Think Twice Finance

Lehman, the Federal Reserve, and “Freedom” After the Financial Crisis.

The financial pages are a rich source of comedy, but it was with extraordinary hilarity that I observed today that Lehman has wasted no time standing on ceremony. It’s back to business as usual for them. Nose to the old grindstone.

Recently the Federal Reserve, in a move, the papers said, necessary for the preservation of our financial system, made loans available to investment banks as well as banks. This was, we were told, to preserve our financial system because the banks and investment banks were capital short, forced to take difficult-to-value assets onto their balance sheets.

This desperate decision was necessary, the financial pages explained, because unfortunately a group of fellows that had somehow managed to seize power in these luckless institutions had taken unconscionable risks. Apparently these boys and girls created thinly capitalized off-balance-sheet investment vehicles, then misled investors into believing they were safe. Now these formerly powerful people have been cast out of their firms for their sins. It’s called reform.

Maybe you thought, as did I, that there might be some relationship between the losses being incurred by financial institutions absorbing and writing down assets from dangerous investment vehicles and the amount the institutions might borrow from the Fed. Maybe you thought, as did I, that these loans would be used to liquefy hard set-upon beleaguered bank assets for the most part, and the shakier investment banks to a lesser degree. That way, the financial system would be saved by the Fed.

Think again, fellow gullible newsreaders! The investment banks are borrowing more than three times as much from the Federal Reserve under the new regime as the far larger, less healthy banks. And Lehman, friends, has created something new, says today’s Wall Street Journal, leaving no stone unturned to make the system safe. They took $2.8 billion in loans, including some risky leveraged buyout debt, and packaged them together within an off-balance-sheet vehicle. What a concept! The liabilities issued by the vehicle were rated investment grade by rating agencies. Useful, since they might have been getting out of practice rating new vehicles investment grade. This will help them get back in the swing of things. Lehman pledged these securities as collateral for low-interest cash from the Fed and, by golly, it worked. Some other investment banks termed the move “brilliant.”

Thanks to Serena Ng and Susanne Craig of the Wall Street Journal for reporting this to us with a straight face. Thanks to the interviewed investment bankers for showing us what is going to be considered “brilliant” in the brave new regulated investment banking world.

We should not however, be surprised by this turn of events. New money, no matter what its cost, will go to its most profitable use. This we teach in Finance 101, lecture one. Firing disgraced investment bankers does not add to the pool of banking ideas. If anything, it reduces them. The leveraged investment vehicle was the most profitable idea going before the crisis. Apparently it still is. What the crisis did that was positive was to point out to the investing public that these vehicles should be avoided, because their risk was underestimated by the rating agencies. No help from Congress, the Fed or backsliding Presidential candidates such as Senator McCabe needed there.

What might have been hoped for from these political and regulatory luminaries as a result of the crisis was elimination of regulatory capital subsidies that made these off-balance-sheet vehicles profitable in the first place. What we got instead was yet another subsidy, an interest rate subsidy in the form of low-cost loans from the public to further encourage old practices by substituting captive taxpayer funds for newly wised-up investor funds.

Lehman is calling this new investment vehicle “Freedom.” How ironic. Now you know just whose freedom the financial regulators are in the business of protecting.