Felix Salmon

What was Lehman doing with Hudson Castle?

By Felix Salmon
April 13, 2010

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:


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.

12 comments so far | RSS Comments RSS

“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.”

I took this comment to be the heart of the story. The accounting is meant to be extremely hard to follow. Hence, regulation and investing are hampered. Without clarity, it’s hard to determine if something is legal or not. Kind of like Fraud and Stupidity. It’s a system built on benefit of the doubt not being clarified.

Posted by DonthelibertDem | Report as abusive

You have two cows. You borrow money against them. Then you lend them to Lehman Brothers….

Posted by RyanM | Report as abusive

I would guess that Lehman bought the Fenway notes when the commercial paper market collapsed. Had they not done so, Fenway would likely have gone bankrupt.

Once they were stuck with them, they tried to figure out some way to turn these notes into cash. One way, according to the Examiner’s Report, was to use the notes to collateralize Lehman’s tri-party repo book held with JPMorgan. Lehman substituted the notes for cash it had previously posted, thus getting some liqudiity.

Do not understand how Fenway would be making loans to anyone. As an SIV/SPE, the proceeds of all of the sales of its commercial paper should have gone to purchasing the assets which supported them, e.g., the MBS which Lehman repo-ed to them.

Posted by Sportello | Report as abusive

Disclaimer: I know nothing about this other than the Times story itself.

Having said that, I think you are making this a bigger mystery than it is. To start with, your last comment is wrong: it is JP Morgan that was the ultimate cash lender, and Lehman the ultimate borrower. The use of all this hocus-pocus to get the money suggests that 1. Lehman had an immediate need for cash, 2. They could not raise it by selling commercial paper directly, 3. nobody was willing do repo with them on their assets, and 4. nobody would buy “Fenway”‘s paper either.

But apparently, they would accept Fenway paper for repo. And naturally, Fenway would repo whatever Lehman wanted – it was a captive entity. In that case, Fenway was a money-laundering service that allowed Lehman to issue paper indirectly. The negative carry on repo vs CP was immaterial because it was just an internal transfer anyway. The point wasn’t to earn carry but to raise the cash.

Posted by Greycap | Report as abusive


Thanks. I’ve been talking about obfuscation, enabled by the auditors who bless it or look the other way, for years.


Maybe it was just the fees. Maybe no one would do business with Lehman after a while because their reputation preceded them. So firms are set up, “fronts” are created, for the sole purpose of pushing paper and keeping the illusion running. Unfortunately for Lehman, “the music stopped” a la Chuck Prince, and they were left with no place to park their *ss.

Posted by FrancineMcKenna | Report as abusive

You know, I can’t help but look at this stuff and think that there is no “there” (i.e., money) there. After all, these guys are bankrupt – the question is: how long were they bankrupt? How long was Madoff worth less than thought?
Complexity was not a bug – it was THE feature.

Posted by fresnodan | Report as abusive

it looks like a simple maturity transformation, from what is shown on the graph.
jpm lends cash vs cp collateral which less risky for them in terms of risk-weighting and maturity than “assets” that are probably longer dated and would get a larger haircut, fenway/hudson is the bagholder if things go wrong. just a guess.

Posted by alea | Report as abusive

My mistake: I should have written “… a collateral-laundering service that allowed them to repo their garbage indirectly.”

Posted by Greycap | Report as abusive

I find it helpful (a la Jon Stewart) to imagine these transactions were done by individuals. It’s odd how much it looks like check kiting when you divide all the numbers by ten million. It’s also interesting to wonder how your bank – or, more likely, the IRS – would react if you actually tried to make these transactions.

Posted by KenInIL | Report as abusive

I wonder if there is any evidence that joining a secret society such as Raven’s Claw Society influence’s a young person’s decisions later in life? Does the secrecy create a certain operating psyche? I wonder how many of the bankers who participated in concealed (and probably illegal) practices were inducted as members of secret societies as young men. I could imagine that the code could have create a sense of security to operate in any way approved by the group. Any reactions?

Posted by BossMcGowry | Report as abusive

my apologies for all the grammar errors…

Posted by BossMcGowry | Report as abusive

Hudson Castle appears to be a standard asset backed commercial paper or ABCP conduit (i.e. shadow bank used to move/finance assets off balance sheet). It’s my impression (because the Fed started treating commercial paper issued by captive conduits as acceptable bank collateral) that many ABCP conduits were supported by the banks that formed them after the ABCP collapse of 2007. (That is, the banks started buying the commercial paper of conduits that were backed by their own guarantees to avoid being forced to take tens if not hundreds of billions of dollars of assets on balance sheet suddenly in 2007/08.) So purchases like Lehman’s of Fenway paper are just examples of what had to happen to keep the ABCP market from collapsing totally (instead of partially).

Posted by csissoko | Report as abusive

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