The Consequences Of Making Real Estate A Commodity

The Consequences Of Making Real Estate A Commodity

While I found the Goldman hearings to be a travesty, and a rerun of the Army McCarthy hearings of 1954, the underlying issue is the Street tried to make real estate into a commodity that can be traded and hedged like a commodity. Instead of trying to understand any of what was really happening, Levin and McCaskill and the other clearly uninformed senators simply wanted to have political theater and denigrate Goldman.

Real estate is not a commodity. It is an asset which does not trade or physically move. It’s value does not shift hourly. There is not a liquid constant world market for a building or for a mortgage. It is not oil, scrap, or corn. Therein lies the real underlying problem. Each building is unique. It is different by many measures form the one even next door. Commodities are exactly the same. Oil is oil. Gold is gold. There may be differences by type of oil, but Brent North Sea is essentially all the same. Just because a building has a mortgage on it does not make that mortgage the same as other mortgages.

When we created the initial hotel mortgage CMBS programs in 1993, we were very clear in our underwriting that a Ramada was not a Ritz Carlton. A 25 year old exterior corridor hotel is not a new Courtyard. A hotel is not just a hotel and it is clearly not a retail center, nor a package of home mortgages.

When you mix subprime residential with B pieces on hotel mortgages, with derivatives of indexes and whatever, all you have is a pile of stuff. The real underlying values cannot ever be discerned. It is just a package of disparate paper. Then you use more indexes and then derivatives of the indexes and you get a security that has no value and no meaning other than an imaginary value that has no underlying basis. It is simply a directional bet as was the case in Abacus. There residential real estate was supposedly converted to securities to be used to take one or the other side of market directional bets. There was nothing illegal about any of what Goldman did, it was just stupid. The Street was creating more and more esoteric paper that had nothing at all to do with the underlying assets. In fact, at some point in this there were not really any underlying assets. Just pieces of paper.

If we are to fix the problem we need to make the clear distinction between real estate assets being unique hard assets with very individual characteristics, and securities or commodities, which real estate is not. As one of the securitization pioneers, at least in the hotel space, I think I understand securitization fairly well. There was very good reason to create it for residential in the eighties so that there was a capital market to fund residential growth when the S&L’s collapsed, which they did by being allowed to make commercial loans. When the concept of securitization was brought to commercial real estate it opened the door to inevitable abuse. It created massive amounts of capital looking for a place to go and that led to the over lending. That got compounded by the inevitable use of derivatives, and the loss of any connection between the real asset and the security.

If we are to avoid the next crash, then we need to go back to tying real estate mortgages  directly to the underlying hard asset and valuing the paper by properly underwriting the asset. If you cannot walk over to the asset and touch it then you have no way to properly value it. Securitization has a place, but we need clear and well considered rules to avoid the runaway insanity we just lived through where children with high powered math degrees, and no understanding of real estate, are allowed to create securities that had no connection to any assets and were simply complex trading vehicles with no reason to have been created in the first place.


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