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You Can’t Spell “Exotic” without “Toxic” and Other Themes to Watch in 2009

CORE Talks // Jan 08, 2009

This is traditionally the time of year when all the pundits come out and give us opinions, forecasts, analysis, and speculation.

Woody Heller and Will Silverman from Studley are two successful industry peers who I highly respect and regard as class acts. Will sent me a note today, and with his permission I am posting it here. It is insightful, smart, and refreshingly intuitive.

“The earth has thankfully cycled through the last of its 365.25 rotations of 2008. As we look ahead, we’d like to offer our view on the emerging themes in 2009. This letter is not meant to be a market overview referencing charts, economic data or historical metrics. Our view of specific predictions is that they are conjecture in good times and dangerous in bad. The only certainty about the future is that it will be governed by presently unforeseen events. Therefore, we focus on themes that appear relevant at present to the business climate in 2009.

The word ‘unthinkable’ is dead.
2008 included an astounding number of economic news items that were heretofore “unthinkable.” We have reached a point where there is virtually no financial page headline capable of startling a prudent thinker. The list of headlines that would have been inconceivable just a few years ago is long and obvious. It includes the fall of once mighty financial houses, the conversion of the most venerable name in high-end finance into a deposit-taking institution (prompting many to ask for their Goldman Sachs toasters), the dramatic expansion of federal economic power, $150 oil, $40 oil, the demise of the credit rating system (a system whose ongoing existence baffles this author), the equity market falling by nearly half, the exposure of the biggest fraud scheme in financial history so far, and perhaps, as a result, a developing threat to the existence of the SEC.

A pessimist would look at this collection of events and correctly decide that their impact on the collective business psyche would be paralysis; lenders afraid to lend, investors afraid to invest and consumers afraid to spend. Everyone knows all too well that the assumptions upon which they have based their economic lives up until this point are less relevant at best and dangerous at worst. Everyone in the real estate industry knows some version of this tale. The general reaction from buyers and lenders upon being told that they’ve been awarded a deal or loan is a combination of remorse and nausea. This situation has created the wide spread between bid and ask that may finally be showing signs of narrowing as some deals are anticipated to be announced in the coming weeks.

An optimist might take a more holistic view. The general upheaval in the markets and steady diet of “unprecedented” news is having another effect; our minds have been opened like never before. Most of us now look with suspicion upon anyone making claims about events that ‘cannot’ or ‘must’ happen. Going forward, we will look to the limits of our imaginations, rather than historical precedent, when analyzing business risks. Ten years ago, having an open mind meant listening when pundits hyped a book called “Dow 36,000.” Now it means that anything from 3,600 to 36,000 is on the table. This new approach will make for healthier assessments of risk if and when markets stabilize.

You can’t spell “Exotic” without “Toxic”
Several years ago a friend of mine, who has gone on to a distinguished career in jurisprudence, performed an interesting chore. He walked into a Bronx chicken coop and asked the owner if he could behead a chicken for $10. I asked him why, and he said “if I am not comfortable with how the chicken gets killed, then I shouldn’t be eating it.” Today’s investors are taking an analogous approach.

We’ve recently begun holding weekly breakfast panel discussions at our offices. One theme that emerged at a recent one was the “simplicity premium.” The fact that bankers, investors, borrowers, lawyers and credit analysts were dealing with structures whose complexity was not fully understood by most of them has been repeated ad nauseum in the business press. Anyone involved in deals presenting a maze of securitized debt, half a dozen b-notes, complicated inter-creditor agreements and preferred equity structures, knows that these are among the most challenging to exit. Many of these structures are complicated at best and dysfunctional at worst – particularly those in which inter-creditor agreements appear to have been written in a vacuum. Investors are wary of the complexity created by these structures and the pricing of such positions reflects this wariness. The investor believes that for similar pricing, he can enter a deal without these layers of complexity. Therefore the owners of these positions are left in a quandary: either they can sell their complicated positions at a heavy discount or they can monetize other less complicated, and therefore less discounted assets (presuming they have any). The result is the pursuit of transactions that could be described as “stressed seller, unstressed asset;” condo developers marketing their leased retail space, major REITs selling well-leased office assets, and investors selling LP interests in the secondary market. Of course, those without “unstressed” assets to sell find themselves competing with this more attractive product. All of that said, there is a contradictory force at work in the marketplace, as discussed below.

Distress – The “D” Word
Baron Rothschild famously said “Buy when there’s blood in the streets.” Investors following this advice are particularly keen on finding the most distressed assets in the marketplace. The first question we’re frequently asked when presenting an idea or opportunity these days is “how much pain is the seller experiencing?” Most of our colleagues and competitors report a similar story about the three things needed for a deal to sell today: available or assumable financing, reasonable transaction size and an excellent tale of woe. Without that tale, the purchaser will have a challenging time convincing his investors that they are making a prudent decision. After all, why buy from someone who is not desperate to sell? Oddly, desperation makes an asset more desirable because of the implied discount. Brokers are therefore often put in the counterintuitive position of attempting to portray their clients in the most distressed light possible. This obsession with distress has reached such proportions that a famously distressed asset will receive more attention than an elective sale of an identical asset, even if the elective seller were known to be a seller at market pricing.

The Race for Silver
In this world of uncertainty, one thing is for sure: the bottom will appear clearest in the rearview mirror. I’m told by my elders that timing the bottom has historically been more art than science. Some are less forgiving and suggest that precisely timing the bottom is tantamount to hitting an 18 in Blackjack and drawing a 3; maybe you won, but it doesn’t mean you’re a genius. This eagerness to let someone else establish the bottom and then buy on the resulting upswing has contributed to the market paralysis discussed everywhere. Investors purchasing Downtown buildings for $25 per square foot in the early 1990s were thought to be crazy at the time. People would do well to recall that accusation when they dismiss those in the market today as buying too early.

Wall Street as Whipping Boy, Conflicts Abound
Political and economic pundits have been having a jolly time pointing out conflicts and contradictions in the financial world. Weeks after winning the Nobel Prize in Economic Sciences, Paul Krugman penned an op-ed piece that effectively declared moral equivalency between Bernard Madoff and Wall Street in general. Google provides a crude indicator for the zeitgeist as a search for the phrase “Glass Steagall conflicts led to crisis” returns over 66,000 results. Many of the lawsuits that will inevitably arise as the economic crisis goes forward will focus on real and perceived conflicts in the financial world. Investment banks have been on the defensive in this regard, introducing heretofore unthinkable(!) clawback compensation schemes that allow firms to revisit compensation as deals and trades take shape. Academics have begun making noise about nationalizing the ratings agencies. The viability of business models with inherent conflicts will be challenged going forward. For the last fifty years ‘no one ever got fired for hiring IBM,’ but the new mantra may be ‘no one ever got sued for hiring _____.’ Service providers of all stripes will offer greater disclosure than ever before. Anticipate large firms disposing of conflict-creating units. Fiduciaries will be having enough hard conversations as it is, without also having to explain the conflicts of their service providers.

“…even if the blood is your own”
The line above is the often left out second half of Rothschild’s advice. There is a Far Side cartoon in which a man picks up a brick that was obviously used to break his window and attached to the brick is a note that says “Bricks thrown through your window? Call Al’s Glass.” An analogous situation is presently afoot in the real estate world. The most coveted hires are those who were involved in the most challenged loans. Yesterday’s CMBS originator is today’s distressed debt fund manager. The originators of the best performing loans are in the least demand. After all, they don’t offer the inside track to any opportunities. Industry outsiders have noticed this trend and made light of it. Time will tell if their criticism is warranted.

The Absence of Vitriol & Suspended Animation.
When I entered the industry, I was repeatedly told tales of vitriolic negotiations between borrowers and lenders during the last downturn. Tom Wolfe’s famous portrayal of the workout banker wearing skull and cross-bone suspenders comes to mind. Anecdotally, it would appear that this animosity is largely absent today. The main reason for this absence is the same reason lenders have been slow to “take back the keys.” There is barely a market into which they can sell the assets once they have recovered them. The result is what some have called a state of suspended animation in the real estate industry. Many equity, mezzanine and first loan positions are underwater or substantially impaired, but the process of adjusting the capital stack to reflect reality is slow to take place. This pace is unlikely to accelerate until new pricing parameters are established and buyers re-enter the market. The transactions that will set these parameters are presently afoot, but several more are needed before investors can establish comfort. Oddly, the Madoff situation could accelerate this process by forcing sales that set market prices.

Going Forward
Let’s conclude with the most interesting remark about the market we’ve heard of late. Our friend Tommy Craig at Hines said “I was at a recent industry holiday party, and I beamed with pride as I looked at all of my intelligent and eccentric colleagues. Then I realized something. There are not enough narcotics on this planet to keep these people inactive for the next 24 months.”

Welcome back to work. Good luck in 2009.