United States: Lehman Brothers Broker-Dealer Emergency Liquidity Program, 2008

The Fed provided expanded PDCF financing to LBI because “the FRBNY and Lehman believed, correctly, that . . . parties that previously had provided Lehman with overnight secured financing through repos would refuse to ‘roll’ (i.e., renew) those repos beginning on Monday, September 15” (Valukas 2010b, 2118–19).

The FRBNY established the Primary Dealer Credit Facility on March 16, 2008, to provide overnight secured financing to primary dealers.^FNThe FRBNY defines primary dealers as its counterparties in the implementation of monetary policy (FRBNY n.d.b) The goal of the program was to support the orderly functioning of repo markets and financial markets more generally in the early stages of the Global Financial Crisis (FRBNY 2008). For a full account of the PDCF as a broad-based program, see Yang (2020).

Lehman Brothers Inc. was the broker-dealer subsidiary of Lehman Brothers Holdings Inc. (Wiggins and Metrick 2019). LBHI suffered a sustained lack of confidence in the wake of the Bear Stearns rescue owing to the similarity of its business model to the rescued investment bank (Alvarez, Dudley, and Liang 2020). Starting in the summer and continuing through the fall of 2008, Fed officials considered the ramifications of a possible Lehman bankruptcy. According to the Financial Crisis Inquiry Report (the FCIC report), which was written to present the conclusions of the Financial Crisis Inquiry Committee, the fundamental issue was that the SEC would want LBI to continue functioning after a bankruptcy (FCIC 2011). Given the legal constraint that any loan be reasonably commensurate with the amount of unencumbered collateral the firm could offer, and a view among policymakers that a loan should be made only in the event it saved the firm, a bridge loan to LBI was viewed as viable, whereas a loan to LBHI was not (Geithner and Metrick 2018). Further, authorities considered the bridge loan to LBI to be a key measure to contain the damage of an LBHI bankruptcy (Bernanke 2015; Geithner 2014; Paulson 2010). A loan through the PDCF would allow the broker-dealer to work down its trading book, facilitating a more orderly wind-down, inclusive of a sale of much of the business to Barclays, before the broker-dealer’s liquidation through the SIPA process (Bernanke 2015; Geithner and Metrick 2018). SIPA liquidations for US broker-dealers are managed by the SIPC, a government-created nonprofit funded by the investment industry (SIPC 2009).

The goal was to delay the SIPA liquidation for a few days to allow LBI to pay back its repo lenders and allow Barclays to purchase most of the broker-dealer (Bernanke 2015). If the firm had immediately entered SIPA liquidation on September 15, Lehman’s repo obligations could have been subject to a stay as part of the proceedings. In an automatic stay, a failed company’s counterparties would be unable to seize collateral for some period of time. Repo lenders were exempt from the automatic stay provisions of the US bankruptcy code, but they would not necessarily be exempt from the stay in a SIPA liquidation given the rights held by the SIPC (Bane et al. 2008).^FNIn a SIPA liquidation, the SIPC held the right “to seek a stay of foreclosures on or other dispositions of securities collateral, securities sold by a debtor under a repurchase agreement or securities loaned under a securities lending agreement” (Bane et al. 2008). Indeed, when LBI was liquidated later in the week, SIPA imposed a 21-day stay on its remaining repo lenders (Giddens 2010).

On the weekend of September 12–14, Lehman weekend, authorities faced the reality that LBHI would need to file for bankruptcy after an unsuccessful sale of LBHI to Barclays (FCIC 2011). Whatever the condition of the parent company, then–Fed Chairman Bernanke and other officials at the Fed and SEC considered LBI, the broker-dealer, to be solvent, and authorities were confident that the broker-dealer could achieve an orderly wind-down of its operations in the wake of the holding company’s bankruptcy filing (Bernanke 2015). Moreover, officials thought a Barclays deal would still happen for the bulk of LBI. However, JPMorgan, LBI’s clearing bank, had informed authorities earlier in the weekend that it would not be willing to unwind LBI’s repo positions unless the Fed expanded the types of collateral that could be financed through the PDCF to include all types of collateral that JPMorgan and Bank of New York Mellon (BNY Mellon), the other tri-party repo clearing bank, accepted. In tri-party repo transactions, the tri-party repo clearing banks took a substantial amount of intraday risk. Each morning, clearing banks returned cash to lenders and took possession of borrowers’ collateral, known as “unwinding” repo loans (FCIC 2011, 284). Thus, the clearing banks took significant credit risk on those positions until the evening, when they matched lenders and borrowers for the next day’s loans. That weekend, JPMorgan was worried about continuing to provide intraday credit in the event repo lenders pulled back from Lehman, if the Fed was not going to make PDCF funding available on all of the collateral it held for Lehman (FCIC 2011).

On September 14, 2008, the Fed did expand the types of eligible collateral for the PDCF to closely match collateral accepted by tri-party repo clearing banks (Fed 2008c). Having learned of this, JPMorgan officials communicated internally that it would continue to provide clearing and settlement services as long as LBI “was doing an orderly liquidation” (Valukas 2010b, 2121). JPMorgan would continue to unwind the tri-party book given that LBI was not filing, and it would post any end-of-day LBI positions to the PDCF (Buyers-Russo 2008a; Buyers-Russo 2008b). JPMorgan did unwind $87 billion in trades for Lehman on the morning of Monday, September 15, and held those positions until the evening. However, JPMorgan’s position on lending to Lehman became more unclear on Monday, prompting continued correspondence between FRBNY officials and JPMorgan (Valukas 2010b). By mid-morning Monday, JPMorgan clarified that it would continue to serve as LBI’s clearing bank but would limit its aggregate payments settlement exposure to LBI to $1 billion (Buyers-Russo 2008a; Buyers-Russo 2008b; Valukas 2010b).

The PDCF was a broad-based FRBNY facility available to all registered primary dealers. However, the FRBNY limited LBI’s eligible collateral to those assets which had been pledged to its tri-party repo clearing bank, JPMorgan, as of September 12, 2008—referred to as the “Friday criteria” (Valukas 2010b, 2119–20). According to then–FRBNY General Counsel Baxter, the Friday criteria satisfied the FRBNY’s need to verify that none of the collateral pledged to the PDCF could be subject to a superior claim in LBHI’s bankruptcy proceedings. He added that the criterion also ensured that PDCF collateral would not be subject to claims of fraudulent conveyance.^FNFraudulent conveyance refers to the transfer of property to prevent or delay the payment of debt to a creditor without the creditor’s knowledge (Cornell n.d.) In protecting against both scenarios, the Fed intended for the Friday criteria to prevent the FRBNY from being exposed to any situation in which it may have been under-secured (see Key Design Decision No. 10, Balance Sheet Protection). In addition to the Friday criteria, the FRBNY assigned steeper haircuts to LBI’s assets owing to the bankrupt status of its parent (Baxter 2010b).

Alongside PDCF borrowing, LBI also received liquidity from the Term Securities Lending Facility (TSLF) and the Fed’s open market operations (OMOs) (Valukas 2010b).^FNThe Federal Reserve had started using temporary OMOs in the second half of 2007 as a means of providing the banking system with additional reserves while keeping the federal funds rate near its target (English and Mosser 2020). By fall 2008, OMOs and other conventional tools were already heavily engaged, contributing to the Fed’s use of its Section 13(3) lending authority (English and Mosser 2020). On September 15, 2008, the FRBNY provided $18.5 billion to LBI using the TSLF^FNA former FRBNY official involved in the LBI assistance told YPFS that, while the Fed charged LBI higher haircuts on PDCF loans, it did not do so for the TSLF owing to the higher-quality collateral required to borrow from the TSLF. and $2.8 billion using OMO overnight trades that occurred every night (Alvarez & Marsal 2008). LBI continued to access these facilities until September 18. Barclays also lent LBI $15.8 billion overnight from September 15 to 17 (Fleming and Sarkar 2014). On September 18, Barclays replaced the Fed as LBI’s source of secured funding (Valukas 2010b).

On September 18, 2008, Barclays Capital Inc. began to provide the necessary funding for LBI to continue to wind down its tri-party repo operations (see Key Design Decision No. 4, Administration). Figure 2 shows the borrowing from the PDCF and TSLF by Barclays in the days following the agreement, up to the formal purchase of LBI on September 22, 2008.

The Fed used the authority granted by Section 13(3) of the Federal Reserve Act to establish the PDCF (Yang 2020). This authority was premised on “unusual and exigent circumstances” and required the Fed to be “secured to the satisfaction” of Fed officials (US Government 2008). Federal Reserve officials have defined this stipulation to mandate that Fed authorities are reasonably certain ex ante that the central bank will be repaid in full. The authority is also considered to be discretionary, allowing interpretive space to determine the level of security necessary to be “satisfied” (Alvarez 2022, 5–6).

Former Federal Reserve Board General Counsel Scott Alvarez emphasizes the discretionary nature of 13(3) lending; on the decision not to lend to LBHI, he says, “we just didn’t feel we could take the losses that would be associated with that, given the authority that we had” (Alvarez 2022, 5, 19). Former FRBNY General Counsel Thomas Baxter cites the necessity of satisfactory security as the reason that authorities did not provide an unsecured and unlimited guarantee to LBHI. He asserts that creditors knew that LBHI was insolvent, and that the Fed would have been lending into an ongoing run from a bank that could not be saved (Baxter 2020).

As discussed in the Overview, the view of the inability for the loan to save all of LBHI proved important in policymakers’ determination of appropriate use of their Section 13(3) authority. Baxter testified to the FCIC that [emphasis added], “In this case, Lehman had no ability to pledge the amount of collateral required to satisfactorily secure a Fed guarantee, one large enough to credibly withstand a run by Lehman’s creditors and counterparties” (Baxter 2010a, 9). Former FRBNY President Timothy Geithner later writes, “The Fed’s emergency authorities limited how much risk we could take; we were the central bank of the United States, and we weren’t going to defy our own governing law to lend into a run” (Geithner 2014, 187). Geithner also has since pointed out that “the absence of an explicit solvency test in the Federal Reserve Act does not mean that the lending tools should or could be used to sustain firms that are not viable. To lend freely to the nonviable carries many risks” (Geithner 2019, 22).

LBHI’s outcome thus contrasts with the Fed’s ad hoc assistance in the rescue of Bear Stearns, which, unlike LBHI in the Fed’s view, had going-concern value, as demonstrated by the fact that it was being acquired by JPMorgan. In that case—of having a viable acquirer—Geithner says that the Fed’s loan met its “secured to the satisfaction” standard because “if we held on to the assets for a few years, we would probably break even”—that is, the Fed would have an ex ante expectation of full repayment (Geithner 2014, 156; US Government 2008). Similarly, LBI appeared to have a likely, though not immediate, buyer in Barclays (Valukas 2010b).

Geithner says that authorities were reasonably confident in lending to LBI largely owing to its smaller size and the quality of collateral—as well as its SIPA resolution independent of the bankruptcy process. LBI’s liquidity needs were much smaller than LBHI’s, and the value of its collateral was sufficient to cover its immediate financing needs and allow its business to continue functioning as it unwound its positions. He says that most of the assets that caused concern over LBHI’s viability were held outside LBI (Geithner and Metrick 2018). Additionally, the Friday criteria served as a key legal mitigant, preventing a situation in which the FRBNY could have been under-secured (see Key Design Decision No. 10, Balance Sheet Protection) (Baxter 2010b).

As Geithner writes in a 2019 article:

By contrast for the holding company, “without a willing buyer and without access to a resolution regime like the FDIC’s regime for banks [see the Summary Evaluation], we believed that to lend on a scale necessary to save it would be outside the limits of what we could do” (Geithner 2019, 23).

The FRBNY administered the PDCF, providing secured funding to LBI between September 15 and 17 (FRBNY 2009; FRBNY n.d.a). JPMorgan priced LBI’s TSLF and PDCF collateral, but not that which was used for OMO (see Key Design Decision No. 2, Part of a Package) (Alvarez & Marsal 2008).

Despite the Fed's willingness to provide funding, some FRBNY officials were concerned about its exposure to LBI given the two-week funding time frame. On September 16, the FRBNY contacted Barclays and stated that for LBI to continue accessing PDCF funding, Barclays needed to remove FRBNY’s exposure to LBI before the closing of the sale agreement (Valukas 2010b). Barclays’s US based broker-dealer, Barclays Capital Inc., already had access to the PDCF as a primary dealer (FRBNY n.d.a; GAO 2011).

On September 17, 2008, Barclays and the FRBNY came to an agreement (the replacement transaction), which stated that Barclays would take over as LBI’s source of secured funding^FNBarclays had already been providing LBI with liquidity through tri-party repo (see Figure 3). (LaRocca 2008). In exchange, Barclays would receive the LBI securities that had been pledged to the FRBNY, including residential mortgage-backed securities that were not part of the asset purchase agreement being negotiated between Barclays Capital Inc. and LBI. The replacement transaction unwound FRBNY’s financing of LBI on September 18, with FRBNY delivering LBI collateral to LBI’s clearing box^FNThe term “clearing box” refers to the primary dealer’s allocation of securities used in tri-party repo operations (Copeland et al. 2012). at JPMorgan in exchange for a $46.2 billion advance. LBI and Barclays then entered into a tri-party repo transaction through JPMorgan (Valukas 2010b). During the period between the replacement transaction and the closure of the sale (September 18–22), Barclays borrowed $47.9 billion on September 18, $16 billion on September 19, and $16 billion on September 22 (FRBNY n.d.a; Fleming and Sarkar 2014).

The PDCF was subject to the oversight rules outlined in the FRA, which stipulated only that emergency lending facilities were subject to “limitations, restrictions, and regulations” as the Fed’s Board of Governors may define (US Government 2008). The Government Accountability Office (GAO) mentions the PDCF assistance to Lehman in its review of the Fed’s emergency lending activities during the GFC. The report emphasizes that though LBHI’s CEO served on the board of the FRBNY, the firm did not receive individual assistance to prevent its failure (GAO 2011).

The Fed mentioned the PDCF in its February 2009 Monetary Policy Report to the Congress, although it did not mention the LBI-specific terms (Fed 2009a). The Committee on Banking, Housing, and Urban Affairs of the Senate (Senate Banking Committee) and the Committee on Financial Services of the House of Representatives (House Finance Committee) exercised oversight over the Federal Reserve (US Government 2008).

The trustee overseeing LBI’s SIPA liquidation regularly met with and provided information to US regulatory bodies, including the FRBNY, SEC, FINRA,^FNFINRA is a private, not-for-profit organization that oversees US broker-dealers with the goal of promoting market confidence (FINRA n.d.). and the Commodity Futures Trading Commission (CFTC). The SIPC considered coordination with government to be very important, and the trustee received and responded to requests for information from dozens of federal, state, and local government agencies (Giddens 2010). 

Section 125 of the Emergency Economic Stabilization Act (EESA) passed on October 3, 2008, established the Congressional Oversight Panel and tasked it with reviewing the state of financial markets and regulation (COP 2011; US Congress 2008, sec. 125). Section 129 of the EESA required the Fed to report to the Senate Banking Committee and the House Finance Committee within seven days of any use of Section 13(3) lending authority (US Congress 2008, sec. 129). The law also required that the Fed provide updates every 60 days while the 13(3) loan was outstanding (US Congress 2008, sec. 129). The Fed compliantly issued periodic reports on its outstanding lending facilities, the first of which was released on December 29, 2008 (Fed 2008d). Its February 2009 report on outstanding lending facilities mentioned the broad-based usage of the PDCF but did not mention LBI specifically (Fed 2009b).

On September 14, 2008, the Fed announced revisions to the PDCF, expanding its criteria to closely match collateral accepted in the tri-party repo market (Fed 2008c).

On September 15, 2008, the day that LBHI filed for bankruptcy, the Securities Investor Protection Corporation stated that customer accounts at LBI were safe (Reuters 2008). The SIPC policy stated that brokerage firms were required to keep customer cash and securities separate from company accounts. The SIPC president stated that LBI had done this properly and said the SIPC would not take immediate action but play a standby role (Pitt 2008). Because all customer property was accounted for, the SIPC stated that it had not started a liquidation proceeding and did not anticipate doing so. FINRA also sought to reassure the public, stating that LBI was in good standing (Reuters 2008). CME Group Inc., a large derivatives exchange, said that LBI continued to meet all its obligations to CME Clearing (AP 2008). The SEC also released a statement emphasizing that LBI had not been part of LBHI’s bankruptcy, that customer assets were safe, and that SEC staff would “oversee the orderly transfer of customer assets to one or more SIPC-insured brokerage firms” (SEC 2008).

Lehman Brothers issued a press release and LBHI filed an 8-K report on September 16, 2008, announcing that Barclays had agreed to acquire most of LBI’s business (Lehman Brothers 2008; LBHI 2008). The press release also stated that Barclays would provide a “substantial interim credit facility” to fund LBI’s daily operations (Lehman Brothers 2008, PDF 2).

On September 18, 2008, the SIPC issued a statement saying that it would place LBI into liquidation the following day, September 19. The statement said that authorities made the action in connection with the proposed sale to Barclays, which was also scheduled for a hearing on September 19 (SIPC 2008a). On September 20, the SIPC communicated that under the asset purchase agreement negotiated in Bankruptcy Court, Barclays was to acquire many of LBI’s business assets. Customer accounts were transferred to Barclays Capital Inc. or a separate trading platform (SIPC 2008b). Customer claims left in LBI for SIPA liquidation proceedings originally amounted to $23 billion (SIPC 2022).

The FRBNY committed to support the daily financing needs of LBI for up to two weeks (Valukas 2010b). The size of the loans was limited to the amount of eligible collateral that satisfied the Friday criteria (see Key Design Decision No. 10, Balance Sheet Protection) (Baxter 2010b; FRBNY 2009). On September 15, 2008, LBI borrowed $28 billion, followed by borrowing of approximately $20 billion on September 16 and 17 (FRBNY n.d.a). LBI had $73 billion in liabilities on its estimated balance sheet on September 15, 2008 (Valukas 2010b).

On September 17, 2008, Barclays agreed that it would fund LBI’s daily operations until the sale closed (LaRocca 2008; Valukas 2010b). Barclays Capital Inc. borrowed $47.9 billion from the PDCF on September 18 and $16 billion on September 19 and 22 (FRBNY n.d.a; Fleming and Sarkar 2014).

Former FRBNY President Geithner says that the relatively small size of the lending was one of the considerations when choosing to lend to LBI and not LBHI (Geithner 2019; Geithner and Metrick 2018). Former FRBNY General Counsel Baxter and Fed Board General Counsel Alvarez echo that view, writing with a coauthor, “Importantly, Lehman’s broker-dealer needed a more limited amount of financing” (Alvarez, Baxter, and Hoyt 2020, 159).

The PDCF charged the FRBNY’s primary credit rate, which was 2.25% (FRBNY n.d.a; FRBNY 2009).^FNPDCF borrowers who accessed the PDCF on more than 30 out of 120 business days were also charged a frequency-based fee (FRBNY 2009). At the time, “Regulation A”—the rules written by the Fed to govern its provision of liquidity under Section 13(3), among other things—called for all Section 13(3) lending to be provided at an interest rate “above the highest rate in effect for advances to depository institutions”(Fed 2008b, 201.4[d]). This would suggest a rate higher than the primary credit rate (indeed, perhaps higher than the secondary credit rate available to banks at a premium to the primary credit rate) (Kelly 2021). However, the Fed regularly made exceptions to this rule in providing emergency credit during the GFC (Fed 2009c; Kelly 2021).

During Lehman weekend, the FRBNY advised LBI that it would provide up to two weeks^FNAs previously mentioned, some at the FRBNY believed that it was risking too much exposure with the two-week funding time frame (Valukas 2010b). of overnight secured financing through the PDCF to support an orderly wind-down of LBI’s repo funding (Valukas 2010b). LBI accessed the PDCF between September 15 and 17 (FRBNY n.d.a). The FRBNY’s replacement transaction with Barclays unwound FRBNY’s financing of LBI on September 18, 2008 (LaRocca 2008; Valukas 2010b). 

On September 14, 2008, the Fed announced an expansion of collateral eligible to be pledged at the PDCF. The announcement stated that eligibility had been broadened to “closely match” collateral eligible to be pledged in the tri-party repo systems of the two major clearing banks (Fed 2008c). The PDCF provided loans with recourse to the recipient’s other assets (Yang 2020).

The FRBNY, in what became known as the Friday criteria, did not allow for intra-Lehman collateral transfers to increase LBI’s borrowing capacity at the PDCF. The criterion obligated LBI to certify that it owned the securities that it pledged to the PDCF as of September 12, 2008, that the securities had not been transferred by LBHI. Authorities considered this certification to be an important mitigant of legal risk given LBI’s situation as a subsidiary of a bankrupt parent. Then–FRBNY General Counsel Thomas Baxter said that if LBHI had been able to transfer securities to LBI to be pledged at the PDCF, those securities could have become subject to preference or conveyance claims by creditors. This would have left the FRBNY under-secured. A series of emails involving FRBNY officials and Lehman employees confirmed that LBI’s PDCF collateral matched the type of assets that were in its tri-party book on September 12 (Baxter 2010b). The collateral breakdown is shown in Figure 3.

Figure 3: LBI Borrowing, September 15–17, 2008

Source: Fleming and Sarkar 2014.

The FRBNY also imposed steeper haircuts on LBI’s collateral because of the bankrupt status of its parent. Baxter said that the increased haircuts accounted for LBI’s “diminished creditworthiness resulting from the loss of its parent’s support” (Baxter 2010b, 2). The FRBNY imposed on LBI a haircut of 20% on all non-US-government collateral, while other borrowers saw lower haircuts for highly rated private-label securities (Burke 2008; Fed 2020). Haircuts on LBI’s Treasury and agency collateral, except for agency real estate mortgage investment conduits and collateralized mortgage obligations, did not exceed 8% (Burke 2008).

William Dudley stated that the 20% haircut on non-Treasury and non-agency collateral was approximately three times higher than the market was offering, an amount that gave the FRBNY a “fair degree of protection” (Fed 2008a, 7). Moreover, that the PDCF loan was helping to bridge LBI to being purchased by Barclays offered the Fed additional protection, as the Fed would be facing Barclays after the acquisition (Bernanke 2015; Geithner and Metrick 2018; Valukas 2010b).

Between September 17, 2008, and September 24, 2008, the Federal Reserve sold $71 billion of its traditional securities holdings (FRBC n.d.). Chairman Bernanke details the importance of this process in relation to maintaining the federal funds rate during instances of emergency lending:

The Treasury’s Supplementary Financing Program, announced on September 17, 2008, was also intended to help control the federal funds rate. Treasury issued short-term bills in excess of its regular borrowing program, depositing the proceeds at the Federal Reserve (Fed 2009d).

Even with these efforts, the increase in use of Fed emergency facilities outpaced its ability to drain reserves, weakening the Fed’s control over the federal funds rate (Kohn and Sack 2020). Between mid-September and December 2008, when the Fed lowered rates to the zero lower bound and recalibrated its new policy of paying interest on reserves, the effective funds rate was consistently 50 basis points below the target rate (Fed 2024; Kohn and Sack 2020).

The PDCF required borrowing firms to provide the Fed with regular information about their financial condition. This provided Fed authorities with visibility into non-depository firms’ balance sheets that had not been previously available (Alvarez, Dudley, and Liang 2020).