Securitization ploy first used by Lehman is now commonplace.
A dodgy securitization technique first used by Lehman Brothers to stave off its bankruptcy is now being routinely employed by banks to vacuum up ultra-low-rate short-term borrowings. Corporates—especially small and medium-sized enterprises, but also large-cap companies—are indirect beneficiaries, since the process is one factor in supporting whatever bank credit supply is available.
Essentially, banks are securitizing corporate loans of varying degrees of credit quality and using the resulting highly rated securities as collateral for their own borrowings. The technique relies on rating agencies’ ongoing willingness to rate the senior tranches of collateralized loan obligations as money good. Although this garbage-into-gold arbitrage caused widespread losses during the financial crisis, the banks don’t actually sell the securities to third parties, so the CLO bonds and their ratings are subject to far less scrutiny than deals floated to investors would be.
One rating agency securitization official said these transactions make up a large part of his firm’s ongoing ratings requests.
The approach is very similar to Lehman Brothers’ $2.8 billion Freedom CLO, which it backed in March 2008 with some 66 hung leveraged and/or unsecured loans. It got the $2.26bn senior note rated single-A and gave the impression that the entire deal was sold to investors. In reality, Lehman stuffed it into the Federal Reserve’s Primary Dealer Credit Facility (PDCF), one of the Fed’s emergency lending facilities, three separate times, to borrow over $6bn in total.
Lehman boss Dick Fuld knew this was dodgy—an email from him eventually surfaced in which he directed his staff to pull out any mention of the Fed made in connection to the Freedom issue. “Press will be in attendance at the shareholder meeting and my concern is that volunteering this information would result in a story,” Fuld wrote.
Although the Freedom deal came under criticism in the aftermath of Lehman’s collapse, as an example of the government’s lack of scrutiny of the collateral it accepted, the approach now appears to have become accepted.