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Transcript: View from the Top with Tom Barrack of Colony Capital
Published: October 23 2009 15:41 | Last updated: October 23 2009 15:41Henny Sender, international financial correspondent, interviewed Tom Barrack, chief executive and chairman of Colony Capital aboutbad mortgage lending, property cycles and investment opportunities in the US. This is a transcript of that interview.
PART 1: On bad mortgage lendingFT:
Tom, thank you so much for joining us today.
TB:
It’s a great pleasure - thanks for having me.
FT:
So let’s start with something that you said to me the last time we talked, which is how the securitization market actually destroyedprudent lending. Can you explain how that whole dynamic worked?
TB:
Yeah I mean so the trick was how do you originate more mortgages, and Wall Street adapted to that by saying, ”The way we’lloriginate them is we will originate them in SIVs or conduits, we’ll package them up, we’ll carve them up into all these various pieces,S&P or Moody’s will come along with their magic wand and they’ll wrap it with a triple A or a double A rating, and now we’ll train a wholenew category of buyers to have an appetite to eat this stuff and we’ll trade in it.So if you just look at it simply what happened to a bank - banks usually operate at 10-to-1 leverage, so you could own a bank with 8per cent capital. So if you originate a mortgage on your books as an asset, you kind of have embedded 10-to-1 leverage of every dollarof your equity.But what happened in the securitization market is you could originate these loans, sell them into a securitization and through asecuritization then sell them into a CDO and you could go from 10-to-1 leverage to 30-to-1 leverage to 300-to-1 leverage and the buyercould care less whether the property was on 5th Avenue in New York or on Madison Avenue in Wisconsin.
FT:
And that drove up the price way beyond what any economic rationalization would say was just?
TB:
Absolutely. Hugely. Because now you had an unbelievable appetite and demand for the mortgage product, underwriting standardswent down, loan devalues went up, because in the competitive marketplace, to get that borrower now to borrow more money, the morelax you are in your underwriting standards, the more they will borrow, covenants gave way because borrowers, then in a competitiveenvironment, said, ”Well I don’t want to do this, I don’t want to do that,” and you end up with this unbelievable massive amount of debt capital running into the real estate sector.
FT:
So how do we get out of this now? I mean it seems that the government thrust is to say: you know, it was leverage that got usinto the mess but we can’t really afford for prices to dive, so we need to somehow support prices by adding leverage again. Is that agood or a bad thing?
TB:
If you look at the real estate industry, CMBS, the securitizations that we’re talking about, the securitization market is driven byliquidity and liquidity is driven by Talf. So the government creates in essence a refinancing entity, which people can trade in and out of this stuff. And we all laugh about the mantra in this part of the lending business being ”extend and pretend,” that the answer is thelonger you postpone it, that maybe something good will happen - and this is what is causing interference in the marketplace is thegovernment intervention - and a lot of times they’re attempting to do the right thing, and it’s helped so far but it makes it veryunpredictable to have a belief one way or the other.And the pieces of paper actually have nothing to do with the fundamentals of what’s going on with the underlying collateral. I think thisis the message across the realm is in fundamentals of everything in the corporate world, in the industrial world, in the real estate world,fundamentals at the gross revenue level continue to deteriorate. So if you talk to every CEO, every CEO says, ”My business stinks, I’vetaken all the costs and expenses that I can off of that fruitful tree, I’m losing market share, the consumer is much more knowledgeableabout what and why and when their buying, and my gross revenue line continues to falter. Yet the stock market goes from a nine to aneighteen multiple because of liquidity. And the same thing is happening across all segments of the real estate business.So it’s hard to know what is happening, whether we’re creating another inflationary bubble because with all of this artificial stimulus andliquidity the valuation metrics are off or whether it’s a precursor to a recovery and it’s for real and psychologically we’re just laggingbehind as we always do and things are going to get better.
PART 2: On property cyclesFT:
But it’s always perilous to overgeneralize from history, but obviously you lived through, thrived and prospered from the last downcycle in real estate 20 years ago; what are the similarities, what are the differences between this cycle and the last one?
TB:
Real estate is always the drunk driver on every economic highway in every decade. Everybody’s always disappointed by real estate.And if you look at real estate entrepreneurs, the risk profile is hugely upward and hugely downward because of the leveragability of theassets and the cyclicality of the valuation of those assets is always the same.So in the ’90s you had a little different situation. In the ’90s you had a whole decade before the RTC. Everybody looks back and says”The RTC was so simple; you guys had it so easy, all you had to do was buy stuff at 22 cents on the dollar.” At the time we all thoughtwe were insane buying anything at 22 cents on the dollar because it looked like the world was going right into the sea.
FT:
Really?
TB:
Absolutely.
FT:
So it was terrifying then as well?
TB:
Terrifying. And everybody thought we were idiots, by the way. Now everybody looks back and say, ”Well this was lucky.” They neversay you’re brilliant, they just say you were lucky. And we accept that. But what happened is 1991, which was really the onset of theRTC was the successor to ten years of the government doing exactly what the government is doing now.Different problem: then it was an oversupply of product and demand hadn’t caught up. That’s not the situation today: it’s a contractionin demand, not an oversupply of stuff. So in ’85 they said, ”Okay, we need to fix this but we can’t take down all the assets. We don’tknow how to pay for it.” The precursor of the FDIC was something called FSLIC, which was the program that guaranteed savings andloans.So they said, ”Okay, we’ll create a different kind of capital regulatory environment, we’ll ease capital regulations, we’ll change GAAPaccounting, we’ll create a precursor to Tarp with supervisory good will and capital share because then all of this stuff --So the assets aren’t moving today the way the assets moved in the ’90s. Why? Because a different resolution strategy of postponingand extending those terms and a funding source doesn’t exist. So FDIC insurance - that’s insuring $5,000bn of deposits on 0.25 per
 
cent of premiums. They can’t possibly take all of these bad assets, fill the hole in the balance sheet of these banks and then sell theassets in an open market. So it takes a different resolution strategy.So what you experienced in the markets in ’91 was market-clearing pricing. The RTC came and said, ”Okay, we have a group of crazyguys who will pay something, we don’t know what they’ll pay,” there was no money in the marketplace at that time, ”and we’re goingto sell these assets at whatever they sell for.” They went into this pool, started recycling, within four or five years they solvedthemselves.Today that’s not happening; you have PPIP programs, you have some options, but mostly what’s happening is bank resolutions withother banks.And so this bank holding company act is protecting the banking system. So what happens on the deals that you’ve seen transpire is thisright-down process is a negotiation with the government and the buyer, because the buyer says, ”What I really want is deposits. Iunderstand deposits, so I want all the CDs, all the checking accounts, all the bank branches, and I’ll pay par plus something for those.But over here on the asset side, all of this garbage loans - I have no idea what they’re worth, so I want you, the government to takethe first-loss position on what this is worth.” And this argument goes on between the governments, between who takes the first loss,who takes the second loss, what’s the sharing. But the game to be played there is to find the deepest discount so that the acquisitivebuyer of a troubled institution has the government be responsible for the deepest amount of losses possible.Big banks are just the opposite: big banks take loan loss reserves on a conservative basis, but what they’re trying to do is build up theirreserves over time, they’re awash with liquidity, they’re making tons of money today and if they don’t have to take that deep discountof mark to market today, what they believe is that over time value will return, their reserves will have built up, and even if they thenneeded to dispose of that asset it’ll be against higher reserves and loan values will have increased.So nobody’s being deceptive; they’re both just having two very distinctive business plans. But the business plan for both is there hasnever been a better time to be a bank in America than today, if you have a clean balance sheet and you can originate new mortgagestoday without worrying about the legacy assets that were created in 2005, 2006, 2007. It’s at the highest spreads with the lowestinterest rate cost on the most conservative underwriting assumptions ever in history.
FT:
So does that suggest that we will escape hideous pain, that we won’t see massive defaults coming up, that we can avoid a Japan-like situation?
TB:
What may happen here is the unthinkable thing: that all this actually works. So what happens is these toxic assets don’t end upclogging the system, they end up being realigned over time. And so the discounts of what we’re all worrying about is the trillions of dollars of remarked value come back slowly over time. And in a way it’s zero per cent interest rates that can happen.Now on the other side of that is inflation. So everybody says, ”But how long can you keep interest rates at zero? Can you do it longenough that they don’t have to take the realization on the asset side of life, and what is inflation going to look like on the other side?” And I think the answer is at the moment nobody cares about inflation; it’s survive and get out of this mess.But what we’re seeing in the marketplace is that these deep discounts on assets - on all sorts of assets: real estate assets, which you’rein one of the best office buildings in Manhattan; in most office building in Manhattan today the rent is less than half of what it was 24months ago. So impute any metrics you want onto an income stream, that building, leveraged or unleveraged, is worth half. But it’sonly worth half at that moment in time if you have to sell it at that moment in time. If you don’t have to sell it at that moment in timethen you can withstand an increase, potentially, of income over time and a reattribution of value. And this is the hope; this is the magicwand, that the banking industry, that the government is hoping will work. I don’t know if it will or it won’t.
PART 3: On US opportunitiesFT:
Tom, you spend so much of your time traveling the whole world; at the moment you feel the opportunities are better here thananywhere else in the world?
TB:
Yeah, in our business. I think generically you look at China and Brazil and India and say, ”If I made Kleenex I would be in thosemarkets,” but in our businesses, the volatility, an unforeseen intervening event is always the engine that drives outsides returns.You come back to America, which is still the most transparent society in the world, it has the best information, it has the best legalsystem, it has the most predictable and aspiring population, and at the moment total confusion. So if you must look at market share, inour business most of the people who were in our business two years ago are gone. The bank sector is in search for itself, it’s going to bea tremendous opportunity, real estate sector is in shambles - there’s no transactions, there’s no value. People don’t know what value is;very difficult to lay your hands on it. And the flux of debt of this $7,000bn of deleveraging that’s still going on will produce tremendousopportunities to the people who can figure out how to sit on a viable side of that debt program, because we will recover from this; Idon’t know whether the road is an L recovery, a W recovery, a V recovery, a W-W recovery or will recover.And on the other side of this, the value creation, once we get to growth, will be phenomenal. So if you can control on a conservativebasis assets today at percentages of original value, and a capital structure that will allow you to hold them over time, I think - debt isthe new equity and America is the new emerging market. There’s no reason to go outside of the 212 area code.
FT:
How do foreign investors see the real estate opportunity here?
TB:
Differently. The South Americans believe inflation is going to hit us over the head like a sledge hammer, so they love it. The dollar,of course --
FT:
We’re the new Argentina?
TB:
Absolutely. So if you don’t need money; if you own an office building and you have no debt and you want to borrow 40 per cent of today’s value there’s some insurance companies that will make that capital available. But until debt moved back into the system, untilthe assets reprice themselves, especially at a moment where tenants in everything need less; if you’re an office user you’re using less;if you had a public storage facility where you were storing things you got rid of it; if you had a second home you sold it. If you’ve in aretail shopping mall, you used to have retail sales at $750 a square foot, now you have retail sales at $200.So everybody’s using less of everything. That will then come back, but in the meantime debt has to reprice itself, tenants will continueto contract, demand will continue to contract. And then on the other side of this is where you really reap real estate benefits, becausewhat happened is nobody during this period is building anything. So there’s no new product coming on the market and you’ll takeadvantage of that lag effect when you get some growth; the question is what is going to get us growth? Why would we have growthoutside of stimulus? I don’t know.
LONG/SHORT
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