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On June 13, 2008, Federal Reserve Vice Chairman Donald Kohn emailed Chairman Ben Bernanke about his grave concerns over Lehman Brothers. This wasn’t September, when all the fireworks exploded, it was months beforehand when everything was supposedly fixed and moving in the right direction. That’s what they all said.

In public.

The night before this email, Kohn and System General Counsel Scott Alvarez had been on the phone with staff members at the central bank’s New York branch (FRBNY), members of the SEC, as well as some officials from the Treasury Department. Lehman Brothers had decided it was going to raise $6 billion in equity capital which many – and many government people – believed was going to quiet the situation.

Lehman’s CEO Dick Fuld had called FRBNY President Tim Geithner instead to let him know he really didn’t know what else to do; as it was described by Kohn in the earlier email to Bernanke, “He really has no alternative plan at this point.” What Fuld really wanted, according to the Vice Chairman, was someone at the Fed or Treasury to talk about how this $6 billion was a big deal, “for us to tell people to buy their [Lehman’s] stock Monday morning.”

No one in the government was willing to go nearly that far on the investment bank’s behalf. What was otherwise decided from conversations between DC and NYC, among FRBNY and Treasury, was that Secretary Hank Paulson would make a statement in Japan about how “primary dealers have learned lessons from March and are reducing leverage, building capital and bolstering liquidity.”

This was, if you’ll recall, the message that officials up and down the lineup had been sending to the public; that Bear Stearns had represented the worst of it, the trough. It was only good things from then on. The Fed back in control after a close call.

Paulson obliged. The evening of the 13th, a Friday, Robert Steel from Treasury emailed Thomas Russo at Lehman to let him know of a Bloomberg article written by John Brinsley describing the Treasury Secretary at the G-8 meeting in Osaka saying “some” banks since Bear had indeed learned their lesson and were working diligently on improving their underlying position, only implying Lehman and its $6 billion must’ve been one.

Russo forwarded this to Fuld.

The reason Paulson wouldn’t go any further was likely due to what Kohn told Bernanke earlier that same day. In the June 13 email, the Vice Chairman relayed to the Chairman:

“They [Lehman Brothers] are a ‘bond house’ that grew in recent years by being aggressive in mortgage securitization etc. One of the hedge fund types on Cape Cod told me that his colleagues think Lehman can't survive--the question is when and how they go out of business not whether. He claimed this was a widely shared view on the Street.”

The operative problem wasn’t the first word in “mortgage securitization”, though that’s how the story’s been told ever since. Subprime mortgages, in fact, have been especially singled out. These were not, however, the story of Lehman Brothers. As discussed last week, Lehman, like Bear, repo issues.


Authorities at the Federal Reserve and throughout the government have access to data in real-time that those of us who’ve been watching closely and trying often desperately to understand any situation can only dream of possessing. And time and again you watch from the future – these emails were released only a few years ago, kept under lock and key by the Financial Crisis Inquiry Commission - as authorities take all this information and then have no idea what they’re looking at.

Lehman was already near dead in the water by June 2008. How bad was it? Another nugget included in the FCIC exhibits was a liquidity profile Lehman’s Robert Azerad had put together for the bank just a week before the equity fiasco noted above. On June 6, Azerad’s numbers had shown $188 billion in its repo book at the end of its fiscal second quarter compared to $231 billion closing its first.

That wasn’t progress.

Why? Of that repo, “non traditional” collateral types had made up $105 billion of the $188 total. Not necessarily subprime mortgages, a little bit of everything that wasn’t government or agency. Much of it European.

In fact, the collateral side got so dicey Lehman was forced to get truly creative, inventing securitization vehicles like Freedom, Spruce, and Sasco to turn otherwise illiquid stand-alone loans being unwillingly warehoused into repo-able securities. This was the bank’s bread and butter business, after all; as Kohn had mentioned to Bernanke, that’s why they were a “bond house.” Literally conjuring bonds from other forms of credit.

But in the case of Freedom, Spruce, Sasco, RLT, or Excalibur, Thalia, and Saphir over in Europe, Lehman wasn’t packaging loans to further its same “bond house” business like always, picking up where it left off in 2007. Rather, the bank in desperation was trying to make investment grade securities out of them which would meet either the Fed’s or the ECB’s eligibility thresholds.

Maybe even satisfy JP Morgan.

It had been a slow-motion wreck up to that point in June, with events accelerating not even a month later. While Fed and Treasury officials continued to say all the right things in public, behind the scenes they were trying to game-plan what Kohn’s Cape Cod hedge fund type had cautioned; insolvency.

On July 10, one step closer, Karl Mocharko, a Senior Trader at Federated Investors, a mid-level money market fund manager active in repo, emailed a bunch of people at both Lehman Brothers and JP Morgan advising them that Federated was pulling out of any triparty repo arrangements it had with Lehman over JPM.

Yes, the issue was Morgan.

“Because JP Chase the triparty clearing bank is unwilling to negotiate in good faith with Federated, we will no longer pursue additional business with Lehman. We will also do as much current REPO as possible with dealers that utilize BONY as their custodian and only back with JP Chase as necessary.”

Federated hadn’t been alone in its disgust, either. Dreyfus had also notified each investment firm that it, too, was pulling out. And, of course, officials looking in on the situation – Bernanke would later confess that the Fed has put in a “small team” of auditors at Lehman and other dealers during this time – somehow managed to think this a favorable development.

Federal Reserve Bank of Chicago’s David Marshall emailed one official circle telling them on the afternoon of July 11, a day later, how this was progress:

“Kim Taylor sent me a follow-up e-mail. The repo lines that were pulled from Lehman were from Dreyfus and Federated. These are mid sized players, but not dealers. Kim thought that this represented an improvement to the picture.”

The fracture dated back to April 2008, and even earlier going back to November 2007. JP Morgan, as triparty repo custodian, was taking steps to protect itself by unilaterally rewriting custody agreements – the bad faith which had exasperated Federated’s Mocharko.

When news of Federated’s decision hit Lehman on July 10, Lehman’s George Van Schaick wrote to John Feraca, a managing director at the bank, to tell him, “We have been trying to negotiate triparty docs on new Federated funds with Chase for over 6 months now. These new funds would have cash for ‘Non-traditional collateral.’”

For mid-level players, Federated had put together $900 million for Non-IG/ABS repo (the “non-traditional” collateral types), including $500 million in “new funds” which Lehman in July 2008 really, really needed.

Lawyers on all sides had gotten involved back in April. Of the major legal issues, apparently JP Morgan (Chase) had added the language “The Margin Value of Securities shall equal or exceed the Sale Price at the times calculated by Bank pursuant to this agreement.” Previously, it had specified the “Repurchase Price.”

This was a huge change in a way that may not seem apparent – even to regulators, obviously.

One of Lehman’s lawyers, Charles Witck, wrote to George Van Schaik on April 23 in obvious disgust:

“Quite bluntly, whether we choose to margin on the Sale (Purchase) Price or the Repurchase Price is a business decision arising out of a negotiation between Lehman and Federated: it is none of JPMorgan's business and they should not be interfering in the economic terms of the transaction particularly when Federated (and most investment companies) view this as a regulatory issue.”

That wasn’t all, JPM was also changing indemnification terms by no longer accepting “split indemnification.” While a complicated issue, here’s Witck again explaining the meat of it:

“To make matters worse, JP Morgan is insisting upon a new provision which have both Lehman and Federated ‘absolutely’ indemnify JP Morgan…for any losses ‘incurred as a result of complying with the instructions of’ Lehman and Federated.”

Taking it one step further, and tipping its hand as to what was really going on here:

“JPMorgan inserted language that, in the event that Federated is undercollateralized or Lehman has insufficient cash to repurchase the Purchased Securities on the Repurchase Date, JPMorgan can, without notice to Lehman, advance cash on Lehman's behalf and charge Lehman interest for such advance.”

“Undercollateralized” is the key, as was changing the margin arrangement to the Repurchase rather than Sale price for any collateral exchanged.

In other words, taken altogether, what Morgan had actually been doing was indirectly warning Federated (and others) about the collateral it was processing in repo from Lehman (and not just Lehman, others, too); thereby, moving with extreme prejudice to protect itself as triparty repo custodian who, in the event of insolvency or bankruptcy, might/could/almost certainly get stuck with this “non traditional” collateral as repo middleman.

Back on July 13, two days after Federated pulled out of JPM-intermediated repo with Lehman, Federal Reserve Board staff member Patrick Parkinson emailed FRBNY’s Lucinda Brickler to advise her as to what the official response to JPM’s antics should be:

“And we should tell JPMC that with the PDCF in place refusing to unwind is unnecessary and would be unforgivable. It is unnecessary because even if JPMC is right that LB [Lehman Brothers] will have trouble rolling its repos with private counterparties we will provide the credit necessary to obviate any credit extensions to LB by JPMC.”

“Refusing to unwind” meant seizing collateral from Lehman pledged as part of the triparty arrangement between it and JP Morgan Chase (JPMC). Why would JPM ever do so? Simple; as should have been made plain in the legal wrangling between itself, Lehman, and Federated, JPM contemplated a situation where the market price of collateral (the Repurchase price) might fall so low that Federated or anyone else would walk away leaving JPM holding the bag, and lawsuits at its door.

Thus, indemnified against possible losses arising from nothing more than “complying with the instructions of” Lehman and its repo counterparties, Morgan Chase could advance cash on its own authority to repurchase any collateral, getting itself out of one sticky situation, and then seize sufficient other Lehman securities to make itself whole.

The lower the market price of them, especially non-traditional, the more collateral JPM would have to defensively demand.

Until there might be none left.

By September 13, this was no mere speculation. Reality had hit home, especially as it pertained to the uselessness of the PDCF. In theory, the Primary Dealer Credit Facility sounds like the perfect answer; if JPM or the rest of the repo market won’t take your collateral, the Fed will!

Patrick Parkinson had claimed just this to Scott Alvarez back on July 21, 2008:

“We lend to LB against non-OMO collateral, then we turn around and borrow against the same collateral, presumably from other PDs [Primary Dealers]. The institutional investors who had fled LB presumably would fund the other PDs.”

Brilliant! Easy peasy.

Like I said, these people have all the information in the world and no idea what to do with it because they don’t know what it shows them. If Lehman’s collateral is causing JPM severe angst, that’s not a Lehman or JPM problem; it’s a sure sign of one of those systemic thing-ies.

What wouldn’t become fully apparent until September 13 was what even a small collateral/repo disruption would do to Lehman as a systemically important money dealer sparking even more contagion.  As I wrote last week about the “regulatory arbitrage in the presence of non-harmonised re-hypothecation regimes”, it’s only the tip of the iceberg.

In Lehman’s 2008 case, a gross shortfall of as little as $100 million in repo funding for Lehman Brothers Inc. (LBI, the US subsidiary) would trigger provisions in various credit facility arrangements between it and Lehman Brothers Holdings (LBHI, the parent) considering the funding gap a default event for LBHI.

This would then trigger more provisions in syndicated as well as bilateral transactions, including derivatives, especially when it came to Lehman Brothers International Europe (LBIE) where much of the firm’s collateral for repo was custodied (as discussed last week).

Because of the “regulatory arbitrage in the presence of non-harmonised re-hypothecation regimes” which had meant moving collateral to LBIE, default wasn’t a straightforward process for the orderly unwinding of re-pledged and rehypothecated collateral ostensibly owned by LBIE’s customers (another pitfall JPM had correctly anticipated, especially in its actions demanding more margin collateral from Lehman in the weeks leading up to its collapse).

On September 13, at the brink of failure, Christopher Tsuboi, a senior staffer in the Bank Supervision/Operational Risk division of FRBNY wrote and forwarded a “highly confidential” memo outlining “how a default for their [Lehman’s] B/D units may trigger a cascade of defaults to the subs which have large OTC deriv books.”

“The majority of securities financing is done out of the LBI (US B/D) and LBIE (UK B/D) subsidiaries. In these entities, repos are transacted under the standard BMA form of master purchase agreement (US) or GMRA agreements (UK). According to Lehman, these agreements are considered ‘standalone’: that is, contractually speaking, a default by LBHI on its credit facilities does not necessarily trigger a default for the LBI subsidiary on its repo lines. In practice, it may become difficult to roll overnight repo in this event.” [emphasis added]

Default, in other words, wasn’t really the problem; the repo market would be. Out of collateral, no funding options left, the PDCF and the Fed utterly clueless and useless, Lehman would be finished. And, unlike the PDCF scenario Mr. Parkinson had outlined, the entire repo market froze.

The fuzzy nature of collateral underpins everything; money dealers’ money dealing activities up and down the line, all across this global eurodollar system, depend upon collateral as its entire basis. From derivatives to plain vanilla lending, in the middle of all of it are these really complicated ways that securities are used and, really, abused as a “normal” part of doing business in this modern global money framework.

Collateralized lending in theory is really simple; in practice, it’s anything but.

In everything they did, officials only thought about how they might save Lehman (or Bear before it); individual institutions. They never saw the big picture, unable to discern the forest (systemic collateral) from the trees (Lehman, AIG, etc.) And they had every last bit of information they needed at their disposal to do this.

The problem was Economics, more specifically econometrics. For decades, monetary proficiency and even basic level technical competence had fallen by the wayside in the new “expectations” regime which depended instead upon the whole world believing Alan Greenspan or his successors would be on top of things – when they so weren’t.

But why do we care about this in 2020? A dozen years later, isn’t this just academic trivia?

The problem, the whole Global Financial Crisis #1, wasn’t really Lehman Brothers, rather it was the system of which Lehman was a key part. That system remains today even if Lehman doesn’t. More to the current point, the fact that there hasn’t been another Lehman Brothers since doesn’t actually mean anything. March 2020 showed all the same systemic (collateral) vulnerabilities regardless of the specific impacts upon individual participants.

I’ll finish this week in the same way as last week; amidst all this vaccine euphoria and inflation hysteria, check out the bills. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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