What was Lehman doing with Hudson Castle?

By Felix Salmon
April 13, 2010
tell you something then they're trusting you to trust them:

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There’s one thing that newspapers can do and bloggers can’t, and that’s splash a big story all over the front page and just by doing so make it news. Newspapers like the NYT and WSJ have built up very good reputations over decades, and so if they tell you something then they’re trusting you to trust them:

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.

It’s a juicy story, and I daresay it’s even true. But I can’t see the smoking gun for all the smoke. Lehman ceased to be the controlling shareholder of Hudson Castle in 2004. And no matter how many times I read this, I simply can’t understand it at all:

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…

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 investment in a California property developer, SunCal, which 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.

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?

Certainly there was some very crazy stuff going on around Hudson Castle — and knowing what we know about Lehman, it’s entirely plausible that the crazy stuff was all designed “to shift investments off its books”. But the main reason I have to believe that story that is that I trust the NYT. If I read this story on a blog somewhere, I’d dismiss it as borderline-incomprehensible conspiracy-theory rambling; but since I saw it featured prominently in the NYT, I know that some highly respected and respectable journalists and editors really believe there’s a story here.

I just wish they’d done a better job of showing us what Lehman was doing, rather than just telling us — and then trying to support their assertions with a series of details which really doesn’t make any sense.

Update: The NYT has now added this graphic to the story, which helps:

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Ultimately, though, it still seems that Lehman was the lender of cash here: it’s not clear how this structure gets investments off its books at all. The only part of the structure which might do that is the bit on the far left, but $3 billion seems a very large sum to pay for facilitating a simple secured loan.

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