How Lehman Played Musical Chairs With Its Loans

While some argued whether the glass was half empty or half full at Lehman Brothers (NYSE: LEH) over the last month, Lehman itself was busy ensuring no more water spilled out of the cup.

According to The Wall Street Journal, Lehman moved $2.8 billion in difficult-to-sell loans sitting on its books into a new conduit cleverly named "Freedom."

Despite being viewed as toxic waste by the rest of the market, rating agencies including Moody's (NYSE: MCO) gave their seal of approval, branding most of the newly structured securities with an "investment-grade" backing. After shuffling around its collection of loans, Lehman used part of "Freedom" as collateral to borrow funds from the Federal Reserve bank through the newly formed Primary Dealer Credit Facility, which requires the investment-grade rating on collateral.

While the Fed's new actions to help struggling investment banks such as Lehman are last-ditch attempts at preventing another Bear Stearns (NYSE: BSC) implosion and the systemic aftershocks that could follow, I still watch these moves with a wary eye. It's safe to say that a financial market without JPMorgan Chase's (NYSE: JPM) eleventh-hour adoption of Bear Stearns would have pushed markets into uncharted disarray -- a path that should be avoided at all costs.

But I'm still reluctant to assume repackaging loans and using Fed chief Ben Bernanke's coffers to plug a hole will save these sinking ships.

For starters, I've begun taking credit ratings with a grain of salt. After Ambac (NYSE: ABK) and MBIA (NYSE: MBI) came perilously close to the brink earlier this year when some of the collateralized debt obligations (CDOs) they insured (that were blessed with lofty credit ratings) got annihilated, rating agencies lost a good deal of confidence from the investment community, and rightfully so. Regardless of the investment-grade rating on the new securities, it's likely Lehman will still face an uphill battle with these troubled loans, some of which were used to finance leveraged buyouts.

Deja vu all over again
Now you've got an interesting situation: shaky assets being used as collateral to take on more debt. Sound familiar? That's how the credit crunch started in the first place. Regardless of who takes claim to the assets -- a bank, hedge fund, individual investor, or the Federal Reserve itself -- loans made under assumptions out of Fantasyland still bear a tremendous amount of risk.

The flip side of the coin is, of course, Bernanke sitting back and doing nothing, letting some financial firms teeter on the brink of collapse. Nobody wants that to happen. Nonetheless, Lehman -- or any other investment firm taking the Fed up on its new lending facilities -- is hardly out of the woods.

The Fed's moves may provide precious time for the bond market to recover, but in due time the music may stop for good, making sore losers of those who rely on the value of these loans in an expensive game of musical chairs.

Related Foolishness:

• Take That, Lehman Short-Sellers!
• Lehman Brothers Holds Tough
• Buffett Beats Bernanke