On Wednesday, Sept. 10, Lehman Brothers attempted to calm investor jitters by announcing plans to carve from its balance sheet $25 billion to $30 billion in commercial real estate investments. The new publicly traded company was to hold the portfolio of predominantly senior whole loans, and provide shelter while investors awaited their positions to stabilize.

Two days later, the venerable firm that rose in the 1840s from a humble general store in Montgomery, Ala., looked anything but stable. The stock price had declined a full 93% for the year, dropping to just $3.69 per share. Lehman emerged from a weekend of talks with U.S. Treasury Secretary Henry Paulson, Bank of America and Barclays Capital, only to file bankruptcy.

Barclays quickly moved in to pick off Lehman's New York headquarters building, 745 Seventh Avenue, along with two data centers and the firm's broker-dealer unit for $1.75 billion.

“The underlying theme to everything that's going on right now is the lack of transparency and when the storm passes, we're going to have to think how to provide transparency for many of these financial vehicles that have been created over the past couple of decades,” says Dan Fasulo, managing director of research for Real Capital Analytics.

Indeed, as Lehman was filing bankruptcy, the U.S. financial system was teetering on the brink of collapse. The first question: Assuming the world would survive the immediate crisis, what impact — if any — would Lehman's downfall have on the commercial real estate industry?

Debt DNA

The answer to that question undoubtedly lies in understanding Lehman's complex portfolio of commercial real estate investments. For starters, Lehman held a total of $32.6 billion in senior whole loans ($15.8 billion), mezzanine loans ($4.4 billion), equity positions ($6.6 billion) and $4.3 billion in securities.

Of the $4.3 billion in securities, the firm held only $600 million in U.S. commercial mortgage-backed securities. “That's an inconsequential amount that could be absorbed easily,” says John Fitzpatrick, senior portfolio manager of real estate capital markets at Allstate Investments LLC.

In fact, it is the senior whole loans and mezz loans — not the CMBS — that pose the most ominous threat to commercial real estate prices. If the entire almost $16 billion in whole loans were to hit the market at distress prices, says Fitzpatrick, “that could affect all commercial real estate markets and could ultimately affect security markets.” Such an occurrence could reprice all whole loans to lower levels.

“The vicious circle that I call the toilet bowl of everybody hanging their feet off the edge, was that they continued to mark down assets, which required them to go out and get more capital, which put fear into the market, which lowered the asset prices even farther, especially like CMBS, and it was a rinse-repeat cycle,” says Fitzpatrick.

Odd man out

It has been postulated by industry experts that Lehman simply got stuck without a chair when the music stopped. The prime example of that may well be Lehman's $22.2 billion joint venture with Tishman Speyer to acquire apartment REIT Archstone-Smith last year. This single deal accounted for 61% of the bank's total acquisition volume since 2001, reports Marcus & Millichap.

While some of the apartment properties have sold since the deal closed in October 2007, most have not, largely as a result of the sudden credit crisis and the ailing economy. Many of the properties, in fact, are concentrated in upscale neighborhoods in Washington, D.C. Southern California, the San Francisco Bay Area, New York, Seattle and Boston.

Lehman's skin in the game? About $250 million in equity and another $2.2 billion in debt. “That equity portion is probably wiped out at this point,” says Fasulo. Given that commercial property values have fallen 10% to 15% in the U.S. on average, he says, if the equity portion were in even the top 10% of the capital stack, it would be now gone.

With an estimated 94% of Lehman's senior whole loans being floating rate loans, valuations plummeting and credit more expensive and harder to come by, the investment giant reported historic third-quarter losses of $3.9 billion, which it largely attributed to writedowns on its real estate holdings.

“One of the factors that I believe ultimately contributed to Lehman having no choice other than to declare bankruptcy,” says Hessam Nadji, senior vice president and director of research for Marcus & Millichap, “was that it took too long for them to come to terms or at least disclose the magnitude of their troubled assets and to be more willing to dispose of some of those assets at more of a discount.”

THE LAST DAYS OF LEHMAN

October 2007

Lehman stock drops on alleged rumors of $7 billion write-down

September 7

Fed announces bailout of Fannie Mae and Freddie Mac

September 10

Lehman proposes to isolate commercial real estate investments from balance sheet in spin-off company

September 13

Lehman in talks with Bank of America and Barclays over plan to save investment bank

September 14

Merrill Lynch agrees to sell itself to Bank of America for $50 billion

September 15

Lehman declares bankruptcy on $613 billion in debt

September 16

Fed announces $85 billion takeover of insurance giant AIG

September 16

Barclays enters into agreement to buy Lehman's broker-dealer unit, U.S. headquarters building and New Jersey data centers for $1.75 billion

September 19

Fed announces toxic mortgage bailout plan