The Great Deformation (100 page)

Yet the tsunami of new rooms that materialized during 2004–2008 was not a manifestation of the free market. As in so many other economic sectors in the aftermath of the dot-com bust, the free market had attempted the opposite; that is, to close down the rampant overbuilding of hotels which had occurred in the late 1990s.

But when the Fed cranked up the flow of cheap credit to a fever pitch during the second Greenspan bubble, the monetary central planners succeeded in levitating another spree of malinvestments in a sector already saturated with excess capacity. The supply of new hotel rooms surged from just 30,000 in 2003 to 100,000 in 2006 and hit 200,000 new rooms during the 2008 peak.

This building boom raised nationwide hotel construction spending from a $10 billion annual rate in 2003 to $40 billion by 2008. Developers scrambled to deliver new hotels to tax-advantaged real estate trusts (hotel REITs) and the CMBS (commercial mortgage backed securities) market. These financial investors, in turn, placed rooms by the thousands in brand franchising and hotel management company deals.

The hotel sector provided a stunning example of the manner in which the Fed's financial repression policies fostered a chain of economic deformations that fed upon one another. Artificial consumer demand financed by MEW (mortgage equity withdrawal) goosed leisure travel and therefore hotel revenues and operating profits. This demand surge, in turn, generated a boom in hotel room construction which was funded by cheap debt and
tax shelter schemes. The resulting boost to industry growth rates and cash flows then elicited a spree of hotel company LBOs, which extracted billions of CEW (corporate equity withdrawal) that was paid out to stock speculators at the 2006–2008 market top. In this manner, proceeds from millions of home ATMs across the land ended up in the bank accounts of the 1 percent.

Blackstone's LBO of Extended Stay America in March 2004 was archetypical. The purchase price was $3.1 billion, of which less than $500 million was funded by sponsor equity. While “revpar” (revenue per available room) for extended stay hotels had been negative in 2002 and 2003 owing to the capacity glut left over from the 1990s bubble, Blackstone caught the second Greenspan wave perfectly. During 2004, the extended stay segment saw revpar gains of 5 percent, and then it was off to the races with double-digit gains in 2005 and 2006.

At the same time, Extended Stay America added new rooms hand over fist owing to the building boom then under way. When Blackstone exited the deal just thirty-nine months later in June 2007 (on the eve of its own IPO), the chain's room count had grown from 50,000 to 76,000 and revpar by nearly 20 percent. More importantly, mania was running at high tide in the hotel financing markets.

Consequently, Blackstone was able to sell its 680-unit hotel chain for $8 billion, resulting in a $2.1 billion gain or 4X its investment. This was a truly astonishing price which amounted to $105,000 per room, yet these were bare-bones, no service hotels which generated only $35 per night of revenue from their extended-stay customers.

The arithmetic thus underscores the lodging market mania. These ultralow priced rooms would have generated only about of $3,500 in annual EBITDA after appropriate CapEx reserves for well-worn decade-old hotel rooms. This meant that the buyer's purchase multiple was 30X sustainable free cash flow.

One of the hallmarks of financial manias is that propositions which are perfectly absurd nevertheless get widely embraced by those caught up in the excitement. In this case, one David Lichtenstein, proprietor of Lightstone Group, had been plying the leveraged real estate business since exactly the time that Alan Greenspan had kicked off the era of bubble finance in October 1987. Thus, Lichtenstein was financially teethed on the notion that the Fed had abolished the downside. This sentiment was vividly evident in his 2004 proclamation: “We don't care what analysts say. We will buy anything.”

As the Fed's financial party reached its roaring crescendo in June 2007, therefore, he was not shy about publicly declaiming his pleasure at being bagged by a truly absurd purchase price. “There seems to be a feeling on Wall Street that because Blackstone is going public, they want to show what
a complete cycle looks like,” Lichtenstein rhapsodized, “and we're the lucky beneficiaries of that.”

Indeed. Everything about what happened at the June 2007 closing subsequently amounts to a brutal demonstration of the great financial deformation wrought by the nation's central bank. By then the leveraged lending market had finally gone berserk. A consortium of Wall Street underwriters led by Wachovia bank and including Bear Stearns, Bank America, Merrill Lynch, and the other usual suspects loaned $7.4 billion to Lightstone, or 92.5 percent of the purchase price.

In point of fact, each of Extended Stay America's guest rooms embodied approximately $35,000 worth of drywall, plywood, cinderblock, rebar, paint, and labor. Now, however, the deranged financial markets were seeing fit to loan the hotel company's new owners three times their replacement cost—about $97,000 per room to be exact.

Indeed, these no-frills hotel rooms resembled an interconnected trailer park under a single roof; the “rooms” were occupied for an average of twenty days per stay by traveling construction workers and temporary nursing home employees. So the question recurs as to why an investor would mortgage such units at three times their replacement cost.

David Lichtenstein, however, had a ready answer: “I don't know much about the hotel business, but the price was right … I also liked the fact that it was a simple business … there is no food and beverage, no conventions, no bar mitzvahs. And it only takes one employee for every ten rooms to run these properties.”

The ordinary laws of the free market, of course, suggest that if something doesn't cost much to produce, then it isn't worth very much, either. Yet that very truism goes to the heart of the higher order of deformation that was now at work in the mega-LBO market. Operating at the very top of the leveraged buyout pyramid, punters like David Lichtenstein were simply buying call options on the upside of these debt-ridden enterprises for comparatively meager amounts.

Thus, it turns out that underneath the $7.4 billion of debt in the Lightstone deal, the sliver of purported equity was not all it was cracked up to be; that is, it was mostly borrowed money, too. Blackstone itself provided $200 million of “rollover” equity. Consequently, the Lightstone Group had become the controlling shareholder based on a mere $200 million “equity” investment. However, the high rollers at Citibank who were advising Lichtenstein on the deal were apparently of the view that a banker should never say never when it comes to scalping a fee from a customer. Therefore, in return for a $6 million deal fee, they loaned Lichtenstein and his colleagues $120 million so they could fund their $200 million equity commitment.

In short, the Lightstone Group controlled an $8 billion financial edifice based on a cash investment of $80 million; all the rest was borrowed and stuffed into one tier or another of the LBO's rickety capital structure. Moreover, there can be no doubt that Lichtenstein viewed his 1 percent stake as a pure roll of the dice. After the deal cratered, he answered a deposition question about his $200 million “equity” investment by pinning the tail squarely on his bankers: “Like the banks just said blow the damn stuff out … we don't care … just sell the [equity] paper as fast as you can. Citibank just said pay us as many fees as you can … and I said I am getting 95%, 99% financing … Okay.”

There can also be little doubt as to why Citigroup had been so cavalier in advising its client. It happened that the great financial “supermarket” that Sandy Weill built was doing a little internal “cross-selling.” It had been selected to co-lead Blackstone's IPO and thereby obtain a generous helping of the $170 million fee pot that would soon be whacked up among the underwriters. At the same time, its M&A department had snagged Lichtenstein as a buy-side client.

The “synergy” was lost on no one: one arm of the bank found the “mullet” and the other side grabbed the fees. Moreover, Blackstone's exit from its Extended Stay America deal had been a hurry-up affair because it provided a perfect example of its investment prowess that could be showcased in its own IPO road show. Accordingly, its selling memorandum for Extended Stay America issued in February 2007 came complete with what was known in the trade as a “stapled financing.”

Specifically, potential buyers were told that a $7 billion debt package had already been arranged through Wachovia and Bear Stearns. In order to complete their bids, therefore, prospective buyers only needed to stand up on their tippy toes and place a modest slice of “equity” on top of the tower of prepackaged debt.

Blackstone's “stapled financing” was surely a sign of the mania. This arrangement also explains why Citibank told Lichtenstein to ignore an independent appraisal he had commissioned which suggested that the company was worth only $5 billion. As far as Citibank was apparently concerned, Lichtenstein was their “mark,” not their client, and his job was to get the deal closed fast, not to worry about a mere $3 billion potential overvaluation. As it happened, Lightstone Group signed this massive $8 billion deal on April 12, just fifty-five days after it had received the offering memo. At the other end, the deal closed in early June just five days before Citigroup launched the Blackstone IPO road show. Accordingly, in June 2007 Senator Carter Glass of Virginia was justly rolling in his grave.

LIGHTSTONE'S HORRID STAY AT EXTENDED STAY

When Wachovia and the rest of its syndicate funded the $7.4 billion debt portion of the transaction on a bridge loan basis, they had an analysis from Standard & Poor's which said the company was only worth $4.8 billion. So on the eve of the “fee fest” occasioned by Blackstone's IPO, the Wall Street banks wrote a bridge loan for 150 percent of what even their hirelings at the rating agencies believed Extended Stay America was actually worth.

As indicated, Extended Stay's assets were essentially drywall motel rooms painted in three colors. The reason presumably adult bankers believed such flimsy assets could be leveraged at 150 percent of their ostensible value was that they were in the business of hiding the pea.

Thus, the senior portion of the financing consisted of $4.1 billion of mortgage loans that were dumped into a structured finance pool, or “conduit,” known as a commercial mortgage-backed security (CMBS). Then this huge pool of debt was sliced into eighteen different tranches. Six of these tranches were given the highest AAA rating, meaning that the $2.6 billion of mortgage-backed securities issued from this tranche had first call on the cash from interest and principle payments coming into the pool. Below that there were many more tranches, each with a lower claim on the mortgage pool's cash, and therefore a greater risk of loss.

And that was the simple part! The CMBS debt had a direct lien on the hotels in the operating subsidiaries, but there were many more layers—$3.3 billion worth—which did not own anything except the stock of subsidiaries which had already hocked all of their hard assets. This so-called mezzanine or subordinated debt was also sliced into a dozen different layers, and each was subject to mind-boggling complexities with respect to access to cash flow from the hotels.

The details of this capital structure were daunting, but the purpose was crystal clear; it was designed to turn a sow's ear into a silk purse. During boom times these subordinated tranches were saleable to high-yield mutual funds and credit-oriented hedge funds because they were designed to satisfy the hunger for “yield” which had been induced by the Fed's interest rate repression policies. In truth, however, these junk securities were vastly overvalued relative to their embedded risks. So when the US economy weakened and hotel revpar began to head south in 2008 the subordinated tranches plummeted in value.

The sudden, drastic repricing of these subordinated debt tranches, which had been replicated by Wall Street in thousands of so-called “structured finance” deals, was the proximate cause of the September 2008 meltdown. This is powerfully illustrated by the fate of the $7.4 billion Extended
Stay financing, much of which remained stuffed in the Wall Street meth labs until the very end.

Thus, Wachovia still held $1.5 billion of the Extended Stay financing, while Bank America had retained $1.4 billion and Bear Stearns $1.1 billion. But underneath the surface the picture was even worse. Each of the three underwriters of this deal would soon join the ranks of the departed, and one of the reasons was that they had disproportionately retained the bottom-dwelling sludge from their structured finance labs.

In this case, Wachovia's retention included about $1 billion of the lowest-rate mezzanine tranches, and the other two underwriters each had close to $1 billion of this sludge as well. Overall, the three underwriters had retained nearly 85 percent of the $3.3 billion of mezzanine debt issued to fund the Extended Stay deal; it was worth virtually nothing and had proved unsalable even after Cramer issued the “all clear.”

Moreover, when the army of nomad workers who occupied the Extended Stay rooms twenty days at a crack were demobilized by the faltering economy in 2008, revpar plummeted by 25 percent. Soon EBITDA was falling drastically below plan, even as it became evident that Blackstone had bagged Lichtenstein with tired and under-maintained hotel rooms that needed far more capital expenditure than provided for in the selling memo that had accompanied the “stapled financing.”

Indeed, with debt at nearly $100,000 per room an honest free market interest rate would have required more than $10,000 per room in debt service, or three times the available free cash flow. The Extended Stay deal was thus not even a zombie; it was dead in the water the moment Blackstone's pitiful posse of underwriters trotted out their “stapled financing.”