Lehman Brothers used repurchase agreements to make $3 billion in loans to itself and make itself look healthy when it was not, said a March 10 Bloomberg News story by Christine Richard and Bob Ivry.
But the transaction, as described by the reporters, was not unusual. It’s just an example of how repo works.
Here’s how critics claim the Lehman deal worked, according to Bloomberg:
–Lehman got a repo loan from a trust, using troubled real estate loans as collateral. Lehman stood behind the loans, promising, as in all repos, to buy them back later at a higher price.
–The trust issued asset-backed commercial paper, which was backed by the loans and rated highly by credit rating agencies. The high rating was possible in part because Lehman stood behind the paper.
–Lehman used the repo loan to buy the commercial paper from the trust.
–Lehman then used the commercial paper as collateral for repo loans from J.P. Morgan.
Some experts interviewed by Bloomberg reporters raised questions about the deal. Was this just one Lehman department lending money to another? Was Lehman duping JP Morgan by getting a repo loan with lousy collateral Lehman itself created, thus handing Morgan a double dose of Lehman risk? Was Lehman using its own risky but highly rated securities to create the illusion of health so it could get a repo loan from Morgan?
All of this may or may not be true. But the transaction was a classic repo.
And Lehman could still do the same thing today, because the Dodd-Frank Act did little to reform repos. Dodd-Frank does let the Federal Reserve limit banks’ short-term debt, and a spokeswoman told Bloomberg the Fed will propose a rule by January 2012.
Dodd-Frank also puts some limits on repo and derivative transactions with affiliates and other financial institutions. This last provision could reduce systemic interconnectedness and cut back on risky insider deals among affiliates, depending on how regulators enforce it, some experts claim.
“These kinds of transactions had a lot to do with the financial crisis and Dodd-Frank doesn’t target them in any direct way.” David Skeel, a professor at the University of Pennsylvania Law School in Philadelphia, told Bloomberg.
Here’s more from Bloomberg:
Lehman sold its real estate assets under a repurchase contract, or “repo” — meaning the bank was agreeing to buy them back later at a higher price. Then Fenway Funding LLC, a Fenway Capital subsidiary, issued short-term notes backed by the assets — and Lehman bought the notes, said Irena M. Goldstein, a lawyer who represents the Fenway entities, in a July 2009 deposition.
“It was basically, at the end of the day, one Lehman entity owing money to another Lehman entity through Fenway as a conduit,” Goldstein, a Dewey & LeBoeuf partner, said in her deposition. It was given in a lawsuit brought against Lehman by SunCal Cos., an Irvine, California-based developer. The suit, which seeks to put Lehman’s interests in 22 bankrupt projects behind other creditors’, is awaiting a decision from the 9th U.S. Circuit Court of Appeals.
Here are some facts about repurchase transactions to keep in mind when analyzing the Lehman/Fenway/JPMorgan deal:
-Most mortgage originators finance their mortgage loans this way.
-It’s usual for a dealer like Lehman to buy the commercial paper from the trust that is doing the securitizing (Fenway, in this case) and resell the paper to investors, because investors aren’t allowed to buy directly from these trusts. Whatever Lehman couldn’t sell, it would repo out, just like it daily repoed out most of the securities in its inventory.
-The prospectus or private placement memo for the securities would disclose that Lehman stood behind the commercial paper. All JP Morgan had to do was look.
-If JP Morgan was fine making a repo loan to Lehman, it would also have been fine knowing that Lehman had guaranteed the mortgages underlying the repo collateral.
RepoWatch readers who think the Lehman transaction is suspicious might also wonder about other typical repo transactions described at RepoWatch’s About Repo.
Here’s a charming Bloomberg anecdote that reminds RepoWatch of the S&L days:
One of the (Fenway) loans was on 10,000 acres (4,046 hectares) of land in California’s Mojave Desert, about 60 miles (97 kilometers) north of Los Angeles, for a project called Ritter Ranch. None of the 7,200 homes planned there has been built, said David Soyka, a SunCal spokesman.