Friday, April 11, 2008

We have this mess because of financial engineering and absence of the rating agencies. Now Lehman is using the same financial engineering to use junk securities as collateral to borrow from the Fed.

In recent weeks, Lehman moved $2.8 billion in loans, including some risky leveraged-buyout debt that has been difficult to sell, into a newly created investment vehicle it named "Freedom," which in turn issued debt securities backed by the loans.

About $2.26 billion of the securities received investment-grade credit ratings from Moody's Investors Service and Standard & Poor's. Lehman then pledged some of the securities as collateral for a low-interest, short-term cash loan from the Federal Reserve, according to people familiar with the matter.

The result for Lehman: By repackaging unsold debt and turning to the Fed's new borrowing facility, it was able to turn loans that had been mostly shunned by investors for months into cash it could use to finance its business.

Just like good old "AAA" subprime securities. Mix subprime loans with a few prime and Alt-a loans and you got your self a "AAA" security.

But this is ok becuase this is to save the "System."

One person familiar with the matter said the vehicle was named Freedom because it was designed to give Lehman freedom to tap as much cash as possible if needed. The size of the borrowing from the Fed wasn't known, but the person said it wasn't "material" and was meant as a test of what the Fed would accept.

A number of Wall Street executives called Lehman's move "brilliant" and said they may follow suit. One senior finance executive at a rival of Lehman's said his main reservation with Lehman's move was that it might lead to criticism that Wall Street is taking its junk to the Fed for cash. Still, he noted that unlike many troubled mortgage securities, there is a discernible market for leveraged loans.

This was only a test. More of it is still to come. May be this can be the next profit center. Buy junk securities at 10 cents on the dollar and give it to fed.

I guess this is why Goldman has been transffering securities to Level 3. Just mark them to Fantasy price and give it as collateral to fed.

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