Bad due diligence leads to financial catastrophe for commercial property investors

Throughout this real estate bust I've been banging the drum that it was bad due diligence on real estate investments that led to to catastrophe, whether it was a young family stretching to buy a home, lenders funding a construction loan for a new subdivision or, more recently, private equity firms unloading trophy office properties. If you only trust those who are making money from your transaction, then you must be prepared for the consequences of such a decision. From a New York Times story:

In 2007, Sam Zell, the billionaire Chicago investor, sold a portfolio of 573 properties he had assembled over three decades, Equity Office Properties Trust, to the Blackstone Group for $39 billion. It was the largest private equity deal in history, but Blackstone did not stop there: it immediately flipped hundreds of the buildings for $27 billion. Today, the wreckage of those purchases is strewn across the country, from Southern California to Austin, Tex., to Chicago to New York. Many of the 16 companies that bought Equity Office buildings are now stuck with punishing debt, properties whose values are plummeting and millions of feet of office space they cannot fill... The impact could ripple beyond the companies that bought Equity Office buildings and the investment banks that financed them. If the owners cannot make their loan payments, it could create a financial crisis for the pension funds, hedge funds and insurance companies that hold securities based on Equity Office mortgages... Mr. Zell, who became chairman and chief executive of the Tribune Company after selling Equity Office, amassed his supersize real estate portfolio over many years. But the deal to sell the properties to Blackstone, the big private equity firm run by Stephen A. Schwarzman, occurred with lightning speed and what one executive who participated in the transaction called, “short-form due diligence.”... The buyers found lenders only too willing to finance as much as 90 percent or more of the purchase price, even as profit margins shrank, on a bet that rents and values would continue to rise. The investment banks, including Morgan Stanley, Wachovia, Goldman Sachs, Bear Stearns and Lehman Brothers, in turn collected their fees as they packaged the loans as securities and sold them to investors...

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Little or no due diligence on mortgage loans during the housing boom

I wonder what Gordon Gekko would say today about greed being good, because in the long run it certainly didn't work so well for the housing & mortgage markets. In fact, it seems that it was greed which was a primary culprit in keeping loan reviewers at bay who were raising red flags as questionable sub-prime mortgages were taking off. From the L.A. Times:

Freelance financial watchdogs who examined the paperwork on sub-prime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade. The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright -- such as borrowers' incomes that seemed inflated or documents that looked fake -- but the problems were glossed over, ignored or stricken from reports...

In interviews with The Times, eight experienced loan reviewers said that as marginal lending increased, quantity took precedence over quality. Squads of 10 to 15 veteran loan checkers gave way, they said, to packs of 40 to 50 mostly novice reviewers posted at or near sub-prime factories such as now-defunct Orange County lenders New Century Financial Corp. and Ameriquest Mortgage Co.

Executives at the two main firms that hired the freelancers -- Shelton, Conn.-based Clayton Holdings Inc. and San Francisco-based Bohan Group -- say the reviewers weren't there to find every potential problem with a sub-prime loan. Rather, the executives say, the job was to perform specific tests to help buyers determine how much to pay for a pool of loans. In some cases, the investors wanted only minimal testing, said Frank P. Filipps, Clayton's chairman and CEO...

As time passed, Clayton and Bohan executives said, Wall Street firms and their investor customers accepted increasing levels of default and fraud in sub-prime loans as they grew to trust software designed to offset those risks by charging higher interest rates, extra fees and penalties for paying off mortgages early.

As Wall Street grew more comfortable, it demanded less of the review process. Early in the decade, a securities firm might have asked Clayton to review 25% to 40% of the sub-prime loans in a pool, compared with typically 10% in 2006, although the requirements varied, Filipps said.

By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50% to 100% of the loans examined, Bohan President Mark Hughes said.

But the freelancers interviewed by The Times never got the memo that their reviews were supposed to be nice and easy. Flying from city to city and typically paid $30 to $40 an hour, with expenses covered, the reviewers say they worked conscientiously to assure the investment banks and mortgage-bond investors that no surprises lay in the files.

Loan reviewer Jana Lujan recalled showing a file to a supervisor in 2004, during a check of sub-prime mortgages made by a Brea bank that regulators later cited for unsound lending. A title report showed a tax lien on the property.

"I said we needed evidence it had been paid off and released," to ensure against foreclosure, Lujan said. "And he said: 'Just go ahead. Assume it's being taken care of.' "

Loan-buyer representatives who were on site during the reviews also showed little interest in the details, Lujan said.

Lujan said one Clayton supervisor would throw away documents that appeared to have been altered fraudulently. The lack of a document in the file meant the loan had to be sold at a slight discount, she said, but it still could be sold.

Lujan, Valenz and one other loan checker said supervisors at Clayton and Bohan also would change the way fees were described so that mortgages would not be red-flagged as potentially predatory under U.S. law, which would render them unsalable and force the sellers to take them back...

The reviewers said the less-thorough approach made their expertise irrelevant and led to pressure to work faster. Valenz and Lujan said they were told to check two or three files an hour when it took an hour or more to do one properly.

One Clayton project supervisor "told us if we spent more than 20 minutes on a file, we were spending 20 minutes too long," Lujan said.

Though quick checks called "data scrubs" could take 20 minutes per loan, Filipps said, complex reviews could take three hours, with the average review taking 80 minutes in 2006.

The biggest problems, the reviewers said, were appraisals that looked inflated and "liar's loans," so nicknamed because borrowers weren't required to prove they earned enough to make their payments.

"You can't tell me a Kmart or a Wal-Mart or a Target floor worker is making $5,000 a month, or a house cleaner is making $10,000," said former loan reviewer Irma Aninger of Palm Desert, a 40-year financial services industry veteran.

Aninger, who did work for Clayton and Bohan, said she tried repeatedly to have such loans marked as unacceptable but was overruled by supervisors, who were known as project leads. "The lead would say, 'You can't do that. You can't call these people liars,' " Aninger said...

THIS is why a federal bailout will be unpopular but necessary. It's simply too late now to punish all of those people who helped perpetuate the house of cards that was the housing boom.