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?

Human Capital Versus Financial Capital: Which Is More Important?

Several days ago, a close friend forwarded me a very interesting article that appeared in the New York Times on March 5, 2010. The article, written by Paul Sullivan, entitled “Learning How to Hedge Yourself, and Not Just Your Portfolio” poses two (2) key questions. First, “[h]ow much are your working years worth?” Second, “[o]r put another way, what is the impact of joblessness on your financial future?” This article was very thought-provoking.

The article discusses the differences between human capital (i.e. your future job-related earnings) and financial capital (i.e. income received in the future from your financial investments). Sullivan points out that economists have long debated the distinctions between human capital and financial capital. Indeed, Sullivan notes that society has placed very little emphasis on human capital until it is far too late. In view of near 10% unemployment rates in the United States, and a substantial dip in the stock market and investment portfolios, the value of work and future earnings from job-related activities has found new importance.

In his article, Sullivan interviewed Michael Gordon, a vice president at New York Life Insurance, who posed an interesting question—“If the stock market goes down, would your income increase, decrease or not change?” At the moment, if you are doing bankruptcy and corporate work-outs, your income might increase. If you are a stockbroker, at least over the past few years, your income might have decreased. If you are a tenured college professor your income has probably stayed the same and largely remained unchanged.

This article left a major impression in my mind. Tuesday, I had lunch with colleague of mind here at Capital Law School, and a former student we both taught who recently graduated. My former student is a litigator in a large law firm, who at the moment happens to be extremely busy. My former student lamented about the down-turn and lack of work at the law firm for young corporate and transactional associates to undertake. Generally, we talked about the general lack of opportunities for young law school graduates over the next several years. We all agreed that we might see a “lost generation” in many industries, not only in the legal profession, for years to come as a direct result of our poor economy. A great deal of human capital has been lost in our current financial crisis. How much of this human capital will we recover over time? Does human capital recover like the stock market? As you can see, talking and thinking about a "lost generation" the other day got me a little depressed.

Mr. Sullivan’s article in the New York Times made me think about how our society needs to place more value and emphasis on human capital through education and training initiatives. As parents we need to impress upon our children the importance of understanding, developing, and valuing their own human capital. If you have a moment I suggest that you take a look at Mr. Sullivan’s article. Please share your thoughts and impressions. Do you agree, or disagree with Mr. Sullivan’s premise? I look forward to hearing your feedback!