There are some things about last fall's capital markets crisis that bear revisiting, such as why it happened in the first place and more importantly, how it might be avoided (or can it?) in the future.

For the third year running, Nrei recently co-sponsored an interesting capital markets roundtable discussion at Columbia University. Some of the real estate industry's leading financial players were present, and here is what they had to say. Particular thanks go to Michael Buckley at E&Y Kenneth Leventhal for inviting us to participate and bring you this unique perspective.

Buckley: One of the things that stuck in my mind a couple of weeks ago at a National Realty Committee meeting is that somebody said the recent creditcrunch was unusual because there were no defaults and it was the first time that something that was caused without an actual default. Is that a correct statement, and what do you make of it?

Joe Rubin: It's true, we're now full-fledged members of the capital markets in real estate. We had a situation where rents and occupancies are at extraordinarily high levels, there are no defaults and yet values are declining. That's not necessarily the reason for the credit crunch last year, but there are a couple of ways you can look at it.

What we in the real estate business are going to have to get used to is that life in the capital markets is a public life not a private life and there is volatility in that market that is very different than we're used to. Exogenous factors like events in Russia and investors who don't really understand us can have major impacts on values.

For example, in the CMBS market, we have a bunch of investors and in the last year particularly a lot of new investors coming into the market who didn't necesarily understand what they were buying. They didn't necessarily understand the product. They only knew they were buying a rated security and they didn't understand how to price the risk associated with that security.

I know one of the things that came out of the decline in the CMBS market last fall is the notion that we all have to price risk better in this market. In the REIT market, we had a 20% decline in REIT share values last year, again when things were good. All these things point to the notion that liquidity is becoming a fundamental factor in real estate valuations.

It's location, location, location and now liquidity. And that liquidity is coming from the capital markets and for whatever reason, whenever that liquidity goes away, values can drop. Valuing in the real estate market has always been reactionary. Value is based on a set of circumstances which we knew taking the past and projected out. But in the capital markets, valuation is anticipatory, like you saw in the REIT stocks where a group of investors having nothing to do with the real estate market are looking at real estate versus a lot of other things and saying, "Gee, I'm looking out two years and maybe there's going to be a recession and maybe real estate is going to be impacted by that recession, so maybe two years from now real estate is not going to be the sector to be in versus oil & gas and transportation so I better get out now before values go down."

Buckley: So a lot of this is getting used to living the public capital markets life and the variety of impacts that other events can have. Joe (Luik), you had maybe a different view and that not much happened and it wasn't a really big event.

Joseph Luik: I agree with everything you said, there isn't much doubt about that. But the real issue in the industry is the fundamentals are great, supply and demand is fine. There was still capital in the market, the insurance companies were in there, the banks, some of them were in there. But the real question was did value decline or did it go to where it should have been because it was overvalued? That's the debate a lot of people have had.

A lot of the guys who started the REITs, they know what real estate is, they've been in the business for 50 years. They know it's not necessarily a huge growth industry. In fact, what it is is you're buying income streams, you're hoping for appreciation in value. What happened, though, was that as the IPOs came out, the REITs, which are only less than 10% of the market, they went out and said, "We're going to sell this thing as a growth stock." This is pretty amazing, but what they were doing as this ball started going down the hill it became a growth stock and Sam Zell and David Simon and all these guys are out saying this thing is great and it's going to grow, and they did it. But all of a sudden when all these other factors occurred, most people looked at it and said, "Well, maybe it's not a growth stock." The REITs were using their somewhat inflated shares as currency and they were buying portfolios with their own stock. This stuff is overvalued.

Don't get me wrong. We took back some paper that declined 20% to 25% in value over the space of six months. But I guess the issue is really whether there was a huge problem at the end of the year or whether it was just an equaling out.

Buckley: In many respects, REIT shares are currency, so you're saying it was overinflated.

Kevin Haggarty: But it wasn't overinflated when it started. If you go back and look at the reasons why the REITs took off, they took off because the economy was expanding and you had supply and demand being very workable because we hadn't had any new buildings for five to seven years.

Guys that were buying properties on the REIT side were buying them in anticipation of the upward side of the recovery. When they were buying it in late-'95 and particularly in '96 and part of '97, it was alright for the REIT stocks to be at 130% to 150% of net asset value, because the asset value still was going to grow. What happened was it got to the point where the values changed at the same time and it was just a point where people should get out. And they went back to being what they should have been. REITs are fundamentally a yield stock, like a utility. It traded like a growth stock for a period of time because it was in a market where growth was possible because you had a lot of guys who were very bright on the real estate side who were buying real estate saying, "There's not a lot of supply out here, we're seeing growth in demand, we're going to fill up these buildings at rising rents and the value of my buildings is going to catch up to where the stock is."

The problem is, people who had the stock didn't get out fast enough.

Patricia Goldstein: But another point on that, though, is they weren't just paying for the future value of the real estate. One of the big discussions you all had a year ago on this was people were buying and paying for management and they were paying beyond what they would pay for the asset value of the real estate and its growth in future value. There was a lot of confusion about that and a lot of people discussed that and said, "We should pay for management" and now I think they've come to the conclusion that these guys couldn't perform magic necessarily.

Obviously management is very important, but the question is how much extra do you pay for that and now we've had a dip below asset value for a number of these companies and there are a lot of analysts who believe that it's going to come back to some equilibrium.

Buckley: Who wants to whack at the CMBS side?

McGrath: Stuart Silverberg just came in ...

Buckley: Speaking of meltdowns ... (laughter)

Goldstein: What happened here is the CMBS market has grown dramatically and it's a market that has really grown up over the last five years. As real estate was improving and prices were increasing, the spreads in the CMBS product tightened. So we ended up in June with a lot of players in the market, very aggressively out there marketing their product which was to make a first mortgage loan on generally small pieces of real estate, though there were larger deals being done also.

Spreads tightened to the point where they were 85 basis points over Treasuries on the AAA-piece. By October the spreads had widened out to 205 and a lot of the buyers for the product and for the lower traunches disappeared entirely. We got to the point in October where we could only sell AAA-paper, if that.

This didn't only happen in real estate, it happened in the corporate world also. But we had a different problem in the real estate market than in the corporate, which is that we had this bottom B-piece. What happened there is you need buyers to come in and buy the riskier bottom piece. But it turned out there were only a few players who did that, but no one really assessed what that meant. They had planned on a lot of new mortgage REITs coming out to buy those pieces. Then all of a sudden there were no bottom buyers whatsoever, on top of which, the markets for liquidity in the other traunches disappeared.

One of the biggest B-piece buyers, Criimi Mae, went into bankruptcy, so there was a default.

There really was no liquidity in the marketplace when we hit October. The flight to quality immediately hit the mortgage market and it was very difficult to sell paper. That is what shut down a lot of the activity and started driving the prices of real estate down because the buyers, whether they were REITs or real estate companies, couldn't finance.

Stuart Silverberg: Pat did a good job in summarizing the meltdown. I'll be a little more specific as to what happened to our company. We had about $5.5 billion worth of whole loans on our books and we're in the process of putting together packages of loans that are repackaged into securities.

The way we were running our business, the economies of scale of packaging in large bulk became both efficient and economical for our firm as well as others, so as securitizations had started out as being a couple hundred million (dollars) at a time, they had grown to several billion dollars. We're in the process of putting together two packages now, both of which will be $2 billion.

So what happens is when firms were originating loans at a very fast pace, they weren't necessarily securitizing them fast enough to keep up with the volume of origination. So when the market tanked, our company and several others got caught in a long position in a very short market. Our losses were probably on the order of magnitude on just our whole loans of about $500 million. But other firms suffered similar fates. Clearly that took away a lot of the equity capital that we used as our risk-based capital to use as a lending platform, clearly drying up the capital markets. As was mentioned here, it had a snowball effect on both our firm as well as others.

Richard Lieb: There's a perspective I want to give since I'm focused mainly on the unsecured side. One thing that's interesting listening to Pat talk about some dates relates to convergence of all of these markets. On the corporate unsecured side for real estate companies, you started to see widening back in June and July, and deals were widening rapidly. By the middle of July, quite honestly our CMBS guys were thinking their ship had come in and it was happy days now that the unsecured market had finally blown up and here nothing was going wrong in their market, everything was fine and was their chance to take all of these unsecured borrowers and make them secured borrowers. Within six weeks, the CMBS market was in total crisis because they were the same buyers who were backing up a lot of these different markets whether it be the unsecured market, the CMBS market, the direct mortgage market. When you cut through it, it was lot of the same people who were at least looking and trying to calibrate between the markets.

Looking back, there was a real early-warning system that this was coming. I'm not sure how many people totally ignored how much these markets were converging.

Robert Blumenthal: But it's been a very quick turnaround. At NYU, we had a meeting this morning with the traditional lenders and it's good to be in the business again. We're back. If you were a floating-rate lender you were a winner because you did not suffer. As interest rates go up the price of bonds goes down. As spreads widen and you have a fixed-rate instrument, the price of your instrument is going to go down. If you're a floating-rate lender which floats to Libor and you haven't hedged that, you're probably OK assuming spreads stayed the same.

If you look at the flow of funds right now, forget about what happened, it's over. Right now it's about how to make a living as borrowers need money. REITs right now are in a position to become secured lenders with a huge opportunity out there to recapitalize REITs with project loans. Who can benefit from that? The people who have liquid balance sheets today. The people on the insurance company side can provide fixed-rate financing, and the banks provide Libor-based financing and flexible pre-payment penalties.

The flow of funds into real estate lending is almost at the level as it was before the crash. Where is it being made up? It's being made up with the traditional life insurance companies, the banks are back in the market, I've seen evidence of insurance companies becoming construction lenders. We're seeing just a tremendous flow.

Now, where are the B-piece buyers coming from? They're back, they're just not charging 12%. They're charging 25% to 30%. When you blend that piece against all the other ratings, you still have financings in the 7%+ range, which makes sense for a borrower. So are they back, is the market coming back? Absolutely to the extent that there are more players. The opportunistic investors are coming into the B-pieces. They're going to make a lot of money, because when the convergence happens and they're lending at 25%, all of a sudden it doesn't take a lot for it to go back to 50% to make a lot of money. If you look back historically at where spreads were when the industry started in the early-'90s, our spread regime on these unrated pieces are pretty much where they were when we started.

Buckley: So there was a repricing regime, the funny money is gone and now we're back to basics.

Haggarty: I think it's only fair when you describe it as Rob did, the underwriting standards changed to some degree and certainly the loan-to-value ratios changed dramatically.

Buckley: So more equity then. Joe, you're operating under the radar screen at a completely different level in some cases. You're buying and selling and making direct investments in development. Where do you get your money and on behalf of your clients?

Joe Morningstar: The bulk of what we are doing is really financing with equity. We are getting conventional financing from commercial banks for two large projects. We have a fund which was started last November called Westport Senior Living. We've raised about $190 million from pension funds and it's still open for subscription. These are CCRCs, it's existing facilities as well as new development and they can be financed very easily because it is a fairly popular product, the demographics are good. We're putting no more than 50% or 60% leverage on them. We certainly wouldn't go to the CMBS market for that because our timeframes are slightly different. We'll take it down with all cash and then go out to the marketplace but there are three or four lenders who are doing this nationally and we have a relationship with them.

Luik: Back up for just a minute. Somebody's problem is somebody else's opportunity. At the end of last year, what we haven't talked about, there were no defaults on mortgages, there was no overbuilding, there was no crisis. There was no real estate depression like you had back in the early-'90s. The market itself was still very fundamentally sound. If you had money, and the insurance companies had money, the pension funds had money, we were still buying CMBS. We were still making loans. The question was whether the sellers of these things were going to sell them to you at the rates that we wanted to buy them at. It's an inefficient market and as corporate spreads widened out, CMBS spreads widened out even more dramatically.

Pat, I don't know if you'll agree or disagree, but the Wall Street firms and the banks are sitting with these long-term mortgages on their balance sheets and they've got to be marked to market. There's the crisis.

Goldstein: The point I was going to make on that, there's a couple of different issues. There's the fixed-rate mortgages that were on the balance sheets of investment banks and the floating-rate mortgages that are on the banks' books. The bookkeeping is very different between the insurance companies which is one aspect because if they make a loan at 150 over and the market moves to 175 they don't have to mark that. They can hold long-term paper and they don't have to take a mark if spreads widen out as long as they have a good real estate loan. If you're in a trading account, which is where most of the CMBS paper was, you have to mark it to market daily or weekly which is what happened with a lot of people. Even though the real estate was performing and paying interest, you have to take these spreads and do a calculation on what's the value of that based on the changing spreads and you have to take a write down. Which is what Nomura had to do, and Goldman and we had to do.

If you're a bank and you had loans on your books and the spreads widened out, then you didn't have to take that mark, if you had a floating-rate loan or a fixed-rate loan. So, depending on who had the paper and in what account they were holding the paper, there were different reactions to what happened in the crisis in terms of the cost at that particular point.

If you were in a situation in which you had to take a mark, what was happening was everybody was trying to exit through the door to get rid of that paper so that as the crisis was deepening they didn't have to keep on taking mark. If you had paper where you liked the real estate and you didn't have that kind of problem you just sat there and held the paper.

Buckley: I assume some of those mark-to-market hits have not been recorded yet. So that's the other shoe. John, let me ask you to bring this back to conventional lending for a minute. Is the market back? Are you back?

John Kirst: Yes. I think the last year is really defined in two periods. It's the period up until about August and then the period after August. The insurance companies, including Equitable, we put out about $700 million of new money last year. Earlier in the year it was hard to find good deals and we had to look in places where the conduits and where Wall Street couldn't tolerate. Things such as buildings that may have good fundamental real estate but not the coverage that the rating agencies would want through the models and through their stress testing.

Later in the year, there was a perception that the traditional lenders who were there could make a commitment and as people have said the absolute coupons to the borrowers were not materially different. The Treasuries went down and the spreads went up, but you were still talking about nominally 7% money. So an insurance company that was able to make those commitments was able to pick up some good bargains, and we certainly participated in our share of those.

I was going back to Pat's comment about the holders of CMBS, because don't forget that people like Long Term Capital were holders of CMBS. They had a big position in AAA CMBS. There was a lot of concern back there about the mark-to-market phenomenon and how much squeeze it would put. Using Long Term Capital as an example, that's one of the things that made investors nervous. But we were out looking, particularly for CMBS issues that we held in the portfolio already, things that might have been underwritten in 1996 under better underwriting standards than the 1991 first half of the year vintage paper. And while you could theoretically get a market of 350 or 400 basis points on BBB CMBS, there were very few sellers for the same reasons that Pat's talking about.

Buckley: So if you had good stuff you didn't sell it.

Kirst: The mortgage REITs are a good example. That's why Criimi Mae blew up. It's no different than what happened to Long Term Capital Management, just different kinds of bonds.

Buckley: How is all of this striking you at Chase?

Ben McGrath: I've heard a couple of comments that everything is back and maybe it's not. I think we all have to pause and reflect on the nature of the real estate market versus the rest of the capital markets that everybody deals in.

Relatively speaking, the real estate capital markets are small. If you look at the typical big, multi-billion-dollar corporate bank loan, it gets syndicated out to 70 banks. And the typical big real estate industry bank loan gets syndicated out to 20 banks, and that would be a really big bank group. Many are only 10 banks. It's just a smaller universe. The same goes for bond deals. Big corporate bond deals sold by a big investment bank are going out to dozens of buyers and get allocated out to many accounts and at the end of the day, it's many fewer for real estate.

The dislocation we suffered in the fall knocked one or two out. There aren't more investors as a result of the fall, so I don't think it was a positive event overall, except that for the institutions investing it was a wakeup call in terms of their risk management practices. For the real estate entrepreneur with a real estate company, I don't see that the landscape has changed for them at all or improved. We need to look for a more revolutionary transition in the market to where many more new players come in and buy paper of all kinds - CMBS paper, fixed-income paper and bank paper. We're not there yet.

Buckley: Back to this idea about how things get syndicated out. Why can't you expand the pool of buyers in an educated way to the asset class, and why has it been so hard to do that?

Martin Ciccio: If you go back five years we can equate progress. Joe hit the pin on the head. Fundamentally the real estate market is actually in better shape than most people have seen it in a long time. But this industry has had a propensity to outlive a balanced market by putting itself in an unbalanced position, particularly when there is lots of capital available.

In the equity markets, REIT prices have clearly come down and leveled out. As far as the bond market, if you look at the CMBS market, the phenomenal growth of that market in a short period of time, it was just too much too quickly. When you had the ripple through the entire capital markets, the impact on the real estate business was a little bit more severe.

Luik: But put it in perspective, Marty. How big is the whole REIT industry?

Ciccio: It's about $140 billion in market cap.

Luik: And look at Coca Cola. And isn't he entire real estate industry what, $3 trillion?

Buckley: That's $140 billion out of $3 trillion

Ciccio: In perspective, that deals with it. With respect to the bond market and the CMBS market, we sold $600 million of Simon paper, two traunches of five and 10, and there were probably 65 buyers for that $600 million. That's not a huge amount of buyers relative to a traditional $600 million corporate bond issue. But as to the depth of that market there are still some concerns.

There were a lot of people scrambling for five months. The beauty of integration into the capital markets is that you also get the ups and the downs of imbalance not necessarily due to your fundamental industry imbalance. But markets recover.

McGrath: Michael, most of the firms represented on this panel are big financial institutions, traditional investment banks and commercial banks that are all about through-put. It's all about doing a big deal and cutting it up into as many little slices as you can and spreading it out to all of your friends at other institutions. Or it's about being a giant institution like Equitable and Teachers that has an almost insatiable demand for investments. Every day a bucket of money shows up and they've got to get it invested.

Granted, that covers a big swath of the market, but there are also many, many banks and community banks and even New York banks that are just portfolio lenders. They're just spread lenders. They like to make a loan and make an interest rate greater than their cost of funds. For the real estate entrepreneur out there, there is still a lot of capital available in that package.