When, in the spring of 2008, there came a sudden burst of CLO issuance, there was some speculation that the securitisations were being created to take advantage of a new Federal Reserve facility.
The Fed’s Primary Dealer Credit Facility, or PDCF, was initiated in March 2008, in response to troubles at Bear Stearns and the seizing-up of money markets. The facility let primary dealers, the Fed’s official trading partners, borrow from the central bank in return for posting investment-grade collateral.
Lehman’s $2.8bn Freedom CLO, we know now thanks to Anton Valukas’ report into the bank’s bankruptcy, was created with the express intention of using the deal at the facility.
The troubled bank pledged Freedom’s $2.26bn senior A-rated tranche to the Fed three times, receiving a total of $6.93bn. Other CLOs, and some as yet “unknown” collateral, were also pledged to the Fed, according to the report.
In total Lehman accessed the PDCF seven times before its bankrupcy.
JP Morgan, meanwhile, did something similar with its $1bn Ares Enhanced Loan Investment Strategy 2008-3 CLO. Other CLOs created at the time — by Deutsche Bank and Barclays – were also thought to be possible contenders for use as PDCF collateral, though that has not been confirmed.
Use of the PDCF was of course, to be expected. The Fed set it up with the idea of relieving market illiquidity. Note for instance, that Citi refused Freedom and similar Lehman CLOs when they were offered as collateral to secure intraday clearing exposure. No one, except the Fed, wanted these things.
The controversy over Lehman’s Freedom deal should focus on the bank’s concealment of the CLO’s purpose — you can’t fault the company for taking advantage of a Fed facility. Reports that the bank had sold about $2.2bn of the senior notes in the securitisation suggested Lehman was finding genuine demand for its assets — something which, we know now, simply wasn’t true in the spring of 2008.
Likewise the bank’s insistence that it was simply “testing” Fed PDCF demand, as opposed to actually tapping the facility, is market obfuscation, as is deleting references to the PDCF in Freedom’s summary.
Transparency, then, was the key.
The market looks to have been more certain of the purpose of JP Morgan’s Ares CLO — and, at least, the bank did mention in its 2008 annual report its use of the PDCF as a source of funding.
The PDCF itself is a pretty transparent thing. The Fed publishes weekly data on its use, which you can also see in the chart from the Federal Bank of New York’s Current Issues in Economics and Finance, below. The small uptick in early 2008 would have been the burst in CLO issuance, we think:
Perhaps the most controversial thing that can be said about the facility — other commentary and general central bank-moral hazard issues notwithstanding — is the valuation side of it.
Because of the way the PDCF is structured, using triparty repo mechanics, it’s left to the clearing banks to actually value the collateral pledged by banks to the Fed. In a triparty structure, the borrower gives collateral to the clearing bank, and it’s the clearing bank which assesses the collateral and applies an appropriate haircut — the difference between the market value of the assets and money lent.
In fact, former FT-blogger-turned-Citi-economist Willem Buiter was onto this when the PDCF was first announced:
This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘ . . . range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?
JP Morgan Chase, incidentally, was Lehman’s triparty clearing bank.
But that’s a whole other story.
Related links:
A rare glimpse into the Fed’s discount window - Zero Hedge
After TAF, le CLO deluge? - FT Alphaville, 2008
Lehman alone in its Fed-Freedom CLO bid? – FT Alphaville