Deleveraging is like a slow, painful death

Phoenix — Growing uncertainty and anxiety over the return of capital — not the return on capital — led to a historic and nightmarish September on Wall Street. The credit crisis deepened sharply in the days immediately after investment bank Lehman Brothers filed for bankruptcy, sending stocks tumbling and prompting Treasury Secretary Henry Paulson to press Congress for passage of a $700 billion federal bailout plan to restore the stability of our financial markets and quell widespread panic.

While it's sad to see the pain the credit crisis is inflicting on Americans — including thousands of job layoffs and shrinking 401(k)s for retirees due to the sagging stock market — it was inevitable that after several years of excessive leverage, the pendulum would swing the other way.

It's just that no one could have foreseen the severity of the correction, or the extent to which some investment banks like Lehman Brothers would bet on mortgage securities backed by subprime loans — and lose. In the end, the 158-year-old Wall Street firm couldn't find its way out of the hole it dug.

Even in commercial real estate there were signs of frothy lending in recent years, though not as severe as in the residential sector. Domestic CMBS volume had been rising dramatically for years and hit a record $230 billion in 2007, up from about $200 billion in 2006, a 15% gain. Meanwhile, loan originations in the commercial/multifamily sector were soaring. Private equity was buying public companies at a feverish pace, largely because cheap debt was so widely available.

The long-held strategy by many borrowers of leveraging to the hilt because “debt is cheaper than equity” has always troubled me. Absent in that statement is the four-letter word “risk.” Up until the credit crunch hit in August 2007, risk wasn't priced into the equation.

While I still struggle to understand credit default swaps, real estate derivatives, collateralized debt obligations and other so-called opaque financial instruments, this much I know to be true: too much debt is never a good thing. Something went haywire with these exotic investment vehicles in terms of the risk modeling, and now the taxpayers will be on the hook for potentially $700 billion.

It's a different world

For nearly five years, borrowers were like the prettiest girl at the party in the commercial real estate financing world. Lenders were tripping over themselves to shovel money out the door. It had become an auction business.

“The cheapest money at the highest advance rate, with the least recourse, would walk away with the prize,” recalls Patrick Feltes, senior vice president of GE Capital Solutions, Franchise Finance, a hotel lender who works out of the Phoenix office.

“Today, I'm the prettiest girl at the party,” says Feltes wryly. “Suddenly, relationship lending is back. If it's a good deal and you are willing to work with me so that I can bank a profitable deal, then yes there is money out there for good product and good sponsors.” His remarks came during a Lodging Conference panel discussion Sept. 24 at the Arizona Biltmore hotel.

The problem for borrowers is that lenders have no sense of urgency, emphasizes panelist Joe Epstein, president and founder of First American Realty Associates, a mortgage banker specializing in hotels. “The lenders know they're in control, and they're taking their time. They are underwriting unbelievably diligently and being tremendously conservative.” They're being very selective about those to whom they're making loans, says Epstein.

Arthur Adler, managing director and CEO of the Americas for Jones Lang LaSalle Hotels, echoed some of Feltes' comments during a separate conference panel discussion focusing on survival skills. JLL Hotels has closed four transactions over the past two months in which it has arranged the property sale for owners and debt financing for buyers.

“There are different sources of credit, and it's not Wall Street,” explains Adler. “It's insurance companies, community banks, regional banks. Maybe we're going to go back to the old days of three-martini lunches and relationship lending.”

Though Adler believes that the deleveraging of financial institutions will benefit the hotel lending market in the long term, he compares the stress that began in the credit markets in August 2007 to a slow, painful death. “Maybe this is the cataclysmic event [the $700 billion federal bailout plan] that will create an environment in which we will see a recovery.” But can we bury the exotic investment products for good?

Contact Editor Matt Valley at [email protected].

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