As Lehman Brothers careened toward bankruptcy in 2008, the New York Federal Reserve Bank came to its rescue, sopping up junk loans that the investment bank couldn't sell in the market, according to a report from court-appointed examiner Anton R. Valukas.

The New York Fed, under the direction of now-Treasury Secretary Tim Geithner, knowingly allowed itself to be used as a "warehouse" for junk loans, the report says, even though Fed guidelines say it can only accept investment grade bonds.

Meanwhile, the Fed and Geithner both strongly oppose a congressional measure to authorize an independent audit of the central bank and its lending facilities. The provision passed the House but is under attack in the Senate, where Banking Committee Chairman Chris Dodd (D-Conn.) says he hopes to stop it.

Without an audit, the Fed is able to conceal the specifics of what it holds on its balance sheet. If the Lehman deal is any indication, the Fed is hiding billions of dollars in toxic loans on its books.

"The Fed legally is forbidden from taking such assets. There's a legal requirement that the Fed's assets be investment grade," Rep. Alan Grayson (D-Fla.) told HuffPost. Grayson, who is the cosponsor of the Grayson-Paul Audit the Fed measure that passed the House, said the Lehman scandal shows precisely why such an audit is needed.

"The net result of this is we know the Fed knowingly bought assets for more than they were worth -- substantially more than they were worth -- and actually created a market for garbage that Lehman was more than happy to push on the Fed because they regarded the public as the suckers of last resort," said Grayson.

A Fed spokesman told the New York Times that a "third party" valued the assets and found they met the standards. Yet the Fed, after accepting the assets, "reduced prices to limit the risk" -- an immediate concession that they were, in fact, over-priced. Otherwise, why reduce their price?

For once, Grayson and Fed Chairman Ben Bernanke are in agreement, to a point. A New York Fed spokesman directed HuffPost to congressional testimony Bernanke delivered last month. "While the emergency credit and liquidity facilities were
important tools for implementing monetary policy during the crisis, we
understand that the unusual nature of those facilities creates a special
obligation to assure the Congress and the public of the integrity of
their operation," Bernanke said. "Accordingly, we would welcome a review
by the GAO of the Federal Reserve's management of all facilities
created under emergency authorities."

Just how far that review would go is the subject of debate in the Senate.

The Valukas report found clear evidence that the New York Fed knew that Lehman was sending it garbage that it had no intention to market. In other words, the baskets of assets were created for the specific
purpose of selling to the Fed for far more than they were worth.

Lehman knew it too: "No intention to market" was scrawled on one of the internal presentations about the assets. A separate bank, Citigroup, later characterized the assets as "bottom of the barrel" and "junk"
when Lehman tried to push them their way, according to the report.

If Lehman hadn't gone bankrupt anyway, the public would have no knowledge of this backdoor bailout. "It's just fortuitous that we found out about this through a bankruptcy proceeding and a trustee that was
willing to allow and pay for some digging," said Grayson. "Do we really
just have to hope for the best, that whenever the Fed does something
wrong, we might someday find out about it?"

Geithner himself was aware that there was a gap between what Lehman claimed the assets were worth and what they were really worth. "The challenge for the Government, and for troubled firms like Lehman, was to
reduce risk exposure, and the act of reducing risk by selling assets
could result in 'collateral damage' by demonstrating weakness and
exposing air' in the marks," Geithner said, according to the report.

The assets, called "Freedom CLOs", were sold to the Fed's "Primary Dealer Credit Facility," according to the report.

Lehman immediately recognized the value of what the Fed had set up. A day after the PDCF was announced, an internal Lehman analysis suggested that "the new 'Primary Dealer Credit Facility' is a LOT bigger deal
than it is being played to be." The facility could be a used as "as a
warehouse for all types of collateral, we should have plenty of
flexibility to structure and rethink CLO/CDO structures."

It was a get-out-of-debt scheme and could "serve as a 'warehouse' for short term securities [b]acked by corporate loans [and] "MAY BE THE 'EXIT STRATEGY' FUNDING SOURCE WE NEED TO GET NEW COMPETITION IN THE
CORPORATE LOAN MARKET," according to the Lehman analysis.

But not one that Lehman felt like discussing with the public. "Given that the press has not focused (yet) on the Fed window in relation to the [Freedom] CLO, I'd suggest deleting the reference in the summary
below," CEO Dick Fuld wrote in an April 4, 2008 email uncovered by the
report. "Press will be in attendance at the shareholder meeting and my
concern is that volunteering this information would result in a story."

Fuld has declared himself vindicated by the report.

The Fed won't say how much more toxic "garbage" is in the Fed's "warehouse" and that also concerns Grayson.

"The Fed's balance sheet is a cartoon version of what's actually inside," said Grayson.
"We only get to basically do autopsies on the carcasses of the Fed's
failures, but what we don't find out is when they show favoritism to
companies that do not end up in bankruptcy."

The Treasury didn't immediately respond to a request for comment. Below is the relevant section of the report:

(c) In Addition to a Liquidity Backstop, Lehman Viewed the PDCF as an Outlet for Its Illiquid Positions

The PDCF not only provided Lehman with a ready response to those who speculated it would go the way of Bear Stearns, but also a potential
vehicle to finance its illiquid corporate and real estate loans. A day
after the PDCF became operational, Lehman personnel commented: "I think
the new 'Primary Dealer Credit Facility' is a LOT bigger deal than it is
being played to be . . . ." They mused that if Lehman could use the
PDCF "as a warehouse for all types of collateral, we should have plenty
of flexibility to structure and rethink CLO/CDO structures . . . ."
Additionally, by viewing the PDCF as "available to serve as a
'warehouse' for short term securities [b]acked by corporate loans," the
facility "MAY BE THE 'EXIT STRATEGY' FUNDING SOURCE WE NEED TO GET NEW
COMPETITION IN THE CORPORATE LOAN MARKET."

Lehman did indeed create securitizations for the PDCF with a view toward
treating the new facility as a "warehouse" for its illiquid leveraged
loans. In March 2008, Lehman packaged 66 corporate loans to create the
"Freedom CLO." The transaction consisted of two tranches: a $2.26
billion senior note, priced at par, rated single A, and designed to be
PDCF eligible, and an unrated $570 million equity tranche. The loans
that Freedom "repackaged" included high‐yield leveraged loans, which
Lehman had difficulty moving off its books, and included unsecured loans
to Countrywide Financial Corp.

Lehman did not intend to market its Freedom CLO, or other similar
securitizations, to investors. Rather, Lehman created the CLOs
exclusively to pledge to the PDCF. An internal presentation documenting
the securitization process for Freedom and similar CLOs named "Spruce"
and "Thalia," noted that the "[r]epackage[d] portfolio of HY [high yield
leveraged loans]" constituting the securitizations, "are not meant to
be marketed."

Handwriting from an unknown source underlines this sentence and notes at
the margin: "No intention to market."

Lehman may have also managed its disclosures to ensure that the public
did not become aware that the CLOs were not created to be sold on the
open market, but rather were intended solely to be pledged to the PDCF.
An April 4, 2008 email containing edits to talking points concerning
the Freedom CLO to be delivered by Fuld stated:

"Given that the press has not focused (yet) on the Fed window in
relation to the [Freedom] CLO, I'd suggest deleting the reference in the
summary below. Press will be in attendance at the shareholder meeting
and my concern is that volunteering this information would result in a
story."

It is unclear, based solely on the e‐mail, why a reference linking the
FRBNY's liquidity facility to the Freedom CLO was deleted. One
explanation could be that Lehman did not want the public to learn that
it had securitized illiquid loans exclusively to be pledged to the PDCF.
Another reason may have been to hide the fact that Lehman needed to
access the PDCF in the first place, given that accessing the securities
dealers' lender of last resort could have negative signaling
implications.

The FRBNY was aware that Lehman viewed the PDCF not only as a liquidity
backstop for financing quality assets, but also as a means to finance
its illiquid assets. Describing a March 20, 2008 meeting between the
FRBNY and Lehman's senior management, FRBNY examiner Jan Voigts wrote
that Lehman "intended to use the PDCF as both a backstop, and business
opportunity." With respect to the Freedom securitization in particular,
Voigts wrote that Lehman saw the PDCF

as an opportunity to move illiquid assets into a securitization that
would be PDCF eligible. They [Lehman] also noted they intended to create
2 or 3 additional PDCF eligible securitizations. We avoided comment on
the securitization but noted the firm's intention to use the PDCF as an
opportunity to finance assets they could not finance elsewhere.

Thus, the FRBNY was aware that Lehman viewed the PDCF as an opportunity
to finance its repackaged illiquid corporate loans. The Examiner's
investigation has not determined whether the FRBNY also understood that
these Freedom-style securitizations were never intended for sale on the
broader market.

In response to a question from FRBNY analyst Patricia Mosser on whether
Voigts knew "if they [Lehman] intend to pledge to triparty or PDCF,"5359
Voigts replied that the Freedom CLO was "created with the PDCF in
mind."

According to internal Lehman documents, Lehman did in fact pledge the
Freedom CLO to the PDCF. On three dates, March 24, 25 and 26, 2008,
Lehman pledged the Freedom CLO to the FRBNY on an overnight basis, and
received $2.13 billion for each transfer.5361 FRBNY discussions
concerning the CLO's underlying assets, however, took place on or around
April 9, 20085362 -- more than a week after the FRBNY began accepting
the CLO.

UPDATE: Tyler Durden at Zero Hedge has been all over this scandal.

Source: Huffington Post.com