Gordon DuGan: How subprime mortgage woes spread through the financial system

February 27, 2008

A first-time homebuyer with limited earning power and a sketchy credit history would seem to have little in common with a blue chip corporation. Or with someone who builds class A office buildings. Or with a prospective college student who lives half way across the country. Or with an old line Wall Street firm.

But thanks to some creative investment vehicles they've all been tied together. Now when the subprime borrower catches a cold, an investment banker on the Street sneezes.

Subprime mortgage problems have spread throughout the financial system and created a full-blown credit crisis, Gordon DuGan, president and CEO of W. P. Carey & Co., told the audience at a recent conference sponsored by the Center for Real Estate Theory and Practice at the W. P. Carey School of Business.

DuGan said he believes that the fear gripping the investment community has gotten out of hand.

A new world

The problems in the credit markets came as little shock to savvy investors and analysts.

"We knew the time was coming. We just didn't know how it would show up," said DuGan, who was with his family on safari in Africa in August and 2000 miles away from the nearest telephone when subprime began to unravel. When he finally checked in, he learned of the first crack in the subprime mortgage sector.

The surprise for some was how borrowers with poor credit histories who had trouble making house payments could affect so many other areas. But, DuGan explained, a downturn in the housing market has the potential to lead to a recession. And, the subprime problem exposed poor underwriting standards in other areas. Investment firms, which carry higher debt/equity ratios, are potentially more vulnerable.

A key factor is how various forms of debts have been linked through "securitization of financial assets," he said.

"Basically the world changed from financial institutions making loans to people and then holding them on their books, to situations where loans were made and put into a pool or bucket, and then bonds were sold against that bucket," DuGan said. "So the ultimate buyer of the loans -- in a different form -- was the person who bought the rated bonds."

Spread around

The pools, which were then sold off as bonds, included two types of loans: commercial mortgage-backed securities (CMBS) and collateralized debt obligations (CDO) from home mortgages and other loans.

One of the drawbacks of pooling loans into securities, DuGan said, is that the investors who ended up the loans had no connection with brokers who originated the loans. At the beginning of the string, many loans were made for the purpose of repackaging and selling them immediately.

All sorts of loans, including such as car loans, credit card loans and student loans, were tossed into the various buckets that the bonds backed, DuGan said, creating the potential for a rapid and widespread credit crunch should any component part of the mix run into trouble.

Result? "Now we read in the paper that the student loan market is being affected by this crisis," DuGan said.

This has undercut confidence in bonds.

"The people who bought these bonds are scared because [what they purchased] … were essentially subprime home loans, and they didn't realize it," he said. "Now they're not sure how these other assets are going to perform."


DuGan cited two examples of venerable Wall Street firms who are more leveraged than they were just a few years ago.

In 2000, Goldman Sachs carried a 6.2 to 1 debt/equity ratio. In 2007, it was 11.2 to 1. Morgan Stanley's debt/equity ratio climbed from 10.6 to 1 to 16.2 to 1 between 2000 and 2007. The firm has $40 billion in equity. It claims $1.2 trillion in assets.

"When you look at a Morgan Stanley financial statement it's very, very difficult to figure out what's on their balance sheet," DuGan said. Morgan Stanley and other financial institutions carry as assets bonds that were part of the securitization process. The combination of uncertainty about the bonds and increased leverage make for a nervous financial house.

Commercial, corporate

Problems in residential real estate credit have spread to commercial real estate credit.

Commercial real state values rose at approximately the same pace as residential real estate from 2000 to 2006, when residential values leveled off. But commercial real estate values kept rising.

At the same time, underwriting standards began to slip. According to Goldman Sachs, 90 percent of the loans backed by commercial mortgage-backed securities in the third quarter of 2006 were interest only.

Fears have grown that CMBS may be the "next subprime mortgage." In January there were no CMBS issues, which, DuGan said, was the first time in years that a whole month went by without one.

Another sign of fear is the high difference, or spread, over Treasuries, that investors are receiving for holding the bonds. An A-rated CMBS went from 91 basis points on Feb. 15, 2007 to 689 basis points in January 2008.

Stock in real estate investment trusts -- REIT -- has fallen off badly as well, and the fear is spreading to corporate bonds.

"People are afraid that even the best companies are going to default on their obligations," DuGan said.

"Even worse," said W. P. Carey finance Professor Anthony Sanders, "the B-rated CMBS have recently topped 1,400 basis points, a sign of the nervousness about the credit-sensitive securities."


"My own take on this -- and this [comes] with a big caveat -- is the fears may be overblown," DuGan said. If there is significant recession, however, then all bets are off, he added.

Evidence that the pendulum may have swung too far is that commercial real estate remains fundamentally solid.

"It's a very different marketplace than the residential marketplace," he said. "And it's driven by very different fundamentals."

He cited a report from Moody's Investors Service which indicated that there does not seem to be an oversupply, unlike in the early 1990s when commercial real estate crashed.

And, commercial borrowers are much more sophisticated than a first-time homebuyer. "This doesn't mean the borrower hasn't taken too much money out or won't default," he said. However, "it's a sophisticated marketplace. They have substantial equity in these properties."

Every loan is made on the basis of cash flow, DuGan said. It some cases the projections are too aggressive, but generally the estimates are realistic, he said.

Demand remains strong. Wachovia, a financial services company, forecasts that the five component parts of commercial building (apartment, industrial, office, retail and hotel) will individually show growth, even as the economy slows. And REITs are producing better than the historical average over the yield from Treasuries, he added.

DuGan believes that investors must "play defensively" going forward. For W. P. Carey & Co., that means looking for long-term leases and a diversified portfolio to ride out any bumps in the road.

Bottom Line:

  • Pain originating in the subprime mortgage market spread quickly to other markets because the loans were lumped together and backed by bonds.
  • Buyers of bonds backed by subprime mortgages didn't realize the nature of the underlying loans, and concern about defaults has spread to other kinds of bonds.
  • Venerable financial houses managed to create high returns through leverage, but that makes them more vulnerable.
  • There are parallels between the commercial real estate and residential real estate markets, but DuGan believes there are also significant differences that make commercial real estate attractive.