Lehman Could Still Follow The Bear

Stearns (BSC), that is. There’s no question that Lehman Brothers (LEH) is playing games with the market and the Federal Reserve is swallowing it. Literally.

Yesterday an SEC filing revealed that Lehman liquidated two money market and one “enhanced” cash fund, absorbing $1.8 billion onto its balance sheet. Lehman took $300 million in writedowns from the funds during its fiscal first quarter. Despite the level of detail Lehman’s CFO Erin Callan presented on their March 18 first quarter earnings call, the liquidation and writedown of the three funds were not specifically mentioned. (This is how Bear’s unraveling began.)

Today’s Wall Street Journal reports that Lehman is now using financial engineering on the Fed. Lehman created a new investment vehicle called “Freedom”. Basically, the fund gives Lehman the freedom to unload their junk at the Fed’s recently opened Primary Dealer Credit Facility for investment banks.

“Freedom” is a CLO (collateralized loan obligation) that bundled up over 60 of Lehman’s loans, with the risk divided into two groups of securities. The higher rated tranches will be used as collateral for loans from the Fed. Some of the loans in the bundle include debt issued to finance the private equity acquisitions of First Data and TXU.

According to the Journal, Lehman claims the junk dropped off at the New York Fed’s doorstep “was meant as a test of what the Fed would accept.” Other Wall Street firms are interested in getting in the game. The Fed is not commenting on Lehman’s collateral or the loan Lehman received.

It is clear that the Treasury and the Federal Reserve used Bear Stearns as their public relations offering to the god of moral hazard. The Fed is allowing Wall Street to continue its financial engineering, and the American taxpayer may end up footing the bill in the future. Investment banks taking their riskiest debt to the Fed is not something the government wants to widely broadcast.

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