization activity. On Saturday, March 29, 2008, Buffett learned of a $100 million problem in Japan that Fuld had not mentioned during their discussions, and Buffett was concerned that Fuld had not been forthcoming about the issue. The problems Buffett saw in the 10‐K along with Fuld’s failure to alert Buffett to the issue in Japan cemented Buffett’s decision not to invest in Lehman.

At some point in their conversations, Fuld and Buffett also discovered that there had been a miscommunication about the conversion price. Buffett was interested only in convertible preferred shares. Buffett told Fuld that he was willing to agree to a $40 conversion price per share, while Fuld thought Buffett was offering to buy in at “up‐ 40,” or 40% above the current market price, which would have been about $56 per share. On Friday, March 28, 2008, Lehman’s stock closed at $37.87. Fuld spoke to Lehman’s Executive Committee and several Board members about his conversations with Buffett. Lehman recognized that an investment by Buffett would provide a “stamp of approval.” However, Lehman already had better offers for its April capital raise, and Lehman did not think it could give a better deal to Buffett at the same time it gave a less attractive deal to others. On Monday, March 31, 2008, before Buffett could tell Fuld that he was not interested, Fuld called Buffett to say that Lehman could not accept his terms.

Last‐Ditch Effort with Buffett

[Hugh “Skip” E. McGee, III, the head of Lehman’s Investment Banking Division] contacted [President David L. Sokol, president of Berkshire Hathaway’s MidAmerican Energy] again in late August or early September 2008 and outlined Lehman’s “Gameplan” for survival, specifically SpinCo. During a subsequent telephone call with Sokol, McGee explained the “good bank/bad bank” scenario and stated that Lehman would need an investor. Sokol believed the e‐mail and call were intended to induce Sokol to pass that information on to Buffett, so Sokol briefed Buffett on SpinCo. Buffett thought the idea would not solve Lehman’s problems.

Sometime during the week prior to Lehman’s bankruptcy, McGee again reached out to Sokol with what both Sokol and McGee described to the Examiner as a “Hail Mary” pass. McGee asked, “Do you have any ideas to save us?” Sokol, who was bear hunting in Alaska at the time, told McGee that he did not.

Judging by the inclusion of the largely irrelevant bear hunting detail at the end, we can tell that this report was written by a frustrated novelist. (And they did an amazing job.) But what we find most remarkable is the insight these sections offer on how Buffett assesses companies.

It’s simple–but not easy–as he combines 10-K analysis with probing questions to management.

Are they willing to put their own money at risk? Are they being upfront? Are they giving investors the full story?

Clearly Buffett didn’t think so.


NY Fed Under Geithner Implicated in Lehman Accounting Fraud Allegation

by Yves Smith at 11:06 pm

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator’s effort to blame the gaping hole in Lehman’s balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.

We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed’s review of Lehman’s solvency. If, as things appear now, Lehman was allowed by the Fed’s inaction to remain in business, when the Fed should have insisted on a wind-down (and the failed Barclay’s said this was not infeasible: even an orderly bankruptcy would have been preferrable, as Harvey Miller, who handled the Lehman BK filing has made clear; a good bank/bad bank structure, with a Fed backstop of the bad bank, would have been an option if the Fed’s justification for inaction was systemic risk), the NY Fed at a minimum helped perpetuate a fraud on investors and counterparties.

This pattern further suggests the Fed, which by its charter is tasked to promote the safety and soundness of the banking system, instead, via its collusion with Lehman management, operated to protect particular actors to the detriment of the public at large.

And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.

I am reading the report, and will provide an update later, but here are the key bits (hat tip reader John M). As much as Karl Denninger has done some terrific initial reporting, he does not go far enough as far as the wider implications are concerned.

The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name, but Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales. Note that at the time (as the report notes) analysts and others kept probing at the seeming miracle of Lehman’s deleveraging in a difficult market. This ruse may also square the circle on a Lehman leak we broke in 2007. A former Lehman MD had reported that most of the deleveraging that had occurred at the end of 2Q 2008 had resulted from the placement of $55 billion of assets with newly-formed entities in which Lehman retained a 45% ownership interest and were operated by former Lehman employees. To put it mildly, these were off balance sheet entities that strained the idea of independence. Bloomberg got hold of the story, and Lehman asserted that only $5 billion of assets had actually been transferred. I am now wondering whether the $55 billion were indeed transferred precisely as the source had said originally (he in turn had been told this by several people at Lehman) but that most of it was via this type of repo, and then re-materialized on Lehman’s balance sheet once the quarter end had passed (the Examiner’s report notes that the amount that Lehman moves off its balance sheet at the end of 2Q 2008 was $50.38 billion, which tallies with the difference between what the Lehman MD said had been moved off balance sheet versus what they fessed up to when asked by Bloomberg) .

Denninger raises one question: were other banks engaging in this type of accounting chicanery? But there is another question: did some of Lehman’s counterparties must have suspected what was going on, given that this took place on a large scale basis at the end of every quarter? How many had an idea that Lehman was engaging in massive window dressing and chose to play along?

But here is the part of the report that discussed how the Fed aided and abetted Lehman misconduct:

the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman gave full and complete financial information to Government agencies, and that the Government never raised significant objections or directed that Lehman take any corrective action.

Yves here. So get this: even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. Its games playing was in full view to those charted with protecting investors and the financial system.

So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Yves here. So get this: the stress tests were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health.

So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.

Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.

It is time for Geithner to go. He is not fit to serve as Treasury secretary.

And the time is overdue for a full audit of the Fed, and in particular the New York Fed, from the start of the Bear crisis through and including all the retrades of the AIG bailout.

Update 12:00 AM, 3/12/10. Oh, boy, the spin is in in the US. Bloomberg focuses on an interesting revelation in the report, but which strikes me as secondary, that JP Morgan and Citi delivered the fatal blow to Lehman by withholding collateral. That JP Morgan seized $17 billion of collateral has been reported elsewhere; the only new elements are Citi’s role and that its and JPM’s actions could serve as grounds for legal action:

“There are a limited number of colorable claims for avoidance actions against JPMorgan and Citibank,” Valukas said in the report. He defined a colorable claim as sufficient credible evidence to persuade a jury to award damages at trial.

The Times pointed ignores the Fed’s lapses, as does the Journal and the major report at the Huffington Post.

Update 3:00 AM. Have now read the germane section a bit (over 300 pages, please do not bust my chops). Every page is stunning (the law firm did a great job, this is one case where big fees are associated with big time value). The nonsense is mile high. Lehman had been doing this sort of thing since 2001. No US law firm would give them cover via an opinion letter for their phony repo accounting, they managed to get the opinion they sought in the UK and accordingly shuffled assets through the UK for the repo 105 transactions. Frankly, if you don’t need colorful characters or glam settings, this is as attention-capturing as Too Big To Fail

More on this topic (What’s this?)

Holy F%$^ing Lehman Brothers Autopsy (Jr Deputy Accountant, 3/12/10)

Move Your Money…

Move your money to a community bank or a credit union…watch the videos.

Here is Arianna Huffington: Move Your Money: A New Year’s Resolution

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