Lehman's Hudson Castle Shenanigans

Lehman Brothers may have exerted an unusually strong influence over a firm that it sold assets to and then used to obtain funding from third-parties according to a New York Times article today. The piece attempts to have a sort of "aha!" flavor to it, pointing out the fishy relationship between the bank and the firm Hudson Castle. But does the article deliver enough evidence to indicate clear wrongdoing?

First, it's important to understand what was going on. Here's an example explained through a diagram provided by the Times:

A simplified explanation: Lehman sold assets to a Special Purpose Vehicle ("Fenway"), which was owned by Hudson Capital. It then sold commercial paper to Lehman, which Lehman used as collateral for a loan from JPMorgan. That provided Lehman with cash the needed.

Things would have been much simpler if JPMorgan had just loaned Lehman money based on Lehman's own assets, but JPMorgan didn't want to take on risk associated with the troubled bank. However, JPMorgan didn't mind being exposed to Fenway, because it didn't realize that some portion of Fenway's assets (it's unclear how much) were actually Lehman's.

There are two potential problems with this relationship:

First, JPMorgan was presumably unaware that Fenway's commercial paper was tied to Lehman. Whether or not Lehman did anything wrong here, however, depends on the circumstances. If the now-failed bank intentionally misled JPMorgan or withheld information, then Lehman acted improperly. But if JPMorgan just failed to do its own due diligence, then it only has itself to blame.

Second, you may notice the dotted line that connects Lehman above Hudson Capital in the diagram above. The New York Times bases most of its article on the idea that Lehman had a strong influence over Hudson. The piece implies that Hudson was controlled by Lehman, though backs off from stating this as clear fact. If Lehman did control Hudson, then the situation is very shady. Lehman shouldn't be selling assets to an entity that's really an extension of itself only to borrow based on those assets through that entity's cleaner name.

Unfortunately, the New York Times doesn't present particularly compelling evidence that Lehman controlled Hudson in the years leading up to the crisis. From the article we know that after 2004:

• Lehman's business accounted for one-tenth of Hudson's revenue.
• Lehman had one Hudson board seat.
• Lehman was Hudson's largest shareholder, but owned only a quarter of the firm.
• Hudson's president was a former Lehman employee, and brought several other former Lehman employees with him.

While some of these points hint at impropriety, they do not prove Lehman controlled Hudson. Prior to 2004, the relationship between these two firms appeared to be a little cozier, according to the article. Lehman controlled Hudson's board at that time. The Times also cites a 2001 memo that suggests Lehman had an "unusual level of control" over Hudson. But that control appears to have dissipated after 2004, which is the time period that actually matters in the context of the financial crisis.

Of course, it is possible that Lehman did, in fact, control Hudson and deserves punishment. But if that's the case, then the New York Times needs some more compelling evidence to prove its point. Without that, the article boils down to a lesson in the dangers of complexity. Financial reform proposals should seek to bring clarity and better disclosure to the shadow banking system to avoid situations like this. If Lehman had been forced to disclose the nature and extent of its relationship with Hudson to its shareholders and clients, then the Times article may never have needed to be written.