Business

Lehman Channeled Risks Through ‘Alter Ego’ Firm

  • Print
  • Single Page
  • Reprints

It was like a hidden passage on Wall Street, a secret channel that enabled billions of dollars to flow through Lehman Brothers.

Patrick Andrade for The New York Times

Lehman Brothers’ headquarters in Midtown Manhattan in 2008. It is now the offices of Barclays Capital.

Multimedia

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.

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.

While Hudson Castle appeared to be an independent business, it was deeply entwined with Lehman. For years, its board was controlled by Lehman, which owned a quarter of the firm. It was also stocked with former Lehman employees.

None of this was disclosed by Lehman, however.

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.

Critics say that such deals helped Lehman and other banks temporarily transfer their exposure to the risky investments tied to subprime mortgages and commercial real estate. Even now, a year and a half after Lehman’s collapse, major banks still undertake such transactions with businesses whose names, like Hudson Castle’s, are rarely mentioned outside of footnotes in financial statements, if at all.

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.

At several points, Lehman did transactions greater than $1 billion with Hudson vehicles, but it is unclear how much money was involved since 2001.

Still, accounting experts say the shadow financial system needs some sunlight.

“How can anyone — regulators, investors or anyone — understand what’s in these financial statements if they have to dig 15 layers deep to find these kinds of interlocking relationships and these kinds of transactions?” said Francine McKenna, an accounting consultant who has examined the financial crisis on her blog, re: The Auditors. “Everybody’s talking about preventing the next crisis, but they can’t prevent the next crisis if they don’t understand all these incestuous relationships.”

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.”

The deal was proposed by Kyle Miller, who worked at Lehman. In the memorandum, Mr. Miller wrote that Lehman’s investment in Hudson Castle would give the bank and its clients access to financing while preventing “headline risk” if any of its deals went south. It would also reduce Lehman’s “moral obligation” to support its off-balance sheet vehicles, he wrote. The arrangement would maximize Lehman’s control over Hudson Castle “without jeopardizing the off-balance sheet accounting treatment.”

Mr. Miller became president of Hudson Castle and brought several Lehman employees with him. Through a Hudson Castle spokesman, Mr. Miller declined a request for an interview.

The spokesman did not dispute the 2001 memorandum but said the relationship with Lehman had evolved. After 2004, “all funding decisions at Hudson Castle were solely made by the management team and neither the board of directors nor Lehman Brothers participated in or influenced those decisions in any way,” he said, adding that Lehman was only a tenth of Hudson’s revenue.

Still, Lehman never told its shareholders about the arrangement. Nor did Moody’s choose to mention it in its credit ratings reports on Hudson Castle’s vehicles. Former Lehman workers, who spoke on the condition that they not be named because of confidentiality agreements with the bank, offered conflicting accounts of the bank’s relationship with Hudson Castle.

One said Lehman bought into Hudson Castle to compete with the big commercial banks like Citigroup, which had a greater ability to lend to corporate clients. “There were no bad intentions around any of this stuff,” this person said.

This article has been revised to reflect the following correction:

Correction: April 14, 2010

An article on Tuesday about Lehman Brothers’ relationship with a smaller company, Hudson Castle, referred incorrectly to the status of a California property developer, SunCal, which had joint investments with Lehman. SunCal’s and Lehman’s investments collapsed; SunCal itself did not.

  • Print
  • Single Page
  • Reprints