Behind Lehman's Faith in Real-Estate Riches By Anton Troianovski Wall Street Journal 03-24-2010

Behind Lehman's Faith in Real-Estate Riches
Bankruptcy Report Finds Property Group's Chief Focused on Reward as Firm Ignored Risk Control
By Anton Troianovski
The Wall Street Journal
March 24, 2010

On May 7, 2007, Lehman Brothers Holdings Inc.'s real-estate chief sent a memo to the bank's executive committee on the ill-fated deal to acquire apartment developer Archstone-Smith Trust. The possible profit, according to the memo: $1.3 billion over 10 years.

But what Lehman Brothers neglected to analyze was just how much risk it was taking on, according to the bankruptcy-court-appointed examiner's report on Lehman Brothers released earlier this month. The firm didn't conduct "stress tests" to see how the $22.2 billion deal would affect its commercial real-estate exposure, according to the report.

The Archstone deal, of course, turned out to be a disaster and contributed to the collapse of Lehman in the fall of 2008—a failure that was widely seen as the spark that set off a global financial meltdown.

The report by the bankruptcy examiner, Anton Valukas, sheds new light on Archstone and Lehman Brothers' other blockbuster real-estate deals and the Wall Street era that made them possible.

The Real-Estate Chief
At the same time, the report offers a portrait of Mark Walsh, the head of Lehman's Global Real Estate Group, who masterminded some of Lehman's most troubled deals as superiors pushed his group to take on more risk. Investors and other observers have cited Lehman Brothers' big bet on commercial real estate as a primary culprit in the firm's collapse.

Mr. Valukas's report instead focuses its biggest criticism on an accounting mechanism that helped Lehman appear to have less debt on its books. The report doesn't tie Mr. Walsh to that mechanism, known inside the Wall Street bank as "Repo 105."

The report says that Lehman Brothers overvalued its Archstone position on its books throughout 2008 and that some involved in the valuation process felt pressure from senior management not to take some markdowns. But it says Lehman Brothers' senior management never overruled any of the real-estate group's proposed valuations.

Senior management also never "predetermined the amount of write-downs that would be taken for a quarter or limited the amount of write-downs [the group] was permitted to take," the report states.

Mr. Walsh, who declined comment, is now looking to pick up the pieces of Lehman Brothers' real-estate bust. He is part of a group of former Lehman Brothers colleagues who have set up a business to take over the bank's real-estate private-equity arm. The buyers are reducing some management fees, but the funds' investors agreed to "reset" some incentive fees for the managers, giving them payouts if asset values rise above their current distressed levels.

"After a yearlong exhaustive inquiry that involved over 250 interviews with different individuals and the review of over 4.7 million documents, the Examiner did not identify any wrongful or improper conduct by Mark Walsh," a spokesman for Mr. Walsh said in a statement. "Indeed, the report contains no suggestion that Mark ever intended to act other than in the best interests of Lehman, its shareholders, and his investors."

The report says Mr. Walsh was "the driving force" behind the 2007 buyout of Archstone, a deal that left Lehman Brothers with $5.4 billion in hard-to-sell exposure to the real-estate market.

Mr. Walsh planned to sell off much of Lehman's position to other investors, but some that had expressed interest—including hedge fund D.E. Shaw & Co. and the Abu Dhabi Investment Authority—balked as the real-estate market worsened, the report says. D.E. Shaw declined to comment and an ADIA spokesman couldn't be reached.

The deal came at a time when Lehman Brothers executives urged Mr. Walsh and his team to double the amount of commercial real-estate risk they took on, according to emails and interviews cited in the report by Mr. Valukas. Lehman Brothers boosted its risk limits for real estate in 2007, before doing away with those limits entirely, Mr. Valukas found.

'Management Believed'
"Mark A. Walsh … was one of the most successful and trusted operators at the firm," Mr. Valukas wrote. "Management believed that Walsh could invest Lehman's capital wisely and could distribute any excess risk to other investors."

Lehman risk managers interviewed by Mr. Valukas said they had "minimal input" in the decision to go ahead with the Archstone deal. An analysis of Lehman's commercial real-estate business by the Office of Thrift Supervision found "major failings in the risk-management process."

Behind the scenes, Mr. Valukas says, some senior Lehman executives worried that Mr. Walsh's group was actually being too aggressive in its write-downs.

The reason, one person told Mr. Valukas, was that Mr. Walsh and his colleagues already knew they wouldn't get bonuses in 2008 and "might be incented to mark down assets more than indicated in 2008 to set the stage to show greater profits in 2009 when bonuses presumably would be reinstated."