By the time Lehman Brothers Holdings Inc. became the biggest bankruptcy in U.S. history, plunging the economy into the worst financial crisis since the 1930s, the firm had made $3 billion in loans to itself in transactions that even today would elude the Dodd-Frank law designed to prevent such financial alchemy.
Lehman turned souring real estate investments into top-rated securities that the bank’s insiders dubbed “goat poo,” according to court records. The securities, called Fenway commercial paper, helped keep Lehman afloat over the summer of 2008, until a trading partner determined they were “worth practically nothing.” That precipitated Lehman’s demise on Sept. 15, 2008, bankruptcy documents and a May 2010 Lehman lawsuit show.
“It wasn’t a mistake to let Lehman fail, it was a mistake to let it live so long,” said Ann Rutledge, a principal with New York-based R&R Consulting and the co-author of two books on structured finance.
Nothing in the 800-plus pages of the Dodd-Frank regulatory overhaul enacted last year would prevent a bank from using similar techniques to try to make regulators, credit-rating companies and lenders believe it was healthier than it was, said David Skeel, a professor at the University of Pennsylvania Law School in Philadelphia.
“These kinds of transactions had a lot to do with the financial crisis and Dodd-Frank doesn’t target them in any direct way,” he said.
Kimberly Macleod, a spokeswoman for Lehman, declined to comment for this story.
Pledged as Collateral
Lehman pledged Fenway notes as collateral to JPMorgan Chase & Co. in June 2008, according to a report by Lehman’s bankruptcy examiner, Anton R. Valukas. By Sept. 11, 2008, JPMorgan concluded the notes -- which Lehman valued at $3 billion -- were “worth practically nothing as collateral,” the report says.
JPMorgan demanded $5 billion in cash to replace the notes and other collateral on Sept. 12, 2008, according to the Valukas report. Supplying those funds tapped Lehman out and accelerated the bankruptcy, Lehman claimed in a May lawsuit. Jennifer Zuccarelli, a JPMorgan spokeswoman, declined to comment.
In its Fenway transactions, Lehman transferred dozens of loans and equity positions in commercial real estate to a conduit called Fenway Capital LLC, a unit of a finance firm called Hudson Castle Group Inc. Lehman owned a minority stake in Hudson Castle for years, the New York Times reported last year.
Lending to Itself
Hudson Castle had no financial stake in the Fenway notes or the underlying assets, nor did it have a relationship with Lehman that influenced the transaction, said Martin J. Bienenstock, a partner with Dewey & LeBoeuf LLP in New York who represents Hudson Castle.
Lehman sold its real estate assets under a repurchase contract, or “repo” -- meaning the bank was agreeing to buy them back later at a higher price. Then Fenway Funding LLC, a Fenway Capital subsidiary, issued short-term notes backed by the assets -- and Lehman bought the notes, said Irena M. Goldstein, a lawyer who represents the Fenway entities, in a July 2009 deposition.
“It was basically, at the end of the day, one Lehman entity owing money to another Lehman entity through Fenway as a conduit,” Goldstein, a Dewey & LeBoeuf partner, said in her deposition. It was given in a lawsuit brought against Lehman by SunCal Cos., an Irvine, California-based developer. The suit, which seeks to put Lehman’s interests in 22 bankrupt projects behind other creditors’, is awaiting a decision from the 9th U.S. Circuit Court of Appeals.
“Repo conduits” like Fenway allow banks to finance longer-term assets such as real estate loans by borrowing short-term from investors such as money-market funds. For Lehman itself to buy the Fenway commercial paper was a sign of trouble, Rutledge said.
“The fact that Lehman bought the Fenway notes after creating them not only raises red flags, it shows that Lehman was trying to sustain the illusion of financial health,” she said.
It’s unclear which assets were backstopping the Fenway notes when Lehman first pledged them to JPMorgan on June 19, 2008; Lehman was allowed to substitute them over time. A document dated Aug. 14, 2008, and sent to potential buyers of the notes makes clear that Lehman will cover interest and principal payments on them “without regard to the market value or credit quality of” the assets.
Records subpoenaed from JPMorgan Chase and dated Sept. 12, 2008, show that by that date, seven loans to SunCal were part of the package. Lehman assigned those loans, which had a total face value of $1.2 billion, a combined market value of $795 million, according to the documents, which were made exhibits to SunCal’s lawsuit against Lehman.
One of the loans was on 10,000 acres (4,046 hectares) of land in California’s Mojave Desert, about 60 miles (97 kilometers) north of Los Angeles, for a project called Ritter Ranch. None of the 7,200 homes planned there has been built, said David Soyka, a SunCal spokesman.
“The California real estate market was a bloody disaster in 2008,” said John Burns, president of John Burns Real Estate Consulting Inc. in Irvine, California.
While other buyers held at least some of the Fenway paper through most of 2008, Lehman was the only buyer of its final issuance, which defaulted in late September that year, according to documents filed in the SunCal litigation and a report by Deutsche Bank AG, the trustee for the commercial paper.
Unaware of Pledge
Lehman reimbursed Hudson Castle $1.6 million in April 2010 for Fenway-related fees and expenses, including legal costs, through the end of February 2010, according to a settlement agreement entered in the bankruptcy case. Hudson Castle didn’t know Lehman pledged the Fenway notes as collateral to JPMorgan until after the bankruptcy, said Bienenstock, Hudson Castle’s lawyer.
“If Lehman did take advantage of JPMorgan by not being candid that the paper was a Lehman credit, Hudson Castle is as outraged and offended as JPMorgan,” he said.
Lehman’s use of certain repo transactions -- those known as Repo 105 deals -- drew criticism in the Valukas report. The bank used such transactions to move as much as $50 billion of assets off its balance sheet just before reporting results -- and did not disclose its obligations to buy the assets back, Valukas found.
The New York Attorney General’s office sued Lehman’s auditors, Ernst & Young LLP, on Dec. 21 for signing off on the Repo 105 deals.
‘Fight Another Day’
Unlike those transactions, the repos Lehman did with Fenway didn’t make assets disappear. Instead, they turned illiquid assets into highly rated securities that the bank used to satisfy JPMorgan’s demand for collateral.
“Lehman was trying to live to fight another day,” said Peter J. Henning, a professor at Wayne State University in Detroit.
In April 2008, hedge fund manager David Einhorn, the president of New York-based Greenlight Capital Inc., told attendees at an investment conference that he was betting against Lehman’s stock because he believed the company was not fairly valuing some real estate assets.
“I suspect that greater transparency on the valuations would not inspire market confidence,” he said.
He also told the group he believed Lehman wanted “to shift the debate to where it is on stronger ground. It wants the market to focus on its liquidity.”
Lehman’s then-Chief Executive Officer Richard S. Fuld Jr. told analysts in June 2008 that the bank’s liquidity -- that is, its immediate access to funds -- was robust.
‘Never Been Stronger’
Lehman’s “liquidity positions have never been stronger,” Fuld said on June 16, 2008. Patricia Hynes, an attorney for Fuld, did not respond to calls and an e-mail seeking comment.
In addition to posting the Fenway notes to JPMorgan as collateral, Lehman improperly included them and other pledged securities in its liquidity pool, the fund meant to be accessible in case of emergency, the Valukas report said. Lehman reported that the pool held $45 billion at the end of May 2008.
While there are no required minimums for such pools, “if you tell the public something you can’t lie about it,” said Bob Byman, a partner with Jenner & Block LLP in Chicago and an editor of the examiner’s report. “The truth was that Fenway wasn’t liquid -- you couldn’t turn it into cash by calling a broker and saying, ‘Sell it.’ But it was also pledged.”
After the near-collapse of Bear Stearns Cos. in March 2008, JPMorgan and other Lehman trading partners, including Citigroup Inc., Bank of America Corp. and HSBC Holdings Plc, began asking for additional cash and securities to protect their positions, according to the Valukas report.
As Lehman’s clearing bank, JPMorgan settled its daily trades and put up money to cover them. By August, Lehman had posted about $8 billion in collateral, including Fenway paper, to JPMorgan, the report said.
Lehman’s guarantee that Fenway would be repaid under its repo won top grades for the commercial paper from Moody’s Corp., which gave the notes the highest of three short-term investment-grade ratings, and from Standard & Poor’s, which gave them its second highest rating. Both companies maintained high ratings for Lehman until its bankruptcy. Edward Sweeney, an S&P spokesman, and Michael Adler, a spokesman for Moody’s, declined to comment.
The guarantee that impressed the credit raters essentially meant that JPMorgan, which was seeking collateral to protect itself against a Lehman default, was “being given more Lehman risk,” said Viral V. Acharya, a finance professor at New York University’s Stern School of Business.
‘Layers of Complexity’
“The purpose of the Fenway transaction seemed to be to create layers of complexity so that JPMorgan would not realize, or not immediately realize, what they were being given,” Acharya said.
It wasn’t until Sept. 11 that JPMorgan executives questioned the value of the commercial paper and other collateral, the Valukas report says. The next day, Craig M. Delany, a managing director at JPMorgan’s investment bank, wrote to a colleague that he considered the Fenway notes “dicey,” according to an e-mail in the report.
Delany and other JPMorgan executives determined that various Lehman collateral, including the Fenway paper, “could not be relied upon to be worth anything near” face value on the open market, the Valukas report says. Delany “assigned no value to Fenway,” it says.
‘A Financial Gun’
As a result, JPMorgan officials requested $5 billion more in cash collateral as a condition of extending credit to Lehman, the report says. Lehman executives, who considered the demand “a financial gun” to their head, posted the money on Sept. 12, a Friday, according to a lawsuit Lehman filed against JPMorgan in May.
It was “essentially its last available $5 billion of cash,” Lehman said in the lawsuit. The following Monday, Lehman declared bankruptcy.
Lehman is suing JPMorgan for allegedly calling for unreasonable amounts of collateral, accelerating its failure. JPMorgan is countersuing, saying it was misled over a portfolio of securities it was left with after Barclays Plc acquired Lehman’s broker-dealer unit.
One such security was Restructured Assets with Enhanced Returns, or RACERS. Like Fenway, it was created through a series of transactions, including repos and guarantees, in which Lehman entities were on both sides of a contract, according to a monthly operating report Lehman filed with the U.S. Securities and Exchange Commission on Jan. 21.
The Lehman employees who called the Fenway notes “goat poo” used the same term for RACERS, according to JPMorgan’s countersuit. In April 2008, one of them called RACERS “toxic,” according to the claim. Mark Lane, a Barclays spokesman, declined to comment.
In the 30 months since Lehman declared bankruptcy, government officials haven’t done enough to require adequate disclosure from financial firms about how they fund themselves, said Acharya, the NYU professor. Regulators should see their day-to-day liability structures -- and then make the data available to markets after a delay, he said.
“The issue of frequency of public and regulatory reporting is worth revisiting,” Acharya said.
While the Dodd-Frank legislation permits the Federal Reserve to limit banks’ short-term debt, “including off-balance sheet exposures,” the Fed has not proposed such a rule yet. It will by January 2012, after seeking public comments, said Barbara Hagenbaugh, a spokeswoman for the U.S. central bank.
Lehman’s use of the Fenway notes reflects the bank’s desperation in the spring and summer of 2008, said William K. Black, a professor of law and economics at the University of Missouri-Kansas City who testified to Congress about the bankruptcy.
“When you’re insolvent, then it’s rats in a maze, a maze with no exit,” Black said. “They scurry and bang against the wall and then go in another direction and bang into the wall again. It doesn’t work at the end of the day.”