Lessons Learned From Those Who Were There – Commercial Observer

They say time is a flat circle. If that’s the case, then let’s take a long loop back to Sept. 15, 2008, a moment in time that’s etched in the annals of American finance, and a world far different than the one we currently inhabit — or is it?

For those who don’t recall the details of that day, Lehman Brothers, a 158-year-old investment bank with than $600 billion in assets and 25,000 employees, declared bankruptcy after the federal government refused to offer itself as a lender of last resort to the beleaguered financial services firm, one that had leveraged itself heavily into a subprime mortgage market that was sinking faster than a stone in the ocean. 

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Just prior to its downfall, Lehman’s stock tumbled to barely $7 a share, after news broke that the firm had failed to close a deal with the Korean Development Bank, a state-owned firm in Seoul. After Lehman reported a quarterly loss of $3.9 billion on Sept. 10 and Moody’s threatened to slash the bank’s credit rating on Sept. 12, a tipping point emerged. The federal government gathered the largest firms on Wall Street together at 33 Liberty Street that weekend for an emergency meeting at the Federal Reserve Bank of New York to hash out a solution by the time markets opened on Monday, Sept. 15. 

But by that point it was too late. There was no buyer to be had. News of the bankruptcy triggered a 4.5 percent one-day drop in the Dow Jones Industrial Average.

“We did not know Lehman Brothers would fail,” said Ronald Dickerman, president and founder of Madison International Realty. “I was concerned for the system. This was systemic risk.” 

One day later, in a shocking reversal, Treasury Secretary Hank Paulson announced an $85 billion government-sponsored bailout for AIG, the multinational insurance and finance corporation, after it became clear that credit default swaps previously issued by AIG — effectively unregulated credit derivatives that acted as insurance against bets made by financial counterparties with one another regarding future price movements — had infected the global financial system and risked destroying the entire edifice of U.S. capitalism. 

“We thought the world was going to end,” said a source who had previously worked at a major investment bank and spoke on the condition of anonymity. 

Had the federal government not bailed out AIG, the interconnectivity of AIG Financial Products and the derivative positions they had with every major investment bank put the global financial system at risk, multiple sources stated.  

None other than Ralph Cioffi, the former senior managing director of Bear Stearns Asset Management, could not believe his eyes at what was occurring. 

Cioffi had already overseen the July 2007 bankruptcy of two Bear Stearns hedge funds with his partner, Matthew Tannin (who did not respond to a request for comment). The pair’s highly leveraged investment vehicles bet heavily on subprime mortgages, and their ruination ultimately paved the way for their investment bank’s demise and shocking sale to JPMorgan Chase (JPM) for $2 a share eight months later.  

“If there hadn’t been steps taken, I’m not sure what would’ve been left within our financial system,” Cioffi told Commercial Observer. “Once the money market broke the buck, and there was a run on basically every financial institution, I’m not sure if it was 24 hours, or 48 hours, but the system was near total collapse.”  

It was a strange time to be alive: America’s investment banks imploded overnight, housing prices declined almost as fast as the Dow Jones Industrial, balance sheets somehow carried leverage at 200 times their capital ratio, and at any moment the nation seemed prepared to enter into another Great Depression. 

For those commercial real estate professionals who survived the upheaval, there remains not only lessons to be learned 15 years after Sept. 15, 2008, but information to be gleaned from how differently capital markets operated during the heady days of those decadent double zeros. 

“Many people knew there was complete chaos going on,” said Manish Shah, senior managing director of Palladius Capital Management, who had left his investment banking position at Bear Stearns prior to its March 2008 bankruptcy. 

“Back then, you had fairly low credit standards, and a crazy duration mismatch — you had those major banks, like Bear, funding itself with short-term commercial paper and doing one-, two-, three-year loans 50 times leveraged, sometimes 200 times leveraged,” Shah continued. “Basic math is if you borrow 200 dollars, and you lose a dollar, then you wipe out your equity. I mean, that’s insane.”  

The insanity actually happened. And for those who were there, there’s never been anything else like it. 

‘This thing has to blow’

Perhaps the strangest element of the entire 2008 financial crisis is not how inevitable it seems in retrospect, but how surprised so many of the participants say they were as it unfolded in front of them. 

“I think there was just a general disbelief as to what was happening and how fast it all happened,” said Cioffi. “With hindsight it was all very clear, but at the time you don’t have the benefit of sitting there and thinking through everything that’s happening because it occurred so quickly.”  

Sam Molinaro, recently retired from his position at UBS, was Bear Stearns’ chief financial officer and chief operating officer during the credit crisis. He watched in disbelief as his firm went from trading at $61 per share on March 12 to being sold to JPMorgan for $2 a share on March 16. 

“We didn’t come into that week thinking we were about to go under. In fact, it was just the opposite: We thought we were managing our way through the problem and had been largely successful in doing that,” Molinaro told CO. “Our situation basically unraveled in 48 hours.”

Seven months later, Lehman collapsed within hours as well — and from there the run on the nation’s investment banks was on. 

In the days following Lehman’s Sept. 15 bankruptcy, numerous other dominos dropped: Bank of America (BAC) finalized a $50 billion takeover of a desperate Merrill Lynch, whose liquidity had evaporated overnight; Washington Mutual, holding $307 billion in assets, was seized by the Federal Deposit Insurance Corporation and remains the largest commercial bank failure in U.S. history; Wells Fargo purchased Wachovia for $15 billion in a shotgun marriage among struggling commercial banks; and Goldman Sachs and Morgan Stanley, a pair or pre-eminent investment bank powerhouses, announced they were turning themselves into “bank holding companies” to access the Federal Reserve’s emergency lending window and effectively end the unregulated investment banking era of late 20th century, early 21st century American finance.  

For Warren de Haan, co-chief executive of Acore Capital, who at the time ran Countrywide Financial’s commercial real estate finance business, the implosion of Lehman and the other firms was eerily similar to the sudden destruction of Long Term Capital Management (LTCM) in 1998. That heavily leveraged hedge fund experienced unexpected losses on various arbitrage spreads and required a $3.6 billion bailout organized by a consortium of Wall Street firms and the federal government.  

De Haan used the lessons of LTCM to hedge his mid-2000s CMBS business at Countrywide Financial against the subprime mortgage market, an expensive bet that paid off for him even as he noticed strange things occurring in the securitized marketplace.

“What we were looking at was leverage on leverage, so the CDO [collateralized debt obligation] market had people taking mezzanine positions which are already leveraged [by virtue of having an A-note or a senior loan ahead of them], and packaging those things together and securitizing them, and getting even more leverage,” recalled de Haan. “You’d have 10 different participants buying different fin-tranches, hedge funds buying 5 percent slivers of a loan, and these tranches are complicated with intercreditor agreements, they’re very high leverage, so when the market moved against them, they very quickly got wiped out all over the place.” 

With investment banks like Lehman, and commercial banks like Wachovia, leveraged 40 to 1 on their balance sheets (at best) when it came to their amount of operating leverage, de Haan saw a situation where the banks were behaving more like private equity firms rather than the fiduciaries of capital they were entrusted to be. 

“What was going through our heads, us and others, was, ‘Yeah, it feels inevitable, and that this is going to happen,’ because of the factors that we’re talking about [with LTCM],” he said. “We looked at this thing and said, ‘This thing has to blow.’ We just didn’t know how badly it was going to blow. And as we started seeing it, it became pretty obvious what was going on.”  

For others who were in the market at the time, like Madison International Realty’s Dickerman, the behaviors of borrowers at the microeconomic level – specifically homeowners and mortgage lenders — is what alerted him to the systemic risk. 

“It was the subprime lending boom with variable-rate mortgages, adjustable-rate mortgages, teaser rates, and that was the eye of the storm,” said Dickerman. “Investors were buying single-family homes, borrowers were sitting down with lenders and saying, ‘I want to borrow $100,000,’ and the lender would say, ‘You could borrow $130,000 and I’ll show you how.’ ” 

As for what happened to Lehman that September morning, Dickerman said that he was surprised the federal government did not come to the rescue of Lehman Brothers CEO Dick Fuld, who desperately pleaded with anyone on Wall Street for a merger and expected to be saved by the arms of a Washington-backed buyer buttressed by taxpayer dollars. 

“Dick Fuld was calling around, trying to make a deal, Hank Paulson was Treasury secretary, and I would have thought that Lehman Brothers would be bailed out,” Dickerman recalled. “But I think at the end of the day, Dick Fuld was not a beloved figure and was not well liked on Wall Street.” 

Fuld, who now serves as chairman of Matrix Private Capital Group, did not respond to a request for comment. 

‘There was no reining in the risk’ 

One of the critical elements of the financial crisis that made it so difficult to contain was that the problems weren’t limited to Lehman Brothers and Bear Stearns — they were everywhere, at every financial institution, and on every balance sheet. 

Years of easy credit engineered by former Federal Reserve Chairman Alan Greenspan following the burst of the dot-com bubble in 2001 combined with a lax regulatory environment that saw the repeal of Glass-Steagall in 1999 (the Depression-era law which had previously forbid commercial banks from engaging in the riskier behavior of investment banks), the passage of the Commodities Futures Modernization Act in 2000 (which exempted derivatives like credit default swaps from being regulated), and a fateful 2004 decision by the Securities and Exchange Commission (SEC) that unshackled debt-to-equity requirements at banks with more than $5 billion in assets from 12-to-1 to … wait for it … unlimited leverage. 

“They’d stopped looking at the fundamentals of the company or business plan, and said, ‘If my competitor is willing to give them $550 million, I’m going to give $650 million to win the business.’ That’s what was happening back then,” said Shah. “What didn’t happen was there were no risk officers that could stop the sales guys.”  

One reason voracious originators could convince firms their dubiously leveraged loans and derivative bets would work out was due to a securitization process that allowed collateralized debt obligations to be created off the debt owed on other collateralized debt obligations, known as CDO-squared. 

“The mentality in that 2000s period was, ‘We will lend whatever it takes to win the business and we will offload the risk,’ ” Shah recalled. “The guys trying to bring in revenue were able to convince firms it would all work out: ‘Our competitors are willing to go very high, we’re going to go slightly higher, we’ll be able to make a nice commission, and, oh, don’t worry, we’ll be able to sell it off.’ ” 

This behavior wasn’t just irresponsible; it bordered on outright fraud, according to the former investment banker who requested anonymity. 

He said that a mentality existed where it didn’t matter if bad credits were being created, just so long as they could be sold on the market, and that that was the way the system worked. 

Jonathan Epstein, managing director at BGO (formerly BentallGreenOak), worked at the time as the head of structured finance of Lehman Brothers in Asia. He described his old firm as being in the business of “selling money,” and said Wall Street firms like Lehman and Bear Stearns got into trouble once they started buying mortgage companies to control the supply of originations and roll over profits to induce investors to further perpetuate the system of leveraged originations.  

“That’s where I think it went off the rails. There was no reining in the risk,” said Epstein. “It was more of ‘How do we keep pumping the system?’ Well, if you want to pump the system, you ultimately have to take more and more risk, and [back then] there was not a lot of commonsense risk analysis.” 

‘A Disaster Waiting to Happen’

Others blamed regulators and ratings agencies — Moody’s Investors Service, Standard & Poors, and Fitch Ratings, who did not respond to requests for comment — for not just being asleep at the wheel, but for signing off on hundreds of billions of dollars of subprime loans as safe AAA products (when in fact it was closer to toxic waste).  

An important distinction to remember is that regulators in this sense are federal and state entities like the SEC, the (now deceased) Office of Thrift Supervision, and New York State Department of Financial Services, whose job is to look under the hood and make sure banks are playing by the rules. Meanwhile, credit ratings agencies are for-profit firms tasked with assessing credit risk, and who made huge returns in the runup to the crisis — and likely experienced a conflict of interest — by giving their stamps of approval to dangerous financial products while receiving a fee from the same firms they were grading. 

“They weren’t distinguishing. They might say they were, but they weren’t differentiating enough between good credits and bad credits,” said de Haan. “They were the eye of the storm and they were the gatekeepers for securitized products.”  

The former investment banker, however, emphasized that it should’ve been obvious to regulators that cracks in the foundation of the financial system had formed due to the enormous wave of off-balance-sheet financing and rampant flow through securitization processes that the largest banks and many regional banks participated in. 

“It was just a disaster waiting to happen, and anyone that was close enough to that market could easily see it,” he said.  

BGO’s Epstein suggested that the watchdogs might not have had the analytical ability to keep up with how fast the investment banks were creating complex financial products for off-balance-sheet and on-balance-sheet use. Epstein compared the confusion of regulators to what occurred among the FBI, CIA and NSA in the run-up to the Sept. 11, 2001, terrorist attacks. 

“Post-9/11, we created the Director of National Intelligence (DNI) office because there was no grouping together of the different intelligence agencies in one spot, where you could’ve picked things up,” he said. “I don’t think that was happening at the regulatory level because everything was siloed: the insurance regulator, the banking regulator, the Fed.”  

Sam Chandan, director of the Chen Institute for Global Real Estate Finance at New York University, worked at REIS, a subsidiary of Moody’s Analytics, at the time of the crisis. Chandan said that technological limitations of the mid-2000s forced ratings agencies to calibrate risk using insufficient data sets that underestimated systemic dangers posed by subprime mortgages. 

“We lived in a different world,” he said. “While events were unfolding in real time, much of the data we had to work with as an industry lagged and was offering a good indication of where we were two months earlier, a quarter earlier, but not operating as a meaningful gauge of where we were that day as events unfolded.” 

However, Matthew Reidy, director of CRE economics at Moody’s, noted that multiple actions have been taken since then that have helped improve the CMBS and securitized marketplaces from a risk standpoint. Notably, risk-retention rules require lenders to retain 5 percent of the originations of a securitized deal on their balance sheets for at least five years. Also, the Federal Reserve stress tests most banks annually, and regulators require deeper transparency on asset-backed securities.  

“In a lot of these things, the key has been improved transparency in the deal itself, and making sure investors are better able to understand what they’re buying,” said Reidy. “At least there’s someone with real skin in the game today.”  

‘That voice in the wind’

As we mark the 15-year anniversary of Lehman’s sudden downfall, the financiers of the time admit they remain humbled by what occurred in those strange days of 2008. 

“In every regard, I think we’ve all learned a lot of lessons,” said de Haan. “As it relates to the amount of leverage, the ways pools are constructed, risk management overall, I’d say all the lenders are more conservative than how they were back then.” 

For Ralph Cioffi, who was indicted for misleading investors while at Bear Stearns and eventually cleared of all six charges, the crisis remains a painful reminder of the perils of following the proverbial madness of crowds. 

“I think one just has to be careful, institutionally and individually, not to get caught up in an investment theme that is just broadly accepted,” he said. “It’s usually that voice in the wind that ends up being right at the end of the day.” 

To Molinaro, who watched his investment bank lose its various lifelines to liquidity over a matter of hours, the 2008 financial crisis was a reminder that perception, rather than reality, dictates whether banks have enough capital to support the risks taken to generate huge profits. 

“If there’s any one lesson, it’s all about liquidity,” said Molinaro. “Bear Stearns and Lehman Brothers didn’t go under because they didn’t have sufficient capital. In fact, each was well capitalized at the moment of their failure. They went under because the markets lost confidence in them and they lost access to funding markets.” 

Since then — and despite the way the landmark Dodd-Frank Wall Street Reform and Consumer Protection Act has been watered down over the years — positive changes have been made to the wider system. The largest banks are now under federal regulation; higher capital requirements have de-risked the banks as they’ve eschewed many products that can’t generate the returns needed to compensate for higher capital costs; and, in an effort to tame speculation, the Volcker rule eliminated pure proprietary trading activities in the banking system. 

But perhaps the most important legacy of the 2008 financial crisis is the way private credit, structured credit, and non-bank credit is now a larger component of the capital markets landscape. 

Funding models for the nation’s most relevant banks like JPMorgan Chase and Bank of America have largely moved away from wholesale markets to deposits, which has added stability to their liquidity profiles at the expense of potentially higher profits from riskier credit. As regulations have forced banks to carry higher capital requirements, the credit risk for many high-yield investments has been pushed on debt funds and alternative lenders who don’t carry the same duration risk as depository institutions.  

Justin Kennedy, managing director and co-founder of 3650 REIT, noted that the banks that survived have gone on to operate as capital markets liquidity providers rather than direct takers of credit risk. 

“If you look today, the largest U.S. banks don’t have exposures remotely similar to 2008,” Kennedy said. “Much of the credit exposures at the big banks have been transferred in the capital markets to credit funds like ours, and those exposures are now taken by private capital, for the most part.”  

However, as someone who lived through an honest-to-God bank run, Molinaro seemed skeptical that private credit can handle those increased exposures that felled the most powerful institutions in American finance just 15 years ago — if they were to emerge again. 

“[The regulations] will likely cause even further lending activities to be pushed out of banks into the shadow banking system,” he said. “It isn’t clear that is a good outcome as more risk moves to unregulated markets where the interconnectedness and systemic risks are less well understood.” 

Brian Pascus can be reached at bpascus@commercialobserver.com.