Circles in the Park, Lehman addition March 12, 2011 at 10:21 am

Bloomberg has a good article about Lehman’s Fenway CP conduit. It’s a complicated story so stick with me.

First, what was Fenway?

Lehman transferred dozens of loans and equity positions in commercial real estate to a conduit called Fenway Capital LLC… Then Fenway Funding LLC, a Fenway Capital subsidiary, issued short-term notes backed by the assets

So far, this is straightforward. Many banks had conduits which issued asset backed commercial paper (‘ABCP’) – notes backed by assets the banks had sold to the conduit.

The first slightly wacky part, though, is that Fenway didn’t buy the assets outright:

Lehman sold its real estate assets under a repurchase contract, or “repo”

Now, an ordinary conduit buys its assets. For Fenway to reverse repo them in implies that Lehman was on the hook for the ultimate performance of the asset; Lehman was just getting them off balance sheet temporarily. Moreover it implies that Fenway needed a lot less credit support for the assets than if it had had to get an A1/P1 ratings on its ABCP on the basis of owning the assets. But, as Moody’s put it:

Due to the distinct structure of repo conduits, there is direct linkage between the Prime-​1 rating of the repo conduit and that of the counterparties under the repurchase (​or similar) transactions into which the conduit has entered.

In other words, a repo conduit is only as good as the person who promises to repurchase the assets – Lehman in this case. (There is more on repo conduits c. 2007 here.)

The next bit, though, is whiffier than a well worn red sock.

Lehman bought the notes

This ought to have broken the scheme. If Lehman owned the notes Fenway Finance issued, then getting a deconsolidation opinion on the Fenway group would have been very hard. In effect Lehman would not have got the assets off balance sheet at all.

(Lest you think that Fenway had enough other buyers that Lehman would not have had to consolidate, Bloomberg tells you Lehman was the only buyer of its final issuance [of notes].)

The final step makes the whole game worthwhile for Lehman:

Lehman pledged Fenway notes as collateral to JPMorgan Chase & Co.

Thus Lehman has transformed collateral that JP would not have accepted, or at least not without a huge haircut, into an asset that they would, using the Fenway circus (and a small amount of credit enhancement). It’s clever. But is it legal?

3 Responses to “Circles in the Park, Lehman addition”

  1. What I find interesting is that the Poster Child of solid risk management, JP Morgan, was at first caught by this trick. Although there were quite a few layers of complexity, this doesn’t sound that hard too find out.

  2. Siram – But the Fenway notes were rated. So that makes them OK, right? I mean, no one would think to do more due diligence than look at the rating would they?

  3. Lol, I see what you mean. I guess this is also the result of how late JP Morgan realized how big the credit risk their triparty repo clearing operation actually was.