How Lehman Brothers Got Its Real Estate Fix

How Lehman Brothers Got Its Real Estate Fix

Photo Illustration by The New York Times

By DEVIN LEONARD
Published: May 2, 2009


BACK when he was a major Wall Street deal maker, Mark A. Walsh, the former head of the global real estate group at Lehman Brothers, had a running joke with Carmine Visone, one of his managing directors. Mr. Visone, 10 years older than his boss, would lecture Mr. Walsh about the importance of fundamentals: land values, construction cost and rents.

Marilynn K. Yee/The New York Times; Chester Higgins Jr./The New York Times; Richard Drew/Associated Press
Mark Walsh and Lehman Brothers financed blockbuster property deals in Manhattan, including the purchases of, from left, the Woolworth Building, the Seagram Building and Lever House.

John Lei for The New York Times
Mark Walsh led Lehman’s global real estate group before the market, and the bank, collapsed.

“He’ll be back,” said the real estate developer Aby Rosen.
As Mr. Visone remembers it, Mr. Walsh would wave his hand dismissively and would argue just as emphatically that the best way to make office buildings spew cash was through the magic of financial engineering. Typically, Mr. Visone gave in.
“He was too smart for me,” Mr. Visone recalls.
Many others were equally in awe of Mr. Walsh’s intellect. Until Lehman Brothers collapsed last September, Mr. Walsh was considered the most brilliant real estate financier on Wall Street. In the ’90s, he pioneered the art of lending to office building developers and then slicing up and repackaging the debt for investors. Less risky pieces went to institutional investors; the lower-rated chunks to hedge funds and others hungry for juicier returns. Lehman pocketed a fee every step of the way, and it often retained a risky piece or two to give its own earnings a kick.
“That was one of Lehman’s strengths,” says Brad Hintz, a former chief financial officer at Lehman who is now an analyst at Sanford C. Bernstein. “In fact, a lot of Wall Street firms tried to duplicate Lehman’s commercial real estate strategy.”
Mr. Walsh, who wore rumpled Brooks Brothers suits and could be painfully awkward in front of crowds, was one of Lehman’s biggest profit producers. Former Lehman executives say Richard S. Fuld Jr., the bank’s chief, relied on Mr. Walsh to bankroll the firm’s swanlike transformation from a second-tier bond trading shop into a full-service investment bank. Former members of his unit, who requested anonymity because they were concerned about being swept up in lawsuits and investigations surrounding Lehman’s collapse, say it generated more than 20 percent of Lehman’s $4 billion in profits at the peak of the real estate boom in 2006.
Many factors, of course, contributed to Lehman’s demise last fall. Near the end, it carried $25 billion in toxic residential mortgages. It was wildly overleveraged. And the federal government made the fateful decision not to rescue Lehman from its mistakes. But when real estate overheated in the years before Lehman’s implosion, Mr. Walsh made billions of dollars in loans and equity investments that also ultimately helped bring down the bank.
Lehman’s bankruptcy hasn’t quelled the controversy about Mr. Walsh’s activities. Last fall, the United States attorney’s office in Manhattan subpoenaed him and other former Lehman executives as part of an investigation into whether the firm improperly valued its commercial real estate holdings, among other things. In March in a civil complaint, Anne Milgram, the New Jersey attorney general, accused Mr. Walsh and 17 other former Lehman officials of defrauding the state’s pension funds by misrepresenting Lehman’s real estate exposure.
Mr. Walsh, 49, declined to be interviewed for this article.
His former co-workers and clients remain staunchly loyal. “I have the greatest respect for him personally and professionally,” says Richard S. Ziman, the former C.E.O. of Arden Realty, a company based in Los Angeles that Mr. Walsh helped take public in 1996 and sell in 2006. “I’d testify in court if that was necessary.”
But even among Mr. Walsh’s supporters, a nagging question remains: How could a real estate wizard who built a thriving business by creating new ways of managing risk by sweeping loans off Lehman’s balance sheet end up doing deals that contradicted everything he seemed to stand for — and contribute to the collapse of one of Wall Street’s most venerable firms?
MR. WALSH grew up in Yonkers, the son of a lawyer who once served as chairman of the New York City Housing Authority. He attended Iona Preparatory School in New Rochelle; the College of the Holy Cross, where he majored in economics; and, finally, the Fordham University School of Law.
After receiving his law degree in 1984, he worked as a real estate lawyer in Miami and handled a lot of foreclosures. That came in handy when he took a job at Lehman in 1988, at the end of an earlier real estate boom that left banks and insurers saddled with mountains of bad loans.
Mr. Walsh bought and sold loans on properties that were often in foreclosure. There were bargains galore. He generated hundreds of millions of profits for the firm and won the confidence of Mr. Fuld, who gave him the authority to make huge loans. Then, along with Ethan Penner of Nomura Securities and Andrew D. Stone of Credit Suisse First Boston, Mr. Walsh discovered securitization. This created an entirely new market for commercial real estate debt. No longer would lenders have to shoulder all the risk from real estate lending. Wall Street could make the same loans and sell them off. The challenge then became lassoing the right kind of developers to back.
The three men marketed their services very differently. Mr. Penner hired Bob Dylan, Stevie Nicks and the Eagles to serenade clients, while Mr. Stone jetted around the country with the likes of Donald Trump. The publicity-shy Mr. Walsh was more understated. Mr. Ziman says Mr. Walsh went fly-fishing with clients in Colorado and Montana.
Developers also loved the fact that Mr. Walsh was willing to lend them enormous sums. In 1997, Barry Sternlicht, then the chief executive of Starwood Hotels and Resorts, needed $7 billion to buy ITT.
“I called up Mark and Goldman Sachs and said, ‘Would you be interested?’ ” he recalls. “Goldman said they were. They came to see us. But we needed to get it done really quickly. Mark said, ‘Yeah, we’ll do it.’ I said, ‘Really? You are going to do it yourselves?’ He said, ‘Yup.’ ”
Mr. Sternlicht says Mr. Walsh brought Mr. Fuld himself to a meeting at the hotelier’s home to assure him that Lehman would back his acquisition. “Dick Fuld sat there in my living room and said: ‘You have our word. We’ll get this done,’ ” Mr. Sternlicht recalls. “We paid a $20 million fee. I was never so happy paying a fee.” Mr. Fuld declined to be interviewed for this article.
During the late ’90s, Mr. Walsh forged close ties with many of the most prominent developers in New York. He bankrolled Tishman Speyer in its purchase of the Chrysler Building in 1997. He backed Steven C. Witkoff in his purchase of the Woolworth Building in 1998. And he financed the acquisitions by the German real estate developers Aby Rosen and Michael Fuchs of the landmark Lever House and Seagram Building.
Mr. Rosen recalls that he and Mr. Walsh closed the $375 million Seagram Building deal in four weeks. “He was fast,” says Mr. Rosen. “He doesn’t try to kill you or retrade. To be honest, there are very few people in the industry you can say that about.”
Mr. Walsh was also skilled at making all that debt vanish from Lehman’s balance sheet before the firm choked on it. On the eve of the financial crisis brought by the near collapse of Long Term Capital Management in 1998, Lehman flushed $3.6 billion in commercial real estate loans through its securitization machine, avoiding some of the losses that crippled other firms, including Nomura and Credit Suisse.
Mr. Walsh was rewarded with more responsibility, and in 2000 was named co-head of a new private equity group dedicated to real estate investments. After raising $1.6 billion from pension funds and university endowments and delivering an internal rate of return of more than 30 percent, the equity franchise easily raised $2.4 billion for a second fund, which closed in 2005. While the market was heating up and low-priced deals were harder to find, the second fund still generated a 15 percent return.
But the funds’ structure created perverse incentives within Mr. Walsh’s group, according to two former members of his team who requested anonymity because of confidentiality agreements they had signed with Lehman.
Lehman owned 20 percent of the funds. Institutions and wealthy investors controlled the rest. Mr. Walsh, in order to raise money, promised to give the outsiders a first peek at deals.
If institutional investors and others passed, Mr. Walsh’s bankers were free to make the same investments with the firm’s money — which was just fine with his troops: they received bigger bonuses on the riskier deals because Lehman didn’t have to share the profits.
But it also meant that more deals that could go wrong ended up on Lehman’s balance sheet. And this is exactly what happened with a set of deals known as “bridge equity” financings.
As real estate went into overdrive in 2003, Mr. Walsh, in order to help clients pump up their offers in heated bidding wars, started frequently putting Lehman’s own cash into deals — alongside the debt they raised. With its cash on the line, Lehman would be dangerously exposed in any downturn, so, once a deal closed, the firm would try to sell its equity stake as quickly as possible.
Lehman made ripe 4 percent fees for its equity investments — twice the going rate for loan securitization. As long as the market was rising, Mr. Walsh’s group was fine. But if the bank couldn’t sell the bridge equity and if real estate prices fell, it could end up with nothing.
“It was a classic assumption that values are going to be higher a year from now,” says Mike Kirby, chairman of Green Street Advisors, a research firm. “That was the mentality at the time.”
Bridge equity quickly became one of Lehman’s signature products, and Mr. Walsh’s group deployed it in dozens of deals, including Tishman Speyer’s $1.7 billion purchase of the MetLife Building on Park Avenue in 2005 and Beacon Capital Partners’ acquisition of the News Corporation’s headquarters on the Avenue of the Americas for more than $1.5 billion in 2006.
“Guys like Tishman Speyer wanted as much of this product as they could get,” says a former real estate banker at a competing Wall Street firm, who requested anonymity because of confidentially agreements he had signed with the bank. “For them, it was a no-brainer. It was like, ‘Bring as much of this on as possible.’ ”
By all accounts, Mr. Walsh made piles of money. He had perks like a corner office over Park Avenue with a private conference room. Yet his ego never matched the size of his deals. Friends say Mr. Walsh lived in a modest home in Rye, N.Y., with his wife, Lisa, and their three boys. His main interest outside of work and family was fishing.
“At the end of the day, he is content to throw a line in the water and fish by himself,” says his friend Dan McNulty, co-chairman of DTZ Rockwood, a real estate investment bank in New York. “He’s a very reflective guy.”
IF Lehman and Mr. Walsh were convinced about the virtues of bridge equity, outside investors weren’t. “It was a gray area,” says a former Lehman executive who asked not to be identified because of his confidentiality agreements with the firm. “It wasn’t the kind of risk that the investors had signed up for. The funds never participated in those deals.”
One partnership pursued by Mr. Walsh exemplified his newfound appetite for ever riskier deals: transactions with the SunCal Companies of Irvine, Calif., an operation with an intriguing business model. It bought land, primarily in its home state, and sought government approval for residential development. If it got the green light, it sold the land to builders for an enormous profit. Mr. Walsh lent SunCal more than $2 billion and formed a close relationship with its founder, Boris Elieff. Mr. Elieff did not return calls seeking comment.
“We had other Goldman Sachs and other people who were clamoring to do business with us,” says Louis Miller, a lawyer for SunCal. “Lehman said, ‘No, we want to you to be exclusive with us.’ They loved SunCal.”
But because the cash flow from the SunCal deals was hard to predict, Lehman’s loans to the company were nearly impossible to syndicate. After all, how do you estimate income from raw land that may or may not be approved for development?
After putting about $140 million from the funds into SunCal deals, Mr. Walsh discovered that the investors wanted out. In 2006, he cashed them out with a tidy profit in exchange for effectively transferring their ownership stake onto Lehman’s balance sheet. That left Lehman with even more SunCal exposure, just before the emergence of the subprime crisis that would pummel the Southern California real estate market.
Others were already sensing danger, and some of Mr. Walsh’s longtime clients started to pull back. Mr. Ziman of Arden Realty sold his company to GE Capital in 2006. He said the real estate market — and, indeed, the entire financial system behind it — was becoming increasingly bizarre.
“Every Monday, I’d get these e-mails from all the investment banks about the deals of the week,” Mr. Ziman recalls. “I kept saying, ‘Where is all this money coming from?’ ”
Lehman wasn’t the only bank throwing bridge equity into real estate. In October 2006, Wachovia and Merrill Lynch pledged $1.5 billion for Tishman Speyer’s $5.4 billion acquisition of Stuyvesant Town, the huge apartment complex in Manhattan. In February, Goldman Sachs, Morgan Stanley and Bear Stearns put up $3.5 billion into the Blackstone Group’s $32 billion deal to buy Equity Office Properties Trust.
Missing out on the Stuyvesant Town deal stung Lehman, said one of the firm’s bankers who declined to be identified because he wasn’t authorized to speak publicly about his time at Lehman. It wasn’t just the lost fees. Mr. Walsh considered Tishman Speyer a core client. What’s more, Tishman Speyer’s chairman, Jerry Speyer, had a close relationship with Mr. Fuld. They were both board members of the Federal Reserve Bank of New York; Mr. Speyer and Mr. Fuld’s wife, Kathleen, were trustees of the Museum of Modern Art.
And it wasn’t long before Mr. Walsh found a way to do an even bigger deal with Mr. Speyer’s company. In May 2007, Lehman and Tishman Speyer offered to buy Archstone-Smith Trust, a $22 billion deal struck at the peak of an already dangerously frothy market. Tishman Speyer put up a mere $250 million of its own equity. Lehman, in a 50-50 partnership with Bank of America, put up $17.1 billion of debt and $4.6 billion in bridge equity financing.
As the credit crisis began to set in during the following summer, the financing for the Archstone deal appeared imperiled. With the markets spiraling downward, rumors were rife that Lehman was having problems and that it might walk away from the Archstone transaction.
Mr. Speyer phoned Mr. Fuld to make sure that he still had Lehman’s backing. “When I placed that call, I knew it was preposterous,” Mr. Speyer recalled in an interview with The New York Times in 2007. “I placed it because I had to. But I knew when I was dialing how the conversation would come out.”
Lehman stuck by Mr. Speyer, and the deal was completed in October 2007. Had Lehman walked away, the partners would have absorbed a $1.5 billion breakup fee. In hindsight, it would have been smart to swallow that loss. But several people involved in the deal say the parties thought that the subprime mortgage crisis would actually help Archstone because people who could no longer afford houses would rent the company’s apartments.
And for his part, Mr. Walsh was reluctant to jeopardize an important client relationship.
A former Lehman executive, who declined to be identified because he wasn’t authorized to speak publicly about his time at the firm, said: “We were very loyal to our clients and had a culture of standing by our clients, even when the road got bumpy. We did not back away from commitments. We could not have built such a dominant franchise with any other approach. That culture, of course, has its risks and downside, including losing money on some transactions.”
Mr. Walsh tried to limit Lehman’s risk. He sold $8.9 billion of the Archstone debt to Fannie Mae and Freddie Mac and persuaded Bank of America and Barclays to buy $2.4 billion of the bridge equity. Even so, Lehman ended up with nearly 25 percent of a hugely overpriced deal just as real estate was imploding. This time, Lehman couldn’t sell its immense hunk of bridge equity, and it was stuck with a $2.2 billion ownership stake that nobody wanted.
Still, there were no hard feelings between the partners. “Mark is an extremely talented investor and a great partner,” Mr. Speyer says. “We look forward to working with him in the future.” Of course, the most that Tishman Speyer could lose on Archstone was $250 million — a pittance next to Lehman’s total $5.4 billion exposure.
Lehman soon had much bigger worries. In March 2008, Bear Stearns nearly collapsed and was sold to JPMorgan Chase in a government-supported deal. Wall Street wondered which bank might be next to fall. Short-sellers thought they knew: Lehman Brothers.
Mr. Walsh and his crew rushed to sell their inventory. Between November 2007 and February 2008, Lehman shed $2.8 billion of its commercial real estate exposure. But that still left $36 billion of hard-to-value leftovers, including debt and equity from Archstone and SunCal.
Last spring, the hedge fund investor David Einhorn, who was shorting Lehman’s stock, suggested that the bank’s positions in Archstone and SunCal might be worthless. Mr. Einhorn said share prices of Archstone’s competitors had tumbled as much as 30 percent since the acquisition was announced. As for SunCal, he pointed out that publicly traded home builders had written down their Southern California land holdings to “pennies on the dollar.”
Mr. Einhorn called for Lehman to take a multibillion-dollar write-down on its Archstone holdings. Lehman said it was valuing its commercial real estate fairly, based on the prices that Mr. Walsh’s group had been getting on the open market as it struggled to free up the bank’s balance sheet.
Lehman ended up with $29 billion in commercial mortgage exposure on its books in the second quarter of 2008 — 30 percent more than Deutsche Bank and Morgan Stanley and 70 percent more than Goldman Sachs.
In early September, Lehman announced that it would stuff its toxic commercial mortgages into a new public company to be spun off to shareholders. The idea went nowhere. “They couldn’t get that commercial real estate off their books to save their lives,” says Mr. Hintz at Sanford C. Bernstein.
In short order, Lehman collapsed.
SOON after Lehman’s bankruptcy, a former executive who declined to be identified because he wasn’t authorized to speak publicly about his time at the firm went to Mr. Walsh’s office to talk. But they sat in silence. After two minutes, the executive left. “It became clear that neither one of us was going to say something that the other didn’t already know, or that we were going to actually have a new idea or bring greater clarity to the situation,” he recalls.
Ultimately, Barclays scooped up part of Lehman’s operations. But it dismissed Mr. Walsh and most of his team. Now the United States attorney’s office and the New Jersey attorney general are trying to determine whether Mr. Walsh did anything wrong.
But according to former Lehman executives who requested anonymity because of confidentially agreements, the values of commercial real estate holdings were determined by an independent committee outside his division.
Mr. Walsh has hired Patrick J. Smith, a former federal prosecutor who is now a partner at DLA Piper, to defend him in these investigations. Mr. Smith declined to comment for this article.
In the meantime, Mr. Walsh is staying busy. He is helping the estate of his former employer dispose of its private equity holdings. His friends say they believe that Mr. Walsh will eventually emerge from the rubble of Lehman’s collapse and return to deal-making.
“Guys like this are very rare,” says Mr. Rosen, the developer. “He’ll be back. He picked up the phone and people listen. Nobody can take that away from him.”
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How Lehman Brothers Got Its Real Estate Fix