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Ten Years Later: What Did the Financial Crisis Teach Us?


Back in 2007, a hedge fund manager attended a Van Cleef & Arpels dinner at Daniel.

It was a ridiculously opulent affair with models walking around the table showcasing the luxury jeweler’s goods.

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Across from him sat the daughter of Robert Smith, one of the top names of Archstone-Smith; the real estate investment trust owned more than 87,000 apartments nationwide.

“She was buying every piece that passed her and announced she was celebrating a big transaction that had just closed,” he told Commercial Observer on the condition of anonymity. “Her father had sold his company to Lehman [and Tishman Speyer].”

The hedge funder asked the acquisition price and was impressed by the number she said.

“I was like, ‘Wow, $2 billion?’ ”

He had misheard.

“No,” she replied, “Twenty-two billion.”

Our hedge funder was baffled. He still is. “I went home and looked at its return expectations, which were low single digits—kind of like today. It was just mind-boggling,” he said.

A few years later, long after the worst had happened and the survivors were sifting through the wreckage, the Lehman estate would sell Archstone-Smith to Sam Zell’s Equity Residential and AvalonBay Communities for just $6.5 billion in cash and stock. (Representatives for Tishman Speyer and the Lehman estate didn’t respond to a request for comment.)

Lehman and Tishman’s Archstone-Smith deal is perhaps emblematic of the heady use of leverage during the pre-crisis high, described by the Financial Crisis Inquiry Commission as a time when “money washed through the economy like water rushing through a broken dam.”

On Sept. 15, 2008, less than one year after Lehman and Tishman’s acquisition was completed, Lehman Brothers filed for bankruptcy.

The 158-year-old investment bank’s collapse timestamps one of the final dominoes to fall in a cumulative, fast-moving downward spiraling of events that included bank failures, bank bailouts, stock market crashes and the propping up of government-backed giants Fannie Mae and Freddie Mac. When all was said and done, the U.S. had experienced the worst financial meltdown since the Great Depression.

So, how has the commercial real estate lending environment evolved over the past decade? And, is hindsight really 20/20?

CO spoke with 20 professionals from various parts of the industry who worked through the crisis—and remain in the business today—to hear their memories of that time and their perspectives on what’s different, and what’s the same, today. The majority wished to remain anonymous.

“Listen,” one lender said, “in retrospect, we can look back and say, ‘Well, we did some really crazy things. We were using leverage on top of leverage on top of leverage and were using underwriting that was more in the windshield than in the rearview mirror.’ But money was just so plentiful back then.”

For others, they were simply closing the deals the market permitted and even encouraged at the time.

“Borrowers, lenders and intermediaries were just doing what they always do…taking advantage of the demand, volume and liquidity that existed in the market,” said Thomas Fish, a co-head of JLL’s real estate investment banking practice. “Everyone was just meeting the market. And the market was telling us, ‘You can do some of these more aggressive deals.’ So that’s what happened. We all met the market.”

‘Crazy Things’

Angelo Mozilo, the former CEO of Countrywide Financial—a lender brought down by its risky mortgages and later acquired by Bank of America, described the pre-crisis period to the Financial Crisis Inquiry Commission as a “gold rush” mentality that overtook the country.

He wasn’t wrong.

Running up to the crisis, several of the sources CO interviewed described financial institutions as simply doing “crazy things,” or as one source put it, “preposterous deals with ridiculously thin spreads.”

But, “banks were under tremendous pressure to produce profits,” said Christian Dalzell, the founder of Dalzell Capital. “They lost focus of what they were doing amid the pressure to put money to work. And if you lose accountability, you lose your market.”

For Stuart Boesky, the CEO of Pembrook Capital Management, “The first indicator was that the deal flow we were seeing coming off Wall Street made no sense, so we couldn’t participate in the deals. Occasionally, we’d see one that actually made sense, and that was because there was a gross error in the underwriting.”

A mezzanine lender concurred: “We received a package for a deal that looked pretty good on a Downtown Manhattan office building. But then we were looking at the floor plan, and they were suggesting that the building was 100,000 square feet, but it was only 80,000 square feet. So they ran the numbers on income produced by a 20 percent larger building than actually existed! A big bank made that loan, and they were trying to sell the mezzanine piece off. So, it was clear to us that these were all bad loans.”

Bad as those confounding deals were, they were peanuts compared to some of the real bombs of the era.

The Stuyvesant Town and Peter Cooper Village deal—in which Tishman Speyer and BlackRock paid $5.4 billion for the complex in 2006—seems to be the poster child for real estate acquisitions that perplexed industry participants pre-crisis.

“All you needed to find was one equity investor and lender who would buy into the story” to make a deal happen, said one lender who considered the Stuy Town deal but turned it down. “In a normal environment, you’re proud of the deals you’ve won. But back then people were happy about the deals they lost.”

Tishman and BlackRock purchased the 11,232-apartment complex from MetLife with the hopes of converting it to market-rate apartments, which turned out to be a pipe dream after rent-regulated tenants sued and successfully halted the process. The property’s rental income didn’t cover the monthly debt service, and the borrowers defaulted.

“We looked at financing Stuy Town. But there was no way you could ever envision those numbers working,” another mezz lender said. “We scratched our heads and we said, ‘Well, maybe they’re not telling us that they got some special permission to knock this stuff down and build something completely different.’ But based on what was there, it could never work. Ever.”  

An attorney who represented another potential bidder on the deal at the time said, “We knew about the limitations of rents that turned into rent law cases, and nobody understood how BlackRock and Tishman got that deal to work.” When Tishman and BlackRock handed the keys over to their creditors in 2010, it was the largest commercial default in U.S. history.

Then there was Harry Macklowe’s purchase of seven Midtown Manhattan buildings from Equity Office Properties in February 2007. Macklowe reportedly only put $50 million of his own equity into the $7 billion deal. “It was the height of insanity,” one lender said. (Macklowe wasn’t immediately reachable for comment.)

Acquisitions at the time were fed almost entirely by debt or bridge equity, unlike today with traditional borrower equity back in vogue.

“Today there is much less leverage and much more equity going into deals,” the lender continued. “This means, if borrowers don’t hit their business plans, you don’t have a domino effect because there is some margin for error before the debt is impacted.”

But back then—in an environment with much higher interest rates, much lower cap rates and heavier pro forma underwriting—people were frequently levering up acquisitions 90 to 95 percent.

“Not everybody was,” one landlord said. “But if they went to Lehman or some other firms, they were getting bridge equity, which was kind of a ticking time bomb.”

Leverage on Leverage

Fish said he believes that excessive leverage in the system is what ultimately brought the market down.

“Not just loan demand but demand for the underlying leverage of [collateralized loan obligation, or CLOs] and [collateralized debt obligations, or CDOs],” he said. “This contributed to undisciplined underwriting. You can look at leverage in the system today and observe that it’s certainly creeping back up with corporate debt at an all-time high. But I don’t think the next market downturn will have anything to do with the supply or demand of commercial real estate. There won’t be an overbuilding situation that causes it to go down; it will be something that is financial markets related.”

Back then, “some of the lenders making CMBS loans could no longer securitize them and got caught holding a couple of the monster deals,” said Josh Zegen, the co-founder of Madison Realty Capital. “That’s when the dynamics changed pretty quickly.”

“If you go look back to the 1980s—Michael Milken and the early securitizations that led to CMBS—that activity was probably good for the markets,” Zegen continued. “It was really the free-wheeling and people abusing the system pre-crisis that led to the crash.”

A variety of exotic securitized products existed pre-crisis, which included complex financial engineering around synthetic collateral (meaning there was nothing tangible securing the investment), referencing bonds’ performance instead through bespoke transactions and credit default swaps.

“Synthetics really were baffling to me as there were no tangible assets behind them,” a CMBS portfolio manager said. “You were mimicking the cash flows of cash bonds, and that shows how much money was out there, and the stupidity. Wall Street basically ran out of cash bonds, so they invented synthetic cash bonds.”

The portfolio manager said he found the amount of bulge-bracket money coming into securitized products pre-crisis “amazing” in retrospect. He added that along with the money came the opulence with “people just spending money…and partying.”

The problem was that “people got so caught up in financial engineering that they lost sight of the fundamentals of what they were engineering,” said one lender who was at a major investment bank pre-crisis.

“And most people cavalierly thought, ‘I can financially engineer anything, I can sell any solution I want through it,’ ” the lender continued. “That was definitely the case with CDO squared [a CDO backed by tranches of other CDOs], with bridge equity and other things that drove valuations. It was a mindset and another way of getting away from the fundamentals of commercial real estate: What are the cash flows like and what is the risk of default?”

In the government’s official Financial Crisis Inquiry Report, Michael Mayo, a managing director at Calyon Securities, said the financial creativity at the time was “like cheap sangria…a lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later.

But the collective market enthusiasm didn’t just apply to securitized products. “Every part of the market behaved that way because of the amount of liquidity,” said a former CDO manager, who at the time was issuing $1 billion CDO deals. “People were looking to buy rated paper even though they didn’t necessarily understand what they were buying,” he said.

Thankfully today, “we’re nowhere near the crisis in terms of vehicles,” one alternative lender said. “The banks were advising their clients to do such stupid things. I remember a bank advising a public real estate firm to do a CDO. I took the offering materials and reverse engineered it to see what the return was for the public company. I called up the bank doing the deal, and I said, ‘We don’t understand it. Your client only makes 1 percent a year on his equity?’ He said, ‘No, no, no. It’s a 10 percent return. It’s 10 percent over 10 years, so 1 percent a year.’ He said that! They put their client in that deal, and the entity went bankrupt.”

The Crash

The low rumblings of trouble were first felt in residential products before permeating to commercial mortgage-backed securities (CMBS) and commercial real estate, the sector lagging as it often does. Specifically, in the subprime mortgage market where borrowers with little or no credit received highly leveraged mortgage loans, later packaged into residential mortgage-backed securities (RMBS) and other more exotic structured vehicles, such as CDOs, and sold off to investors.

For this reporter, covering both RMBS and CMBS at the time, the first domino to fall was subprime mortgage originator New Century Financial’s bankruptcy filing in April 2007. The news came to me as an anonymous tip before the public announcement: “Try calling New Century. It’s toast. I’m telling you—this is the beginning of the end.”

When I tried calling Irvine, Calif.-based New Century for some information, a member of the cleaning staff picked up instead and told me, “They’re gone.”

“The first cracks you felt were when a couple of subprime lenders collapsed,” Zegen said. “I had our fund business plus our brokerage business at the time, and all of a sudden things started to fall apart. Banks pulled back, risk tolerance changed, and leverage changed. The crisis was very much upon us at that point, but people thought the market would come back.”

The first name that penetrated the wider public consciousness was Bear Stearns.

The 85-year old investment bank and second-largest prime brokerage firm in the U.S. headed by Jimmy Cayne—one of the most revered names on Wall Street—took a big leap into mortgage securities, and the implosion of two of Bear Stearns’ subprime hedge funds—Bear Stearns High-Grade Structured Credit Fund and Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund, both heavily invested in thinly traded CDOs—served as the harbinger of doom. It was widely reported at the time that the funds’ managers, Ralph Cioffi and Matt Tannin, had leveraged $1.6 billion of equity to $20 billion of assets.

By the summer of 2007, the funds had collapsed. Cioffi and Tannin were arrested in 2008, accused of misleading institutional and individual investors and forced to do a perp walk. The two were later acquitted, but the collapse of their funds presaged the financial turmoil about to ensue.

“I remember a friend of mine who ran a hedge fund telling me that Bear was going to go under because hedge funds were pulling their prime brokerage services [from it],” said one head of commercial real estate lending.I was in disbelief, thinking, ‘That couldn’t happen, could it?’ ”

An alternative lender got the same scoop from a friend who worked at the Federal Reserve Bank of New York: “I told him, ‘If Bear Stearns is going out of business, then so is Lehman.’ He said, ‘No way. Lehman is far more diversified.’ And I said, ‘No. It isn’t.’ ”

By that point, a few market observers could see the writing on the wall, one being Oppenheimer banking analyst Meredith Whitney, whose bearish view on the health of investment banks—and warnings that Citigroup’s dividends paid to investors were higher than the bank’s profits at the time—made her the recipient of numerous death threats.

Lehman Brothers was, however, the real match that would burn the barn.

Lehman and Bear drew uncomfortable comparisons. Both were known as behemoth mortgage shops with a lack of diversification in their portfolios and a penchant for complex securities.

Before Lehman failed in 2008, it was the fourth largest investment bank in the U.S., behind Goldman Sachs, Morgan Stanley and Merrill Lynch.

And until Bear Stearns’ hedge funds collapsed, Lehman’s stock was faring pretty well. Then—reflecting the market’s increasingly pessimistic assessment of Lehman’s long-term viability—“you’d wake up every day to wild stock swings up and down,” one former Lehman executive said. “But as Lehman employees, we were all in denial, thinking, ‘It could never happen to us.’ ”

“The stock was bouncing between $20 and $60, and I remember thinking, ‘We’re not a $20 stock; we’re either a zero or a $60,’ ” he continued. “Unfortunately, I was right but on the wrong side of it when we went under.”

But some sources that CO spoke to said the bank, headed by CEO Richard Fuld, was an unsurprising casualty of the meltdown, given its eager use of leverage in commercial real estate financings.

“Lehman was doing the highest of high-leverage debt and equity deals. We looked at them as the cowboys of the market back then,” one lender said.  

In the months running up to Lehman’s collapse—the largest bankruptcy in the country’s history, surpassing Enron or WorldCom—Fuld blamed short-sellers for expressing doubts about Lehman’s health and betting against its stock, reportedly stating, “I will hurt the shorts, and that is my goal,” at the bank’s annual shareholder meeting in April 2008.

Lehman wasn’t the first, and it wasn’t the biggest. But Lehman was caught in the headwinds of tremendous political pressure as a giant financial institution that needed saving directly after Bear Stearns, forcing then-Treasury Secretary Henry Paulson’s hand to allow it to fail, after deals with Korean Development Bank and Barclays fell apart. (Paulson did not return a request for an interview.)

“I think letting Lehman fail was a huge mistake,” one lender said. “It would have cost what? $5 billion to save them? And just think about the trillions not saving them cost the economy. I think, put any other investment bank as the second to fail and put Lehman fourth or fifth, and Lehman would have been saved. It was unfortunate, timing-wise, and once they found out about [American International Group] they had to save everything.”

Specifically, AIG received a $182 billion bailout because, as a major seller of credit default swaps, its counterparty risk was so unknown. The insurance giant’s swaps supported both corporate debt and mortgages, and its failure would have triggered further bankruptcies. With its monster volume of synthetic bonds in addition to its cash bonds, nobody could figure out where AIG’s risk started and ended—like a big bowl of cooked spaghetti.

So, could things have ended differently for Lehman? The former executive offered that, had an attempt been made to cut its leverage ratio (which hit 31:1 in 2007, per its 2008 annual report) in half, things could have been different.. although not without severe pain in between.

“Our stock would have tanked,” he said. “In the environment we were in, being the firm to reduce leverage at that point…we would have gotten absolutely hammered.”

CLOs 2.0

It was after Lehman collapsed that the Federal Reserve, the Treasury Department and many others would have to put the pieces back together. Unemployment hit 10 percent in 2009. The S&P 500 tumbled to 677 in March 2009—down 54 percent from October 2007. But by 2010, the markets were largely stabilized.

The structured vehicles of 2018 have evolved significantly compared with those which leveraged the system before the crash, some say. By year-end, $15 billion in CLO issuance is expected, roughly doubling 2017’s $7 billion in issuance.

“Today’s CRE CLOs are a completely different animal,” said one CLO issuer. “Pre-crisis, no lenders had a primary business making senior mortgage loans. Most were mezzanine lenders, and a lot of the Street was financing the debt with warehouse facilities, taking that mezz debt and placing it in CLOs. Today, CLOs are all first mortgages, but they’re transitional in nature, and the issuers keep skin in the game; they keep the subordinate bonds so it’s a matched-term finance vehicle.

“Another big difference is the attachment points start at zero to 65 to 70 percent as opposed to 75 to 95 percent,” he continued. “Nobody is doing CDO squared equivalents. There is real and meaningful skin in the game, so if there are losses, it will hurt these lenders pretty badly.”

An alternative lender disagreed: “I think it’s nonsense. Leverage is leverage, and right now there’s more leverage than there has been in the last 10 years. It’s all great until the music stops and there are defaults and people can’t get out,” he said. “No one is saying there has to be a crash like last time, but real estate is cyclical, and markets are cyclical, and the CLO market is offloading that risk to investors.”

The CMBS portfolio manager said that, with debt funds using CLOs to leverage their bridge lending production, the risk lies in the fact that these bridge loans are being made on transitional assets in the peak of the cycle with some sponsors finding it increasingly challenging to achieve stabilization. “My sense is we are going to see a spike in defaults.”

Skin in the Game

Having skin in the game and accountability in lending practices are the key differences between the lending practices of today and those pre-crisis, numerous sources agreed, with lessons from the market collapse helping to create a more conservative environment today.

Plus, 2018’s lenders are being more selective.

“We take some deals out to market today that are turned down by lenders who tell us, ‘I can’t meet your requested loan terms,’ whether it’s pricing, proceeds or other terms,” Fish said. “We get the deals done, but there is more disciplined underwriting in the marketplace, and I feel it’s attributable to both a continued regulated lending environment as well as discipline that is being instilled by both the lending and debt securities markets.”

The attorney said that he believes today’s market participants are more sophisticated, and to avoid defaults, they’re forcing recapitalizations.

“I think that a lot of the things that would have been done in a typical workout are being done in a typical capital stack of deals without the market seeing the stress outright—so without there being bankruptcy filings,” he said. “People are bringing in new equity partners or lenders or recasting their debt for equity.”

Trouble Spots

So what could bring about a correction at some point? Interviewees offered a few areas of concern, such as refinance risk in a rising-rate environment and slow unit sales in the condominium market. Then, there are concerns about leverage creeping up again.

“The markets, especially on the debt fund side, are more levered than they have been any time I’ve seen in the past 10 years,” Zegen said. “I’m seeing very sophisticated people sign mezzanine loans with intercreditor agreements that are more risky than not. The equity markets are cooler, the credit markets are hotter, and people are taking equity-like risk while getting paid for debt-like returns because there is pressure to put money out.”

Hundreds of new regulations were passed in the wake of the crisis via the Dodd–Frank Wall Street Reform and Consumer Protection Act. They curtailed banks’ lending activities significantly, creating a void in today’s market for alternative private lenders to step in.

“From a financing standpoint, these past 10 years have been pretty transformative. There was such a shift in regulation that it curbed the banking world’s lending activities, and that left a huge void and opportunity for private capital,” Zegen said. “We are one of the earlier debt funds who was around before the crisis, and because we’re still standing after, it has given us a leg up. But how many debt funds have started up today? There are a lot of new entrants. Warren Buffett once said, ‘Be fearful when others are greedy and greedy when others are fearful,’ and I believe that.”

“Private lending has become a pretty good business to be in, but there are some private lenders that are going to be singed,” Boesky said. “What we find troubling is that they are all chasing cash flows—because their lenders want to see a lot of cash flow in deals—but they’re disregarding the quality of that cash flow.”

Dalzell voiced some concern over new entrants to the debt space: “Today there are junior lenders without experience and there are lenders with experience in equity but not debt. Managing a loan through troubled times is a different animal. A lot of guys won’t have the ability or experience to make the right decisions when the market turns.”

Fish said that he is more worried about alternative yields luring investors away from commercial real estate.

“What keeps the tide coming into our asset class are the yields that commercial real estate offers compared with other alternative yields, whether that’s in the form of investing in the asset itself, investing in the debt or elsewhere in the capital stack,” he explained. “As long as rates are relatively low and don’t go up too quickly, they’ll look at our space and see it offers attractive risk-adjusted returns.

Then—separate from the commercial real estate market—there’s the high-yield corporate bond market, which the CMBS portfolio manager referred to as “the new subprime.”

Most of those CO spoke with agreed that, if anything, this market is due for a small correction and not a crash of biblical proportions. And that in itself speaks to the discipline that currently exists in financial markets.

“I think the fact that the real estate world is so different today is people remembering the crisis and saying, ‘I’ll never do that again,’ ” said the former Lehman executive. “Of course, ‘never’ for some people means seven years. But overall I think people—whether they are owners, lenders or whatever—don’t want to go back to that place, even if they didn’t work at a place that went bankrupt.”