"The Secret Life of Lehman Brothers" - A story disappeared from the web...

[WhiskeyGirl]

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

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 company, 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 company. 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 about 20 financial companies. A congressional panel investigating the financial crisis also plans to examine such deals at a hearing next month to focus on Lehman and Bear Stearns, according to sources.

Is there such a thing as 'financial reform' when companies move things off the books?

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 $US1 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 …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 $US7 million to buy into a small financial company, IBEX Capital Markets, that 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 company. 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, 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 maximise Lehman's control over Hudson Castle ''without jeopardising the off-balance sheet accounting treatment''.

One of the vehicles that Hudson Castle created was called Fenway, which was often used to lend to Lehman, including in 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, which is still in business, doing similar work for other banks, bought out Lehman's stake last year. The company's spokesman said Hudson operated independently in the Fenway deal in 2008.

Hudson Castle might have walked away earlier if not for Fenway's ties to Lehman. Lehman itself bought $US3 billion of Fenway notes just before its bankruptcy; they, 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 realised the circular relationship, it ''concluded that Fenway was worth practically nothing'', according the report prepared by the court examiner of Lehman.

NEW YORK TIMES

http://cfd.net.au/home/article/the-secret-life-of-lehman-brothers-20100414-64698.html

http://www.smh.com.au/business/the-secret-life-of-lehman-brothers-20100413-s7rx.html

Worth practically nothing, the best bits auctioned off by the CME shortly after filing for bankruptcy?

Lots of broken links for this story!

[WhiskeyGirl]

The Lehman news website - http://lehman-brothers-news.newslib.com/

""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?" asked 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."

[WhiskeyGirl]

"It’s Mine, Mine All Mine: Can Anyone Catch Lehman Stealing?"

David the CFE and I have another theory:

Collusion.

The crimes are too numerous to prosecute without indicting the whole system and most of the major players. And because they were part of the problem before they were theoretically part of the solution, culpability also attaches to Paulson and Tim Geithner.

David the CFE’s theory is premised on some of the oldest tricks in the book for manipulating revenue recognition and, therefore, reported profits and incentive compensation payouts including stock options - roundtrips, parking, and channel stuffing. In another variation on the theme, global trading company Refco used a round trip loan to repeatedly hide a related-party transaction incurred to delay disclosure of significant uncollectible accounts.  It’s not like these techniques haven’t been used before (by AIG, for example) to offload risk and smooth earnings at quarter- and year-end.

    “This case shows that the Commission will pursue insurance companies and other financial institutions that market or sell so-called financial products that are, in reality, just vehicles to commit financial fraud,” said Stephen M. Cutler, director of the SEC’s Division of Enforcement.

With regard to the financial crisis, these revenue recognition fraud techniques may have been most useful in establishing “observability” of market prices for otherwise illiquid assets. Establishing “market prices” via fraudulent, sham transactions amongst the market participants before quarter-end and year-end reporting periods would have allowed assets to remain on the books longer at inflated values and, therefore, to inflate profits and bonuses. “Market prices” that appeared to support existing valuations sustained the myth. The investments were not written down until long after the market for subprime real estate securities started to wilt.

David the CFE explains this theory in the case of Lehman Brothers:

    Nassim Taleb says about banks: “Banks hire dull people and train them to be even duller. If they look conservative, it’s only because their loans go bust on rare, very rare occasions. But bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug. Taleb further states: “Executives will game the system by showing good performance so they can get their yearly bonus.”

    Lehman paid out $5.2 billion in bonuses in 2006 and $5.7 billion in bonuses in 2007.  Did this result from the executives at the bank gaming the system to increase their bonuses? An example of burying a large loss under the rug can be found in this excerpt from Lehman Brothers in its 2006 10-K:

    We held approximately $2.0 billion and $0.7 billion of non-investment grade retained interests at November 30, 2006 and 2005, respectively. Because these interests primarily represent the junior interests in securitizations for which there are not active trading markets, estimates generally are required in determining fair value. We value these instruments using prudent estimates of expected cash flows and consider the valuation of similar transactions in the market.

    Junior interests in securitizations. Lehman and other firms purchased mortgages that would effectively be resold by them as collateralized debt obligations.  Each of Lehman’s securitizations was broken into tranches in which senior interests received greater preference with respect to collections of interest and principal than junior interests that were entitled to greater profits, if such profits were realized. A junior interest in a securitization is the lowest level of the tranches for collateralized debt obligations. Generally, only the bottom 3% of a securitization was labeled as equity.

    During 2006, housing prices dropped nationally by at least 5% from the spring of 2006 to Lehman’s Nov. 30, 2006 and the default rate was increasing as well. With prices of houses dropping and the default rate increasing, there was a risk of large losses when the buyer defaults. Thus, the junior interests in securitizations that Lehman was purportedly investing in were probably already worthless at the time that Lehman invested in them or at November 30, 2006.

    An auditor would have to suspect a material loss is being hidden and that collusion between several departments at Lehman Brothers and management’s participation in the deception was possible. Ernst and Young, Lehman’s auditors, were probably unwilling to consider such a possibility because auditors accept as dogma that collusion between many employees and multiple departments is unlikely no matter what the motive, i.e., $5.2 billion in bonuses. Auditing standards also do not consider collusion likely. Apparently, auditors did not consider the possibility that two different groups at Lehman Brothers such as the underwriters who sold the securitization IPOs and the trading departments would collude to hide a $1.3 billion loss in a junior equity position that could not be sold.

    Hiding losses on CDOs and mortgages purchased for securitization. A reasonable question to ask was:  If Lehman Brothers started the fiscal year ending Nov. 2007 with $57 billion of CDOs and held them for the year, what would their estimated loss be? Also: What would the additional loss be with $32 billion in CDOs and/or mortgages purchased?

    Presumably, the losses would be in the range of $10 billion to $30 billion. By Nov. 2007, everyone knew of the problems with CDOs. Bear Stearns had already closed two hedge funds investing in CDOs. Merrill Lynch had made huge write downs and forced out its CEO. My guess is that Lehman Brothers engaged in schemes to fool the auditor in order to avoid disclosing losses from their securitizations and investments in CDOs.

    Lehman probably pulled a variation of the old “telecom swap.” In the “telecom swap” cases, one telecom company would sell telecom capacity to another telecom and then purchase the same amount of telecom capacity from the other party. The firm selling the capacity would book the amount received as revenue and the firm purchasing the capacity would book the amount received as a fixed asset. It worked very well in creating fictitious profits for those firms.

    That same trick could be used by financial institutions in the case of CDOs/CDSs. Let’s say Financial Institution A sells collateralized debt obligations with a true fair market value of 90 million to Financial Institution B for 100 million dollars in cash. Financial Institution B purchases collateralized debt obligations with a true fair market value of 90 million dollars from Financial Institution A for 100 million dollars in cash.

    And then those phony trades are shown as the “observable” similar transactions in the market.

    Did the auditors check for this item? Probably not. Why not? Because it’s an example of collusion between Lehman and other companies. Auditors don’t check for collusion no matter how many times they get fooled by it!

    Incentivizing fraud. Auditors, especially inexperienced ones, think management has to actually tell someone if they want to overstate their income. Auditors and the judges that try these cases want to find “smoking gun” memos and emails that say, “Overstate income so we can all get our bonuses and keep our jobs.” But all top management really has to do is tell each unit head that: (a) you and your employees will get large bonuses if your unit reaches its profit goals and, (b) you will not receive a bonus if your unit doesn’t achieve its goals. Then management promotes only those who meet those goals – regardless of how they meet them.

    In other words, each manager within the Lehman brokerage unit had a major incentive to reach his profit goals. And, each employee who worked for those managers also has that incentive because his bonus and promotions are based on meeting those goals, too. Thus, management doesn’t have to direct its employees directly to commit fraud. They can claim plausible deniability because they rather passively allow the employees create their own frauds. Employees who understand the system will game that system by working with others in the organization and outside the organization to produce fake profits.

more here - http://retheauditors.com/2010/02/22/its-mine-mine-all-mine-can-anyone-catch-lehman-stealing/

How does the Obama administration go after the health insurance companies and ignore what goes on with Wall Street?

[WhiskeyGirl]

The Lehman Bankruptcy Examiner threw the word “fraud” into the financial crisis conversation.

The words “auditor malpractice’” followed.

It’s quite likely EY will be called before the US House Oversight Committee to testify about the Lehman bankruptcy. David Einhorn, a member of the much maligned “short club,” will probably be called to testify, too.

I criticized Ernst & Young in mid-2008 for not questioning Lehman’s CFO revolving door. Lehman had chosen another non-CPA CFO, the second one in less than three years. I was following the lead of another Cassandra, David Einhorn. Einhorn is now being heralded because he questioned Lehman’s accounting, in spite of being ridiculed and damned for it at the time. He’s getting almost as much applause as the “whistleblower” du jour, Matthew Lee.

Sources tell me that the SEC Inspector General’s report on the Allied Capital investigation paints an even worse picture of the SEC than those involved ever expected.  For example, it was the SEC lawyer who grilled Einhorn that later became a lobbyist for Allied and was the one who hired private investigators to steal Greenlight Capital’s phone records. Allied Capital’s auditor is KPMG. They are not yet accused of any wrongdoing, but the report also discusses the mis-valuations that Allied was originally accused of by Greenlight.

Maybe it’s time to start listening to the “shorts” and the contrarians.

Many ask me if Ernst & Young will fail because of Lehman.  I have answered that in previous posts.

In short, not immediately.

Maybe E&Y won’t be the first of the remaining Big 4 to fail.  The leadership of the Big 4 are terrified because any one of them could be thrust into the harsh spotlight the way Ernst & Young has been. At any time.

Because they’re all on the brink.

more here - http://retheauditors.com/2010/03/23/for-the-auditors-nothings-over-until-its-over-or-is-it/

How is it possible that so many saw red flags and Congress did nothing? 

John McCain, for all that some made fun of his age, saw a problem and wanted reform.  Barney said no.

After the collapse, secret auctions, by invitation only...

What's wrong with this picture?

[WhiskeyGirl]

The Button-Down Mafia: How the Public Accounting Firms Run a Racket on Investors and Thrive While Their Clients Fail

There's a popular Sicilian proverb:

Cu è surdu, orbu e taci, campa cent'anni 'mpaci.
"He who is deaf, blind, and silent will live a hundred years in peace."

Enron, WorldCom, HealthSouth, Tyco, Parmalat, Adelphia, AIG...You would think enough lessons had been learned. The financial markets are a mess and the capitalist system threatened. The systems in place to anticipate and preempt market risk failed completely. Financial firms leveraged their capital to an unprecedented extent with no checks and balances. Companies took on enormous risks with minimal disclosure to their shareholders.

And the largest global public accounting firms -- KPMG, PricewaterhouseCoopers, Deloitte, and Ernst & Young -- again failed to prevent, warn, or mitigate the desperate financial situation, the national crisis of significant proportions we now find ourselves in.

    "...There were systematic failures in the checks and balances in the system, by Boards of Directors, by credit rating agencies, and by government regulators..."

Even the US Treasury Secretary doesn't hold the public accounting firms accountable for the problems we now face. The Big 4 public accounting firms haven't yet been asked the hard questions by governments, legislators, or regulators.

They're getting a free pass.

more here - http://www.huffingtonpost.com/francine-mckenna/the-button-down-mafia-how_b_174496.html

Is any financial reform going to fix the problem?  Any clue that Geithner, Barney, Dodd, or Obama acknowledge the problem?

How could all those firms fail and nobody notice?