Lehman's Alter Ego: Hudson Castle and the Collapse of Lehman Brothers

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?

Examining The Lehman Brothers Failure: Is This Enron All Over Again?

What led to the demise and failure of Lehman Brothers? This is the precise question that Anton Valukas, a partner in the New York office of the venerable law firm Jenner & Block, was appointed in January 2009 by the U.S. Bankruptcy Court for the Southern District of New York to answer. Indeed, Lehman Brother’s bankruptcy, which was filed on September 15, 2008, is the largest Chapter 11 bankruptcy filing in history. Many would argue that the Lehman collapse has contributed greatly to our current financial crisis—The Great Recession—one of the worst since The Great Depression. Yesterday, Valukas issued a 2,200-plus page Report detailing the failure of Lehman Brothers.

Valukas indentified a number of failures in corporate governance and auditing and financial controls. Valukas observed that Lehman Brothers “repeatedly exceeded its own internal risk limits and controls.” According to Valukas, Lehman’s management made a number of terrible decisions that ultimately led to Lehman’s collapse. Commenting on Lehman’s executives, Valukas noted that conduct “ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation.” Valukas indicated that Lehman Brother’s attempted to forestall its ultimate demise by misleading investors about its true financial picture.

Perhaps most damning, Valukas discloses Lehman’s use of “Repo 105” a financial accounting device to “cook” or alter its balance sheet. Using Repo 105, Lehman shifted $50 billion of toxic assets off its balance sheet during the first and second quarters of 2008, instead of selling and reporting these toxic assets at a loss. Through a loophole and gap, accounting rules allowed Lehman to treat Repo 105 transactions as sales instead of financings. Lehman’s chief financial officer was implicated in emails that indicated that Repo 105’s chief purpose was to reduce liabilities on the balance sheet.

Valukas found that Repo 105 was not disclosed to government regulators, rating agencies, investors, or to Lehman’s board of directors. Lehman apparently did not act alone. Valukas discovered that Ernst & Young, Lehman’s auditor, was made aware of Repo 105 and did not challenge the use of this questionable accounting practice. Repo 105 led to the repossession of billions of taxpayer dollars and investment and retirement funds!!!

We passed Sarbanes-Oxley in the wake of the Enron scandal to try to root out financial and accounting irregularities. How could similar irregularities occur at Lehman Brothers? History has a way of constantly repeating itself. One thing is for certain, the civil lawsuits, and hopefully criminal charges and indictments, will flow shortly. I will do my best to keep you posted in the coming weeks and months.

Remembering Lehman on the First Anniversary of Its Collapse: Part II

Lehman Brothers’ collapse exactly one year ago, on Sept. 15, 2008, ignited a massive contraction in the $3.6 trillion money market industry, which provides short-term loans often referred to as commercial paper, used by businesses worldwide to cover everyday expenses, including payroll and utilities. The panic left companies such as Goodyear Tire & Rubber Co., whose operations are a long way from Wall Street stranded with insufficient cash and ravaged the investment accounts of millions of unsuspecting average Americans.

Everyone knew that Lehman was too big to fail without dire consequences. Tim Geithner, Treasury Secretary, recently said in an interview with Fortune that regulators expected bad things from Lehman’s collapse, but things proved even worse than they expected. When Lehman filed for bankruptcy its commercial paper was transferred to the Reserve Primary Fund. As result, Reserve Primary Fund became the first big money-market mutual fund to have its net asset value fall below $1 per share. It was the first time in history that a money market mutual fund opened with less than $1 per share net asset value. The event scared millions of average investors and prompted the U.S. government to guarantee money fund accounts to avoid a deposit run that could have destroyed short-term financial markets. The U.S. government has been keeping the American financial system functioning every since because companies that were too big to fail, did fail.

Wall Street was aware that the unregulated subprime mortgage lending business and the securitization of such inferior loans into investment vehicles such as collateralized debt obligations (CDOs) had pushed the financial system to the breaking point. What the Wall Street bankers failed to calculate was that short term borrowing would be literally frozen and would throw the global economy into a tailspin. The failure of Wall Street bankers and regulators to understand the importance of commercial paper and how that market would be negatively affected by Lehman’s collapse was critical because its aftershocks came closest to destroying the world economy. The run on money market funds, considered the safest investments after bank deposits, and also the principal buyers of commercial paper, sent shockwaves through the global economy. World stock markets lost $2.85 trillion, or more than 6 percent of their value, within three days of Lehman’s bankruptcy filing. Worldwide the cost of banks borrowing overnight funds from other banks, as measured by the London Interbank Offered Rate, or LIBOR, jumped 4.29 percentage points between Friday, Sept. 12, 2008 and Tuesday, Sept. 16, 2008. “We did not expect how the Lehman Brothers' bankruptcy would transmit through the commercial paper market and cause all the stress in the money funds,” said David Nason, a former assistant Treasury secretary for financial institutions under Treasury Secretary Paulson.

The financial chieftains inclusive of Goldman Sachs and JP Morgan Chase tried desperately to unwind their derivatives trades and keep bank-to-bank loans flowing, but they ignored the commercial paper market, the lifeblood of the economy. It was an oversight that would flat-line the American economy. Within a week of Lehman’s bankruptcy filing, the U.S. government stepped in to halt withdrawals from money market funds and provided a $1.6 trillion backstop for the commercial paper market. With these first defensive measures, the U.S. government became committed to strengthening the American financial industry regardless of the cost. “They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy. Miller stated that “[government officials] were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’” Lehman’s problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were rapidly declining in value as a result of the deteriorating real estate market. Lehman was different because the U.S. government let it declare bankruptcy rather than bail Lehman out, as it had bailed out Bear Stearns, Merrill Lynch and Long-Term Capital Management because no one, not even the U.S. government, wanted to be responsible for Lehman’s undeterminable losses, which could tally into the millions or even billions. As a result, Lehman’s creditors were wiped out as well as its stockholders and the aftershocks are still reverberating in the world economy.

On the one year anniversary of Lehman’s collapse, "policymakers haven’t learned the key lesson of Lehman’s collapse," said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch. Bernstein added “[by] designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe.” Perhaps the U.S. government should consider breaking up financial behemoths such as Bank of America Corp. and Citigroup Inc., or limit their expansion, instead the U.S. government has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger and have created a factual predicate were it could all fall apart, again.

Lydie Nadia Cabrera Pierre-Louis
St. Thomas University

Remembering Lehman on the Eve of the First Anniversary of Its Collapse: Part I

As we approach the first anniversary of Lehman Brothers’ collapse, a failure that many believe triggered the current global economic crisis, we should perhaps pause and reflect on the topsy-turvy financial year that Americans have survived. This is not an anniversary that Richard S. Fuld, Lehman’s former chairman and chief executive officer is looking forward to celebrating. Fuld has been vilified and humiliated before a congressional panel last October and named in nearly 40 different legal actions. “I’ve been pummeled, I’ve been dumped on, and it’s all going to happen again. I can handle it. You know what, let them line up,” Fuld stated recently. To be fair to Fuld, he took control of Lehman in 1994 at one of Lehman’s darkest hours and rebuilt it into the fourth-largest U.S. investment bank, a Wall Street powerhouse whose massively profitable mortgage banking machine inspired rivals’ envy. The question remains, however, how did it all go wrong? Is Fuld really to blame for Lehman’s demise or was Lehman the first victim of a massive systemic failure in the American financial services industry? Perhaps, more importantly, why didn’t the federal government save Lehman like it saved, Long-Term Capital Management, a hedge fund in the late 1990s, Bear Stearns a mere six months before Lehman’s collapse, Merrill Lynch at the same time that it allowed Lehman to collapse, Bank of America, Goldman Sachs, AIG and countless other financial institutions after it allowed Lehman to collapse, that were deemed too big to fail?

On Friday, September 12, 2008, U.S. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke assembled thirty of the most powerful figures in the American banking industry to the headquarters of the U.S. Federal Reserve in New York. The group of thirty was told Merrill Lynch and Lehman Brothers were on the brink of collapse. The U.S. government would not bail them out because it was only a week since the U.S. government had agreed to rescue Fannie Mae and Freddie Mac. It was up to the thirty banking executives in the room to save Merrill and Lehman. The future of the entire global banking system was now under threat because the collapse of these two Wall Street giants would deal a huge blow to the world’s confidence in the U.S. financial industry. In particular it would raise questions as to whether American financial service companies could make good on their debts, if Lehman and Merrill were to collapse.

Ken Lewis, chief executive officer of Bank of America, was interested in buying Merrill, but Lehman was out of the question, primarily because no one was really sure of the Lehman’s true financial condition, that is--the true state of the Lehman’s finances, the true worth of thousands of “esoteric contracts” to which Lehman was a counterparty. There could be billions of dollars in liability for the company that eventually purchased Lehman. Lehman’s potential liability for its outstanding loans was not clear and no one wanted to take on such a tremendous risk. Except perhaps Barclays, a 300 year-old British bank, who wanted flagship operations in the United States. The Financial Services Authority and Bank of England were adamant in their belief that the U.S. Federal Reserve would not allow Lehman to fail. They had grave reservations about the idea of a Barclays-Lehman deal. They wanted reassurances from the U.S. government, in particular they wanted guarantees as a condition precedent to the deal. If Barclays were to purchase Lehman blind, unsure of the liabilities Barclays would inherit from the “esoteric contracts,” the U.S. government would have to provide some insurance for Lehman’s and eventually Barclays’ potential losses. The U.S. government refused not because it did not want to save Lehman but because the U.S. government itself did not know what the ceiling of the potential Lehman losses would be. Lehman was too big for the U.S. government to rescue. The Barclays deal was dead and so was Lehman.


On Monday, September 15, 2008, 158 years after it was founded, Lehman filed for bankruptcy. It was a catastrophic event. Shockwaves were felt throughout the global banking industry. Within days, Halifax Bank of Scotland had been rescued by Lloyds of London. Within two weeks, Bradford & Bingley was nationalized. Within a month, the British government had given financial bailouts to Lloyds of London and Royal Bank of Scotland with an unprecedented £37bn. Banks were in crisis everywhere. Not to be outdone, the United States developed a $700bn Troubled Asset Relief Program (TARP) to bailout American banks. On September 21, 2008, Goldman Sachs and Morgan Stanley were given permission from the U.S. government to convert their status from investment banks to regulated commercial banks, marking the end of the last two major independent Wall Street investment banks. It was the end of an era.

A year later, as we remember Lehman, the American banking system is still fragile, recovery is slow, and many questions and lessons exist regarding the near-death experience of the American banking system. "You had an old 19th century-style panic," said Cary Leahey, senior economist at Decision Economics. "There was no single catalyst" for the upheaval. Economists believe that big investment banks and other influential financial market players had taken on massive risks, borrowing heavily to bet on securities tied to subprime real estate loans which were outside the scope of regulators’ authority. As a result, when the U.S. housing market collapsed, this sent the walls crashing down, freezing credit markets and economic activity in the worst crisis since the Great Depression. Hugh Johnson, chairman and chief investment officer at Johnson Illington Advisors stated that "there was a belief that the financial crisis could not be solved and would lead to a second Great Depression.” The U.S. government took aggressive action. The new regulatory focus may curb the excesses that led to the boom and bust of Lehman. However, the current focus on regulation and risk mitigation "have enormous implications for the availability of risk capital in the U.S. and the primacy of the U.S. financial system," said Joel Naroff of Naroff Economic Advisors.

What shall be remembered about the Lehman collapse?

First, although some historic names have vanished forever and others are mere shadows of their former selves, Wall Street hasn't changed all that much. It still operates on the principle of an insider club where disclosure is minimal even to regulators. The best interest of the public is not the primary concern. Business is good and likely to get better. Simply look at the second quarter earnings report for the major financial service firms. Previously on July 22, 2009, I commented on the amazing second quarter earnings of the large banks that had received TARP funds and queried whether they really needed the TARP funds, in the first place? Currently, the burgeoning need for Wall Street’s capital raising services will be a welcomed relief in a world that's suffered trillions of dollars in losses over the past two years.

Second, regulators and central bankers could not save Lehman because Lehman was too big to save. The huge uncertainty of Lehman’s potential losses illustrated that the world's capital markets have become too powerful relative to the central banks. "The U.S. government didn't let Lehman fail; it didn't have the authority to save it," Treasury Secretary Tim Geithner said in an interview with Fortune.
"The fundamental constraint was that the Treasury at that point had no authority" to put capital into Lehman, and "the central bank did not have the ability to fill a capital hole." There was no buyer willing to assume most of Lehman's obligations, as Morgan Stanley did for Bear Stearns. The U.S. government would have been risking unlimited losses because Lehman didn't have enough collateral to back hundreds of billions or trillions of dollars of outstanding loans.

Third, the American financial markets can overwhelm the U.S. government’s resources. Lehman shall remain an unfortunate footnote in U.S. financial history. However, Lehman's collapse underscores for all of us that financial regulation is not only fashionable, it is instrumental for the survival of the American financial system and global economic stability. Despite everything that has transpired, hope is not lost. In the words of Mr. Fuld, “I’m not a defeatist. I do believe at the end of the day that good guys do win.”

Lydie Nadia Cabrera Pierre-Louis
Assistant Professor of Law
St. Thomas University

Systemically Important Financial Institutions: The Cleveland Federal Reserve Turns To YouTube To Show The Way Forward

What should we do about systemically important financial institutions moving forward? Consider implementing a three-tiered regulatory system. Well, that is the approach recently advanced by James Thomson, a Vice President and Financial Economist at the Cleveland Federal Reserve Bank. In an amusing and simple drawing board presentation on YouTube, Thomson spells out and outlines the regulatory approach he deems best for regulating systemically important financial institutions. Yes, the Federal Reserve Bank of Cleveland is turning to YouTube to show us the way forward!!!

In recent months, the term “systemically important financial institution” has garnered a great deal of media attention and news coverage. What is a systemically important financial institution? It is a financial institution that is so large, or interconnected with other institutions, or unique that it poses the risk of pulling the entire financial system down with it should it fail.
How do you gauge whether an institution is systemically important or not? The Federal Reserve Bank of Cleveland has proposed looking at the institutions size and four additional criteria to determine systemic importance. The Federal Reserve Bank of Cleveland calls these additional requirements the four C’s: contagion, correlation, concentration, and context.

How do the four C’s play themselves out? “Contagion” refers to the “too connected to fail” syndrome. For example, if you have swine flu and go to work, church, or a professional baseball game the “bug” can spread rapidly. The same goes for financial institutions: when one is sick it can spread a “bug” that infects other institutions that are interconnected through loans, deposits, or insurance contracts. “Correlation” refers to the “too many to fail” syndrome. If financial institutions see their peers doing risky things, they decide to join the party. Financial institutions assume if everyone is doing something risky then there is no way the government will let the entire industry fail; regulators will step in to offer a bail-out to all. Under this scenario moral hazard is eroded. “Concentration” refers to the “dominant or essential player” syndrome. If a financial institution dominants a particular business or has a high percentage of money leveraged in a particular area that is risky, this could make the financial institution a systemically important institution. AIG is a prime example of such a firm, in relation to AIG’s dominance of the credit default swap market. The final of the four C’s stands for “context.” This is known as the “conditions matter” syndrome. Let’s assume the financial market is antsy or jittery. The failure of one large firm in the system might be interpreted by investors as a bad omen or sign of things to come, or as a harbinger that underlying market conditions will soon erode. Under such a scenario the financial market collapses. The collapses experienced at Bear Stearns and Lehman Brothers illustrate types of "context" failures.

James Thomson proposes a three-tiered approach to deal with systemically important financial institutions. Tier One would cover high-risk institutions. Potentially, the failure of these institutions would pose the greatest risk to the financial system. Tier One would include complex financial institutions like large interstate banks and multi-state insurance companies. Tier One institutions would be subject to the most stringent regulation.

Tier Two would include moderately complex financial institutions. These institutions would be chosen based on their interconnectivity, involvement in critical market functions and activities, and the affect of stress in the overall economy on their condition. Large regional banks and insurance companies would be the market players regulated under Tier Two. In a sense, Tier Two financial institutions would undergo a more moderate level of regulatory scrutiny.

Finally, Tier Three would cover remaining non-complex financial institutions. Community banks would make up the market participants covered by Tier Three. Tier Three institutions would fall outside the watchful eyes of systemic institutional regulators like the Federal Reserve. The notion is that if a Tier Three institution failed it would be unlikely to cause any widespread ripples in economic markets.

The goal of the three-tiered system Thomson proposes is to equate oversight and regulatory activity with the degree of risk involved with the type of financial institution. Thomson hopes that the risk of being a systemically important financial institution may be mitigated. We shall see. YouTube and the Federal Reserve Bank: what a combination we have unleashed!!!