What have we learned from "The Crash of 2008"?
By Jim Butler, Hotel Lawyer.
Wednesday, 7th January 2009
There are no shortcuts for due diligence! 2008 will go down as a terrible year in many regards. Global economies have come to the precipice of disaster. The Dow had its worst year since 1931- down 34% for the year, representing the loss of more than $7 trillion in wealth.

Many trillions more evaporated from the value of both residential and commercial real estate. Consumer confidence is at its lowest point since they began keeping records. The unthinkable has happened with the fallen pillars of Bear Stearns, Lehman, Merrill Lynch, Freddie Mac, Fannie Mae and AIG. Even GE couldn't sell its commercial paper until the Fed stepped in to buy it. And then there is Bernard Madoff who bilked some of the most sophisticated investors in the world out an estimated $50 billion.

What was wrong with the mortgage mess, CMBS meltdown and Madoff?

None of them would have happened if even a modicum of real due diligence was done by almost anyone involved.



Mortgage mess -- What if borrowers had just tried to understand what obligations they had and their ability to meet them? What if lenders acted like it was their money being lent and the losses would affect them if the borrower couldn't pay or the real estate wasn't worth the loan amount? What if Wall Street had acted with the professional responsibility they should have? Regulators looked into queries? Pension funds, governments, private investors, banks, everyone had looked at what they were really buying? (Remember that silly-sick cartoon that said it all? The Mortgage Mess

The CMBS meltdown -- In commercial real estate, maybe there were not exactly liars loans (no documentation of income or assets) and no negative amortization loans, but to say that valuations were "aggressive" is a ridiculous understatement. The CMBS meltdown could not have happened if people involved at every turn in the process had asked more questions and been more diligent.

From personal experience, many years before the meltdown, one CMBS lender asked me about having our hospitality lawyers represent the lender on its larger CMBS loans, say those of $25 million and up. Envisioning "hundreds" of these loans needing legal representation and due diligence, this lender wanted to know what we could do on pricing. Getting ready to "sharpen my pencil" for all this business, I asked the lender "What kind of price range are you trying to accomplish?"

His answer was that they had been spending only $300 per loan, but were going to go up to $500 for the big loans.

Suffice it to say, that providing just the normal due diligence for this kind of loan, without borrower negotiations and loan documentation, would run at least 10 to 20 times the amount they had in mind.

They were not really asking for due diligence, or couldn't possibly get it for that budget.

Bad lender? No. They were under intense pricing competition from other lenders. But instead of spending $1 on due diligence, they were trying to cut it to $.05. You just don't get the same product. We had to pass on this "opportunity."

But don't wonder why some lenders have had to try foreclosing on defaulted loans without having an originally signed promissory note or mortgage, much less avoiding title or environmental issues.

Bernard L. Madoff -- Maybe the Madoff debacle provides the capping example. In what is clearly the largest Ponzi scheme in history -- probably involving $50 billion -- one man seduced the elite of the elite in the financial world. Who would think that Henry Kaufman, former Chief Economist of Salomon Bros. would be hoodwinked by a Ponzi scheme for several million?

And how did respected institutions like BNP Paribas, Royal Bank of Scotland and Nomura Holdings get tagged for around $500 million each? Or HSBC and other professional investment firms for more than $1 billion each?

The answer to these questions is pretty simple: It was a fundamental failure to perform due diligence.

I think one commentator at dealbreaker.com recently summed up the syndrome best that became an international epidemic. It was his answer to the question of how someone could trust their entire fortune to Madoff. The answer?

Goldman did due diligence in 2001 ["no we didn't", "yes you did"] and gave them a pass.

That kind of sums it all up. No one wanted to say that the emperor had no clothes. No one wanted to do all the due diligence when it seemed like someone else must be doing it. Everyone just "assumed" that it must be OK. Who needs due diligence anyway?

How did we get into this mess?

Butler's first law of economics. With apologies to Sir Isaac Newton (and his First Law of Motion), here is Butler's First Law of Economics:

Once in motion, an economy tends to remain in motion, and will keep going in the same direction (up or down) until a greater force acts upon it to turn it around.

Except for knowing that an abdication of prudence and responsible action will ultimately have a bad effect, most people did not even know about the mortgage mess, much less could have predicted that it would start knocking down the row of dominoes leading to the Crash of 2008.

How do we get out of this mess? and what do we do then?

We hope that the unprecedented commitment of trillions of dollars by the United States, the United Kingdom and other countries around the world will be successful in staving off disaster and causing a rebound or turnaround in the global economies. Unfortunately, it looks likely for this turnaround to take substantial time before it kicks in. That means we will have some tough times before the turnaround.

In these tough times there will be some phenomenal opportunities, and perhaps the greatest transfers of wealth we have ever seen. (See "Out of the Panic and into Opportunities of a Lifetime"). At times like these, it is good to remember that we need to get back to basics, like due diligence.

The "fix" for the future

Oh, and by the way, I have the "fix" to get things going again once we have mopped up enough of this mess to let us go forward. We need securitization like the CMBS markets or some equivalent.

What was missing before was the financial discipline of someone with real "skin in the game" -- enough at risk to make sure that they performed the critical due diligence to avoid unnecessary mistakes and excesses. The next time around, we need to be sure that lenders, or CMBS issuers, retain enough of the investment risk that they feel like the loan is being made with their own money. What a concept!

Gee. Doesn't that sound a lot like the way banks used to act when they syndicated out up to 80 or 90% of their loans, instead of selling 100% to anonymous investors?

This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $50 billion of hotel transactions and more than 100 hotel mixed-used deals in the last 5 years alone. Who's your hotel lawyer?

Our Perspective. We represent developers, owners and lenders. We have helped our clients as business and legal advisors on more than $50 billion of hotel transactions, involving more than 1,000 properties all over the world. For more information, please contact Jim Butler at jbutler@jmbm.com or 310.201.3526.
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