One Of These Things Is Not Like The Others: How Goldman Sachs and Lehman Brothers Hid The Ball From Investors

“Looking for big numbers always makes me tired.”

This column was originally published on Going on April 21, 2010.

The House Committee on Financial Services held a hearing yesterday on the Lehman failure. Goldman Sachs is still all over the news about the SEC’s fraud charges. What’s the difference between Lehman/Hudson Castle – the structured investment vehicle (SIV) mentioned in the New York Times last week – and the SEC fraud charges against Goldman?

Aren’t both about disclosure?

Goldman was selling structured securities to outside parties. Hudson Castle was a Lehman affiliated entity used to make Lehman’s balance sheet look better. But the two stories have another interesting thing in common. 

Structured investment vehicles are not new. Many large banks used entities like Hudson Castle to move money around and turn poor quality assets into shiny new ones.

Many those large banks, in particular Citi and their SIVs, came under intense scrutiny in mid-2007. These entities were used to move subprime mortgages and other assets off the banks’ balance sheets in order to increase their leverage ratios. The SIVs turned around and issued commercial paper using a godfather bank, like Citi, and the assets to create AAA rated commercial paper.

“An SIV is a bank. Its “depositors” are the buyers of its commercial paper. Its capital is from the equity and the mezzanine tranches. If there is a run on the bank, meaning that its ability to attract commercial paper is compromised, then (depending on the legal documents which created the SIV) the originating bank might have to take that bad paper onto their books, giving them losses.”

In December of 2007, Citi bailed out several of its SIVs because ratings agencies were threatening downgrades on the commercial paper backed by subprime assets. Although Citi said there was no legal obligation to do so, $49 billion of SIV assets went back on their balance sheet.

One of the banks harmed significantly during the SIV crisis in late 2007 is none other than one of the “sophisticated investors” harmed by Goldman’s CDO-torpedo fraud.

October 2007: Rhinebridge Plc, a structured investment vehicle run by IKB Deutsche Industriebank AG, said it may not be able to pay back debt related to $23 billion in commercial paper programs. Rhinebridge suffered a ‘mandatory acceleration event’ after IKB’s asset management arm determined the SIV may be unable to repay debt coming due.

Business Week, April 21, 2010: Germany’s BaFin regulator is in contact with the [re] Goldman Sachs’ involvement with IKB Deutschland Industriebank AG…IKB was Germany’s first victim of the U.S. subprime mortgage crisis in 2007 and was bailed out with almost 10 billion euros…

If Hudson Castle’s relationship to Lehman had been disclosed, how might it have changed things?

SIVs launder poor quality assets and turn them into assets that can be sold, traded, or used to support more leverage. Lehman borrowed money from Hudson Castle and its Fenway SPE to buy commercial paper from Hudson Castle and Fenway that was backed by subprime assets but rated highly by ratings agencies because of the backing of Lehman. Lehman then used this commercial paper to collateralize a loan with JP Morgan.

The Lehman Bankruptcy Examiner’s report says Lehman started using the Repo 105 technique to manipulate their balance sheet in 2001. Big banks have been using SIVs to manipulate their balance sheets and improve capital and liquidity ratios for a while, too.

If investors had known – about Repo 105, about the SIVs, about all the tricks and techniques Lehman and the other banks used – they may have forced additional disclosure, regulators may have acted to curb over-leverage and bankruptcies may have occurred sooner.

The SIVs hid precarious capital structures, upside down funding, and self-serving business strategies from the non-insider investor. The failed and bailed out banks were on life support so executives could be paid huge salaries, collect perks and big bonuses, and cash in their stock options.

I think Repo 105 type activities have been very common. And SIVs are, too. A bailout via a super-SIV rescue fund was one of Treasury Secretary Henry Paulson’s first responses to the subprime market turmoil that started in late 2006-early 2007.  But Bear Stearns and Lehman’s failures in 2008 took the spotlight off the SIV issue.

The issue of “control”  – in June 2009 SFAS 167 amended FASB Interpretation 46(R) to require an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE – is subject to judgment and interpretation.  The laws or regulations exist. But regulators and auditors must enforce consistent, ethical, prudent and transparent disclosure to improve transparency.