In the years before its collapse, Lehman used a small company � its �alter ego,� in the words of a former Lehman trader � to shift investments off its books.Repo 105
The firm, called Hudson Castle, played a crucial, behind-the-scenes role at Lehman, according to an internal Lehman document and interviews with former employees. The relationship raises new questions about the extent to which Lehman obscured its financial condition before it plunged into bankruptcy.
Entities like Hudson Castle are part of a vast financial system that operates in the shadows of Wall Street, largely beyond the reach of banking regulators. These entities enable banks to exchange investments for cash to finance their operations and, at times, make their finances look stronger than they are.
The Securities and Exchange Commission is examining various creative borrowing tactics used by some 20 financial companies. A Congressional panel investigating the financial crisis also plans to examine such deals at a hearing in May to focus on Lehman and Bear Stearns, according to two people knowledgeable about the panel�s plans.
Most of these deals are legal. But certain Lehman transactions crossed the line, according to the account of the bank�s demise prepared by an examiner of the bank. Hudson Castle was not mentioned in that report, released last month, which concluded that some of Lehman�s bookkeeping was �materially misleading.� The report did not say that Hudson was involved in the misleading accounting.
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. In repos, banks typically sell assets and promise to buy them back at a set price in the future.
One of the vehicles that Hudson Castle created was called Fenway, which was often used to lend to Lehman, including in the summer of 2008, as the investment bank foundered.
Hudson Castle might have walked away earlier if not for Fenway�s ties to Lehman. Lehman itself bought $3 billion of Fenway notes just before its bankruptcy that, in turn, were used to back a loan from Fenway to a Lehman subsidiary. The loan was secured by part of Lehman's investments with a California property developer, SunCal, and those investments also collapsed. At the time, other lenders were already growing uneasy about dealing with Lehman.
Further complicating the arrangement, Lehman later pledged those Fenway notes to JPMorgan as collateral for still other loans as Lehman began to founder. When JPMorgan realized the circular relationship, �JPMorgan concluded that Fenway was worth practically nothing,� according the report prepared by the court examiner of Lehman.
In case you missed it please consider a March report on The Origins of Lehman�s �Repo 105�
Named after a technical aspect of the gimmick, the accounting sleight of hand helped Lehman temporarily remove about $50 billion of assets from its balance sheet, helping to make it look better than it really was.Repo 105 being illegal did not stop Lehman. Instead, Lehman simply found a British firm using British (not US law) to validate the practice.
Like all repos, short for �repurchase agreements,� it involved what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight.
Unlike other repos, the value of the securities Lehman pledged in Repo 105 transactions were worth 105 percent of the cash it received. In other words, the firm was already taking a haircut on the transactions. And when Lehman eventually repaid the cash it received from its counterparties, it did so with interest, making this a rather expensive technique.
Yet the beauty of Repo 105 was that, according to Lehman adviser Linklaters, the firm could book the transactions as a �sale� rather than a �financing,� as most repos are regarded. That meant that for a few days � and by the fourth quarter of 2007 that meant end-of-quarter � Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.
When Lehman first designed Repo 105 in 2001, however, there was one catch. The firm couldn�t get any American law firms to sign off on the aggressive accounting, namely that these transactions were true sales instead of what amounted to the parking of assets. From the firm�s own Repo 105 accounting policy document, according to the report: Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law.
How Lehman Hid Leverage and Questionable Assets
A 2,200 page Report Shows How, Collapsing, Lehman Hid Woes
According to the report, Lehman used what amounted to financial engineering to temporarily shuffle $50 billion of assets off its books in the months before its collapse in September 2008 to conceal its dependence on leverage, or borrowed money. Senior Lehman executives, as well as the bank�s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas, the chairman of the law firm Jenner & Block and a former federal prosecutor, who filed the report in connection with Lehman�s bankruptcy case.The report says Dick Fuld, CEO of Lehman was �at least grossly negligent�. The key words are "at least". The reality is Dick Fuld makes Bernie Madoff look like a rank amateur.
Richard S. Fuld Jr., Lehman�s former chief executive, certified the misleading accounts, the report said.
�Unbeknownst to the investing public, rating agencies, government regulators, and Lehman�s board of directors, Lehman reverse engineered the firm�s net leverage ratio for public consumption,� Mr. Valukas wrote.
Mr. Fuld was �at least grossly negligent,� the report states, adding that Henry M. Paulson Jr., who was then the Treasury secretary, warned Mr. Fuld that Lehman might fail unless it stabilized its finances or found a buyer.
This begs at least two questions.
1. Where is the criminal indictment of Dick Fuld?
2. How many other Repo 105, leverage hiding, market manipulation, and tax evasion schemes are banks engaged in that we do not know about yet?
Flashback April 17, 2009: Yellen Signals Letting Lehman Collapse Was a Mistake.
Federal Reserve Bank of San Francisco President Janet Yellen signaled that it was a mistake to allow Lehman Brothers Holdings Inc. to collapse, saying the firm was �too big to fail� and its bankruptcy caused a �quantum� jump in the magnitude of the financial crisis.These fraudulent actions show just how wrong such sentiment was. Yet, had Bernanke been able to, he would have bailed out Lehman and taxpayers would undoubtedly be suffering the consequences just as we are with AIG and Fannie Mae.
The world did not end when Lehman went under. Nor would the world have ended had AIG and Fannie Mae not been bailed out either.
The one thing the Fed got right was doing nothing to help Lehman. Ironically, that is the one thing they (and Fed apologists) regret.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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