Archive for the 'Securitization' Category

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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Securitization Was As Much To Blame As Anything

Securitization Was As Much To Blame As Anything

I created the first hotel CMBS programs in March, 1993 so I have a lot of first hand understanding of what happened. Low interest rates and high mortgages were not the cause, just the manifestation of the crisis. While many things and people all came together to create the crisis, the underlying thing that made it all come together was securitization.  If there is no wide availability of capital to loan, then low rates alone cannot have a major impact. Housing and the irresponsible lending could not have happened if there had not been the excessive lending capacity made possible by securitization.  While there was gross ethics failure by Barney Frank covering up for Raines producing phony financials, and pushing subprime lending by Fannie, it was the ability to securitize any mortgage with no real underwriting which really blew the top off the subprime lending market. Wall St enabled the crooked mortgage brokers who were encouraged to make any loan, and to produce even more volume to fill the securitized pools. If it were not for securitization, the warehouse lines would not have been available to the mortgage brokers to make the bad loans. This then flowed over to commercial mortgages where filling the securitized pool became the only goal, not underwriting quality, which was thrown out entirely near the end. If I can sell it, I will loan it, became the mantra.

Subprime lending was not new. It had been around forever. Except that it was done by very experienced small lenders who knew how to judge the risk of a cab driver or waiter who earned money off the books. Risk was carefully controlled and volume was relatively low. It was only when securitization arrived to provide the fuel, along with Barney Frank pushing home ownership for all, and the CRA rules against redlining, that subprime got out of control. It was easy then for Wall St and mortgage brokers to move on to over lending to everyone in order to fill the pools with more and more loans. All it took was someone falsely claiming that house prices never went down in the US, and the party was on.

When we created the original securitized programs in 1993, the underwriting was very tight, there were only a few tranches, there were no CDO, SIV’s, no mezz, and no CDO indexes or other esoteric derivatives dreamed up by a bunch of quant kids who had never developed so much as a bird house, but who were allowed to create models of how real estate risk was to be assigned and priced. They had zero understanding of real estate,  and they became enamored with their computer algorithms. The truth is, nobody can really slice and dice a mortgage or piece of real estate in so many tranches and have any real understanding of the relative risk and pricing of the risk with any degree of reality.

In November,  1993, two of us had a discussion of how we had just created the next S&L crisis except it was going to be far worse. We knew then that Wall St would not be able to resist the temptation to take securitization to ever riskier levels and volumes, and eventually the whole thing would collapse. The outcome was very predictable for those of us who had been around the Street for a long time. We also knew then, that the servicing protocol would never work in a crisis.

The crisis was the fault of everyone-the regulators, politicians, Wall St bankers, crooked mortgage brokers, irresponsible borrowers and the media insisting that everyone should own a home, or that commercial real estate prices were in a new paradigm of cap rate compression. Had it not been for securitization to provide the fuel, the disaster would have been far more contained.