“How Lehman Got Its Real Estate Fix” read the headline in the Sunday Business section of the New York Times yesterday. The 1/3 page picture above the headline removed any doubt whether the referenced “fix” was a good or bad event. It showed a man injecting himself like a heroin addict, the syringe taking the form of the Empire State Building.
The Times article chronicled how, before it failed last year, Lehman Brothers came to own an illiquid $40 billion portfolio of equity investments in large real estate projects. Brainchild of Mark Walsh, a Holy Cross and Fordham Law School graduate, the portfolio consisted of “bridge equity” deals—funds advanced by Lehman from its own balance sheet to real estate developers whose nascent projects Lehman intended to refinance later via securitization. When the pace of securitizations slowed and real estate values tanked in 2007, the portfolio became a millstone around Lehman’s neck. After the Federal Reserve and the rest of Wall Street threw Lehman into the pond to drown last September, the weight of the real estate portfolio assured the outcome.
Also just published is an account of the failure of Lehman’s midtown rival, Bear Stearns. House of Cards: A Tale of Hubris and Wretched Excess on Wall Street [1] is a rich tableaux of three generations of sharp traders who eschewed hiring M.B.A. degree holders in favor of those with P.S.D. degrees—“poor, smart and with a deep desire to get rich.” The firm occupied a third-tier position in the firmament of Wall Street, always profitable, but dedicated to unglamorous business lines that had thin margins, like clearing trades for small brokerage houses. In 1997, however, Bear birthed its golden goose when it joined First Union Capital Markets (part of the Charlotte-based commercial bank that became Wachovia) to securitize subprime residential mortgages for the first time.
The impetus for the securitization of these assets was Congress’s 1995 amendments of the Community Reinvestment Act to promote homeownership among low-income citizens. The percentage of home-owning American households rose from 64% to 69% in only a few years. At the time, Fed Chairman Alan Greenspan publicly worried that “the incremental 5 percent of homeowners had current loan-to-value ratios exceeding 90 percent and that these recent new homeowners were the most highly leveraged.” [2] First Union’s press release issued when it and Bear completed the first securitization of subprime mortgages, $385 million in all, mixed altruism with self-aggrandizement.
The securitization of these affordable mortgages allows us to redeploy capital back into our communities and to expand our ability to provide credit to low and moderate income individuals. First Union is committed to promoting home ownership in traditionally underserved markets through a comprehensive line of competitive and flexible affordable mortgage products. This transaction enables us to continue to aggressively serve those markets.
We are extremely pleased by how well this transaction was received by investors as many of the tranches were significantly oversubscribed. This offering is further proof of investors’ desire for a diverse range of collateral.
Securitizing assets enables First Union to continue to grow its loan portfolio, while at the same time generate additional fee income [and] we also have been very successful in providing innovative asset finance services to clients. We believe there is opportunity to expand our CRA loan securitization capabilities to other companies in the market. [3]
One can infer that the more basic motivation to securitize these loans was that First Union and Bear, like Greenspan, recognized the higher risk of default and loss associated with subprime assets. Securitization simultaneously shifted the risk to others and netted the banks fee income.
Never a force among Wall Street firms in the traditionally profitable banking areas of equity underwriting and merger and acquisition advisory work, Bear became a profit juggernaut on the strength of its ability to originate and securitize mortgages. Executives’ annual compensation soared into eight figures and private jet aircraft became their transportation of choice. Cast aside were the homespun business principles Bear’s emeritus CEO, Alan “Ace” Greenburg, published to the firm’s employees in 1984:
1. Stick to thine own business. 2. Watch thy shop. 3. Limit thy losses. 4. Watch thy expenses like a hawk. 5. Stay humble, humble, humble. 6. When dealing with a new account, know thy customer and know thy customer’s money is up. [4]
Like Lehman’s commitment to commercial real estate, Bear’s residential mortgage strategy worked well, very well, even exceedingly well, until it did not work at all. Also like Lehman, Bear leveraged the strategy, putting its best clients into a proprietary hedge fund that bought subprime mortgage-backed securities from Bear (a violation of SEC rules). Bear even leveraged the leverage, creating a second hedge fund whose investments were riskier and whose ratio of debt to equity was greater than the original fund. When the scheme became unsustainable, Bear, like Lehman, sought to package and sell to investors the worst of the billions of dollars of bad investments held in the funds (in Bear’s case) or on the firm’s balance sheet (in Lehman’s). The end of the story reminded one Bear manager of a caution expressed by Bill Gross, the billionaire investor and CEO of PIMCO, the huge bond fund. Said Gross, “when involved with a trade, look around the room and determine who the chump is and if the chump is not clear to you, assume it is YOU.” Or, as Ace Greenberg said, “Hey, you can’t fly like the eagles and poop like a canary.” [5]
A corporate CEO client of mine in the mid-1990’s said in business he tried to live by two rules: “if you can’t afford to lose, you can’t afford to play” and “treat every dollar as if it is your own.” Securitization led the leaders of Bear, Lehman and other pillars of the financial community to disregard the second rule. They convinced themselves that they could always shift the risk of loss to an unsuspecting buyer of the asset-backed bonds they manufactured and peddled. As an analyst from Sanford Bernstein and former Lehman Brothers CFO said during the summer of 2007, the problem is “more than a Bear Stearns issue, it is an industry issue.” [6] He meant they all held worthless bonds. They were all subprime junkies, trying to get over on one another by selling as risk-free, bonds they had tranched and re-tranched and re-re-tranched. The same way drug dealers dilute their inventory’s potency to increase their profits. One can also interpret the Bernstein analyst’s remark more broadly. For the industry had suspended the central tenet of ethical behavior, the Golden Rule.
The financial success of Bear and its fellow travelers in the subprime mortgage business was built on exploiting others’ desire to be part of the middle-class via home ownership. This is the cruelest irony of the crisis. It calls the lie of all the protestations Bear executives made in their interviews with Cohan about the unfairness of the forced sale of Bear to JP Morgan, including the attendant damage to the Bear “family” through job losses and otherwise. The last word in the matter will take years of litigation to arrive at. In the meantime, and perhaps for all time, each architect of the subprime crisis must wrestle in the smithy of his soul with his culpability for the first financial panic of the 21st Century.
[1] William D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (2009).
[2] Id. at 294.
[3] Id. at 295.
[4] Id. at 199.
[5] Id. at 343, 349.
[6] Id. at 370.
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