Lehman Brothers is smelling an awful lot like Enron these days.

The New York Times splashes a scoop by Louise Story and Eric Dash across two page-one columns revealing how Lehman Brothers used an outside company it controlled to obscure its real indebtedness.

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 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.

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 firm. It was also stocked with former Lehman employees.

None of this was disclosed by Lehman, however.

Ruh roh. Subpoena time!

This wasn’t small potatoes, either: Hudson Capital Castle is Lehman’s second-largest creditor in its bankruptcy case. Here’s how it worked:

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….

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.

If you got brain damage trying to figure this out, you’re not alone. The Times’s graphic helps somewhat. But the point is, well, what’s the point? Why set up this hall of mirrors? Like any hall of mirrors, it’s intentionally confusing. I suspect the Times itself doesn’t know exactly.

The damning thing, it seems, is that Lehman never disclosed this self-dealing to investors. My understanding is when you deal with companies or special-purpose entities that you control or have significant influence over, you have to disclose it.

Here’s a terrific and prophetic CFO article on commercial-paper conduits:

The activities conducted through SPEs in the asset-backed securities market may indeed be a far cry from what Enron did, but they raise the same issues of disclosure and hidden risk. And given that more than a trillion dollars of assets were taken off corporate balance sheets last year and put into SPEs and vehicles known as commercial-paper conduits, the issue may extend beyond comparisons to Enron…

The practice allows originators to sell assets from their balance sheets and devote their capital to generating new business. The good thing about securitization is that it has enabled the extension of credit to far more individuals and businesses in the United States. The bad thing about securitization is that financial-reporting practices haven’t kept up with the innovation. Because the programs are executed in SPEs off-balance-sheet, investors know next to nothing about the risks involved in the activities.

“The banks are a lot more leveraged than we think,” says Ohio State University professor of finance Anthony Sanders. “If they fully disclosed their risks, some people would be telling them to pare back their exposure.”

That piece ran after Enron—in 2002.

I’m not sure why the Times doesn’t mention Ernst & Young, Lehman’s accountant. It seems like they’ll have yet another problem on their hands here.

We’ve noted that the shadow-banking system has pretty much fallen off the regulatory-reform radar. With today’s Lehman story and Friday’s fantastic ProPublica piece on Magnetar, that ought to change.

These stories show the press leading, which is great to see.


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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.