As corporate post mortems go, the report compiled by the bankruptcy examiner of Lehman Brothers Holdings Inc., may go down as the standard in bankruptcy documents. And what it tells us about the collapse of the once-venerable investment house will stand as a clear warning of what commercial real estate strategy not to follow in a brewing economic crisis.
The examiner's nine-volume, multi-thousand page document covers Lehman's collapse from 2007 when it racked up record revenues of nearly $60 billion and record earnings in excess of $4 billion to Sept. 15, 2008, after it lost 95% of its value and was forced to seek Chapter 11 protection in the largest bankruptcy proceeding ever filed.
Much has been made since the report's release this past week about Lehman's repurchase agreements and accounting treatments but the report makes clear that the actions taken by Lehman executives and government agencies were more misguided than criminal.
"There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate," the report notes. "Lehman's financial plight, and the consequences to Lehman's creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by government agencies, who by their own admission might better have anticipated or mitigated the outcome."
Also clearly detailed in the report, is that Lehman made the deliberate decision to embark on an aggressive commercial real estate growth strategy at a time when the sub-prime residential mortgage business was progressing from problem to crisis.
"Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to "double down," hoping to profit from a counter-cyclical strategy," according to the report. "As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls."
"With the implosion and near collapse of Bear Stearns in March 2008, it became clear that Lehman's growth strategy had been flawed, so much so that its very survival was in jeopardy. The markets were shaken by Bear's demise, and Lehman was widely considered to be the next bank that might fail. Confidence was eroding. Lehman pursued a number of strategies to avoid demise. But to buy itself more time, to maintain that critical confidence, Lehman painted a misleading picture of its financial condition."
It All Started in 2007
At the start of the subprime crisis, Lehman was rapidly growing its commercial real estate transactions. Lehman almost doubled Global Real Estate Group's (GREG) balance sheet limit from $36.5 billion in the first quarter 2007 to $60.5 billion in the first quarter 2008, with GREG regularly exceeding its balance sheet limits.
GREG's balance sheet growth was largely the result of a series of large transactions that Lehman concluded between May 2007 and November 2007. Each of the following deals increased the balance sheet by over $1 billion in the respective months.
- May 2007, $2 billion - Lehman financing to Broadway Partners to acquire a sub-portfolio of Beacon Capital Strategic Partners III, LP.
- May 2007, $1.3 billion - Lehman financing to Broadway Real Estate Partners to acquire 237 Park Avenue.
- June 2007, $1.2 billion - Lehman financing to Apollo Investment Corp. for a take private of Innkeepers USA Trust.
- June 2007, $1.1 billion - Lehman financing to Thomas Properties Group to acquire the EOP Austin portfolio.
- June 2007, $1.7 billion - Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio.
- July 2007, $1.5 billion - Lehman financing to ProLogis to acquire the Dermody industrial portfolio.
- July 2007, $2.9 billion - Lehman financing for the acquisition of the Coeur Defense office building.
- August 2007, $1 billion - Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio.
- October 2007, $1.5 billion - Lehman financing to Blackstone for its acquisition of Hilton Hotels. And
- October 2007, $5.4 billion - Lehman financing for the acquisition of the Archstone Smith Trust.
The problem with this growth strategy as the report details was that the growth of the commercial real estate business was facilitated first by an increase in the risk limits but, more importantly, followed by a decision to exceed those limits.
A second problem with the strategy was that internal opposition to grow the firm's commercial real estate business was basically ignored. Lehman managers were warning executives that the growing CRE exposures were particularly risky because Lehman's balance sheet would be directly affected by the declining market values of the underlying real estate if the firm failed to sell its bridge equity positions as planned. Nevertheless, Lehman continued to acquire substantially more bridge equity positions.
Strategy Culminated in Archstone Acquisition
According to the report, the enormous growth of Lehman's commercial real estate balance sheet culminated in Lehman's commitment to participate in an approximately $22 billion joint venture with Tishman Speyer for the acquisition of the publicly held Archstone REIT. Including units under construction, Archstone owned more than 88,000 apartments, which were spread across more than 340 communities within the United States.
At the time the deal was presented to Lehman's executive committee, Lehman intended to sell all Archstone debt at closing.
The U.S. Office of Thrift Supervision (OTS) criticized Lehman's decision to enter into the Archstone transaction in excess of its risk appetite limits. During OTS's yearly review of Lehman in 2007, the OTS noticed that Lehman had exceeded its risk appetite limits and that the Archstone deal was largely responsible for that overage. As a result, in 2008, OTS decided to conduct a targeted review of Lehman's commercial real estate business.
After that targeted review, OTS issued a "negative" report, criticizing Lehman for being "materially overexposed" in the commercial real estate market and for entering into the Archstone deal without sound risk management practices. The report concluded that Lehman's breach of risk limits, caused largely by the Archstone deal, contributed to "major failings in the risk management process."
By contrast, the U.S. Securities & Exchange Commission told the bankruptcy examiner that it was aware of the risk appetite limit excesses, but that it did not second-guess Lehman's business decisions so long as the limit excesses were properly escalated within Lehman's management.
Finally, once it was clear of the damage to come, the report details how Lehman was slow to respond and moved too slowly to exit its illiquid real estate investments.
Before Bear Stearns' near collapse in March 2008, Lehman had two basic ways of reducing its leverage: selling assets, to reduce the numerator in the net leverage formula; or raising equity, to increase the denominator in the net leverage formula. But Lehman did not successfully take either of these tacks during the final quarter of 2007 or the first quarter of 2008.
Although Lehman ultimately took aggressive action to reduce its balance sheet and thus its net leverage, Lehman's management did not make a firm-wide decision to reduce these figures until well after the beginning of the risk appetite and balance sheet limit overages in mid-2007. Moreover, even after Lehman's senior officers directed the business lines to reduce their balance sheets, it took several months for the reduction to be effectuated, particularly with respect to Lehman's illiquid holdings of commercial real estate assets.
It was not until February 2008 that Lehman executives were instructed to "get balance sheet down quickly." But some witnesses interviewed by the examiner said they believed that GREG was not aggressive enough in selling off its portfolio, holding on to positions in a belief that the market would eventually rebound.
Regardless of the reasons for Lehman's slow reaction to its oversized commercial real estate holdings, the report noted that the fact remained that Lehman's balance sheet did not decline until the end of the second quarter of 2008, after Bear Stearns had already collapsed and the credit and commercial real estate markets started grinding to a halt.
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Mark Heschmeyer
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