A few weeks ago I discussed the Lehman Brothers collapse on this blog. Well, as we found out recently, the saga continues. In a April 12, 2010 New York Times story entitled "Lehman Channeled Risks Through 'Alter Ego' Firm " written by Louise Story and Eric Dash, Lehman's use of a small company named Hudson Castle as an "alter ego" was exposed.
Essentially, according to Lehman documents and interviews with former Lehman employees, the NY Times reporters highlighted the critical role Hudson Castle played in keeping a number of transactions off Lehman's balance sheet prior to the Lehman collapse in Septemeber 2008. On the surface Hudson Castle possessed all of the appearances and attributes of a stand-alone corporation. However, as noted, Hudson Castle was entwined and interconnected with Lehman Brothers in ways no one could imagine. For example, for a number of years Lehman owned 1/4 of Hudson Castle equity, controlled the Hudson Board of Directors, and stocked Hudson's ranks with former Lehman employees. Despite this entanglement Lehman did not disclose these facts to shareholders or regulators.
Lehman, and a host of other large banks, use corporations like Hudson Castle to exchange investments for cash--thereby making their cash position and finances look better to the outside world. Often, "off-balance sheet" transactions like the transactions that Lehman and Hudson Castle engaged in are mentioned in occasional financial statement footnotes, and at worst are never mentioned at all. Indeed, in the case of the relationship between Lehman and Hudson Castle, Lehman failed to inform their shareholders about the relationship and arrangement. Additionally, credit rating agency Moody's decided not to mention the Lehman and Hudson Castle relationship in credit ratings reports covering Hudson Castle vehicles.
Sadly, arrangements like the one between Lehman and Hudson Castle are legal. Federal securities disclosure laws require that publicly traded corporations like Lehman, are only obligated to disclose material investments or purchases of public companies. Unfortunately, Lehman's relationship with Hudson Castle did not meet either of these requirements.
In my last post on Lehman Brothers, I discussed Lehman's "Repo 105" program. Apparently, Hudson Castle was at the forefront of the Repo 105 program. Allegedly, "Hudson Castle created at least four separate legal entities to borrow money in the markets by issuing short-term i.o.u.'s to investors. It then used that money to make loans to Lehman and other financial companies, often via repurchase agreements, or repos." Under these repurchase or repo agreements, banks sell assets and promise to buy them back at a set price in the future. The transactions are made to look like arms-length transactions to shift "toxic" or "risky" assets off-balance sheet. The idea is to prevent these off-balance sheet risks from appearing as "headline risk" in the event of their failure or collapse on-balance sheet.
We are finding out more and more about the collapse of Lehman Brothers. I'm interested to find out what other skeletons we end up uncovering. What do you think about Hudson Castle? Are more regulations and tougher disclosure requirements necessary?