In Depth May 6, 2009, 5:44PM EST

The Perils of Global Banking

Selling through subsidiaries, banks have left investors across the globe holding potentially toxic bonds. Now governments may restrain foreign financial firms

By David Henry and Matthew Goldstein

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Guy Billout

JA Solar Holdings, a once-thriving Chinese manufacturer of solar-power cells, is getting a rude introduction to the dangers of global finance. So is Peter Howard, a retired British tax official. And so are Cedric Ruber, a Belgian school inspector, and his father, Rene, a retired employee of the U.S. Army.

Each is trying to recoup money from Lehman Brothers, whose bankruptcy in September paralyzed the world economy. They're just a few of the tens of thousands of burned investors around the world complaining loudly that they were sold toxic bonds that were supposed to be safe. In street demonstrations from Hong Kong to Hamburg, protesters are demanding that their governments do something to get their money back.

Now there's a growing fear among economists, policymakers, and business groups that in the name of protecting their citizens from global financial institutions, governments could slow the flow of capital between countries—at a time when the world economy is already contracting. "We're looking at a period of, at best, a pause of globalization, and more likely a period of 'de-globalization,' " Mohamed El-Erian, chief executive officer of bond giant PIMCO, said at a conference on Apr. 27. Governments are already moving to impose new hurdles on foreign firms. Regulators in Britain have started asking U.S. banks selling bonds there to provide hundreds of pages of proof that the mighty U.S. government, which is backing the bonds, could actually repay them.

A revelation from Lehman's bankruptcy illustrates why public confidence has been so shaken. It turns out that during the credit boom, a little-known Amsterdam unit called Lehman Brothers Treasury churned out $35 billion worth of dubious bonds, fully a quarter of the parent company's total bond debt when it went bust. Many of those bonds, baroque in their complexity, were sold to small investors in Europe and Asia—high finance for the masses. In the U.K., at least 6,000 retirees bought in. Brokers in Asia plied small investors, a few of them mentally ill, with free digital cameras and flat-screen televisions. As Lehman fought for its life in its last six months, it pushed harder to sell the bonds, most of which were "guaranteed" by the parent company in New York.

Or so the investors thought. When Lehman Brothers Holdings collapsed in September, the bonds lost virtually all their value. JA Solar (JASO) ate $100 million. Howard lost $74,000 of his retirement savings. Rene and Cedric Ruber are out some $200,000.

The Amsterdam debacle offers a rare glimpse into Wall Street's relentless drive to exploit foreign markets. Overseas locales provide banks great opportunities for "regulatory arbitrage," the practice of searching high and low for the most beneficial legal environments for particular lines of business. Lehman chose Amsterdam because of the tax benefits there. In recent years Wall Street firms have set up thousands of overseas subsidiaries for various purposes. Among other things, the entities have sold trillions of dollars worth of risky "derivatives" like the ones bought by Howard and the others. Lehman had 433 subsidiaries when it blew up—and it was relatively small. Citigroup (C) has more than 2,400 .

That global tangle of bank subsidiaries is creating bigger problems than anyone realized. The Lehman case shows how hard it can be for burned investors to get their money back in the event of disaster. Its bankruptcy alone has spawned more than 75 insolvency proceedings in 15 countries, each with differing rules. Without coordinated efforts, countries could find themselves pitted against one another. Even Belgium and the Netherlands, two close friends, clashed after the multinational Fortis Bank began to collapse in September. The bankruptcy proceeding quickly devolved into each country looking out for its own citizens.

Tax Haven

Equally worrisome, Wall Street's embrace of foreign markets makes it nearly impossible for national regulators to keep watch over what's being sold abroad and to whom. Even now, in the thick of the credit crisis, the biggest firms on Wall Street, Goldman Sachs (GS) among them, are setting up deals to sell potentially risky investments through foreign subsidiaries. This is one reason why the current financial debacle is unlike any that policymakers have had to confront. "I wouldn't want to be a regulator today," says Fried Frank partner Thomas P. Vartanian, who served as general counsel to the Federal Home Loan Bank Board at the start of the savings and loan crisis of the 1980s. "Some of the buttons on the control panel simply don't work." Prominent regulators concede the point. "A lot of these institutions [that got into trouble] were already regulated," Sheila C. Bair, head of the Federal Deposit Insurance Corp., said at an Apr. 23 industry conference in Washington.

It's no wonder that Lehman's Amsterdam operation is fueling outrage. The operation was created in 1995 to sell "structured notes," a type of derivative that's like a bond except that the payments are tied to the performance of other investments. The subsidiary had an Amsterdam address but was run out of London by Lehman Brothers International (Europe), itself a subsidiary of Lehman Brothers Holdings in New York.

Bankers call such enterprises "special purpose entities," but a more direct term might be "shell company." The Amsterdam unit had no independent staff and was overseen, nominally, by a board of five directors. Two worked for Equity Trust, a Dutch company that provides administrative services for companies and investors—everything from setting up trusts to serving as directors on boards. Equity Trust counted Lehman as a client. What's more, the Amsterdam subsidiary used Equity Trust's mailing address as its own. In the past, the address was used by a unit of Enron. Equity Trust declined to comment.

The Netherlands has emerged as a haven for companies that want to avoid certain taxes on profits. A 2006 report by SOMO, a research group that focuses on multinational companies, found that some 20,000 "mailbox companies" had set up shop in Amsterdam for this purpose alone. That's one reason the Obama Administration is proposing a crackdown on offshore corporate tax havens.

Jeremy Isaacs, head of Lehman Brothers International (Europe), oversaw the Amsterdam unit. He had been something of a wunderkind, embarking on his career in finance at age 18, with a back-office job at a U.K. brokerage. In 1989 he got a job as a derivatives trader at Goldman in London. Isaacs joined Lehman in 1996, at age 31, and within four years had taken the helm of Lehman's entire European operation.

ULTRA-Customized Notes

From 1995 through 2002 the Amsterdam subsidiary was a bit player in the Lehman empire. But as the global credit boom began, Isaacs turned the operation into a virtual factory, issuing $30 billion in structured notes from 2003 through August 2008. At industry conferences during those years, Lehman executives, including CEO Richard S. Fuld Jr., said the Amsterdam notes were an important source of revenue. Isaacs left Lehman two days before it collapsed.

Lehman's Amsterdam notes were bafflingly complex. In all, the unit issued some 4,000 variations, and the documentation for each type often ran to 600 pages. Lehman tailored the notes in an amazing array of styles to cater to just about any investing need. Would someone like a bond that would pay on the "outperformance" of Japanese stocks vs. U.S. stocks? Lehman created them, along with a "rocket tracker" on the Dow Jones Euro Stoxx 50 index. How about a bond for a thrifty soul who wanted to guard against inflation in Italy? Lehman had notes tied to consumer price indexes there, and in Spain and Mexico, too. It shipped the proceeds from selling the bonds back to New York.