Original posted on FT Alphaville by Izabella Kaminska:
Thank heavens for Lehman’s Repo 105.
Revelations of the repurchase arrangement, which helped the former investment bank hide risk ahead of quarterly reporting season, have initiated a spate of investigative reportage on all matters off-balance sheet.
Last week, the Wall Street Journal reported how most of Wall Street’s investment banks were in fact, according to New York Fed data, habitually masking the amount of risk in their balance sheets ahead of quarterly statements via the cunning use of repo markets.
On Tuesday, meanwhile, the New York Times offered a further peek into some of the more Enron-esque practices involved at Lehman.
The latest revelation centres around Lehman’s use of a so-called asset-backed conduit called Hudson Castle to disguise the true state of its balance sheet. The paper dubbed it Lehman’s “alter-ego firm”.
Lehman bought a stake in the vehicle — then called IBEX Capital Markets — in 2001.
It was later renamed Hudson Castle, but the relationship between Lehman and the entity was never disclosed to shareholders or ratings agencies, says the NY Times.
As the paper reported:
The story of Lehman and Hudson Castle begins in 2001, when the housing bubble was just starting to inflate. That year, Lehman spent $7 million to buy into a small financial company, IBEX Capital Markets, which later became Hudson Castle.
From the start, Hudson Castle lived in Lehman’s shadow. According to a 2001 memorandum given to The New York Times, as well as interviews with seven former employees at Lehman and Hudson Castle, Lehman exerted an unusual level of control over the firm. Lehman, the memorandum said, would serve “as the internal and external ‘gatekeeper’ for all business activities conducted by the firm.”
According to the newspaper, Lehman was able among other things to use Hudson Castle to exchange investments for cash and, at times, to make its finances look stronger than they were.
That said, the examiner’s report into the bank’s failure never referenced the entity. The New York Times also reported that former Lehman employees believed there were no bad intentions surrounding the bank’s relationship with the firm.
The Hudson link nevertheless remains intriguing — and especially so if you look at some of the language used in the original memo pitching for Lehman’s investment in IBEX Capital Markets.
Here, for example , are just some snippets:
It’s worth pointing out Lehman didn’t shift investments directly via Hudson Castle. According to the NY Times it used a third party third called Fenway to do that job. As the paper explained:
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. Because of that relationship, Hudson Castle is now the second-largest creditor in the Lehman Estate, after JPMorgan Chase.
Felix Salmon at Reuters has pointed out, though, that the problem comes in the fact the bank ceased to be a controlling shareholder in Hudson Castle in 2004.
That said, Salmon admits it’s hard — given what we know about Lehman now — to dismiss the notion that the whole thing was indeed designed to help the bank shift investments off its books and to keep doing so. Plus, as he states, it was a hugely complicated affair:
This is all, obviously, extremely complicated. Hudson Castle was borrowing short and then lending that money out to banks like Lehman, which would post securities as collateral. (That’s the first thing that doesn’t make sense: since when are repo rates higher than CP rates?)
But obviously Hudson was lending unsecured as well, or else its security interest wasn’t well structured, because now it’s a major Lehman creditor. Yet at the same time Hudson — or its Fenway subsidiary — borrowed $3 billion from Lehman.
And those notes “were used to back a loan from Fenway to a Lehman subsidiary” — this is the point where I completely fail to understand what’s going on. And that loan from Fenway to Lehman was also secured by another loan, to a California property developer — so now it was secured twice? And the Fenway notes were used as security twice over, as well, since besides being pledged back to Fenway they were also pledged to JP Morgan?
Readers might want to attempt to find some more clarity in the original memo, which we’ve put up in Long Room.
For the time being, though, it’s worth pointing out Hudson Castle is still in business and apparently doing similar work for other banks.