I’m often asked “how did you go from being a bank real estate executive to running a successful real estate-based fund that does business in so many states?” One of the chapters in my upcoming book gives you the scoop. Here is that story…
There were construction cranes everywhere! From my office on the eighth floor of the Wachovia Building in downtown Tampa, I had an East-facing view of the Channelside District and the Port of Tampa. Large condo developments were sprouting up as far as the eye could see. The question on my mind was simple, “Who will they find to buy all these units?”
Most of the units were being swallowed up by investors that were plopping down a small down payment as they entered into contracts to buy them. Many investors would simply flip the contract to another investor for a fee and the domino effect was driving up prices. I wondered where the demographics were to support this frenzy. Surely there weren’t that many new jobs in Tampa that would support filling those new condos. If a “local” were to purchase and move into a new unit, they would be leaving behind an empty unit creating a net wash in housing. Those new units had to be filled by new residents in order to avoid a housing glut in the market. That being said, the bank I worked for along with all of the banks were desperately competing to finance the next condo complex.
The year was 2005 and the frenzy didn’t make sense to me. I had spent my entire adult life studying sound loan underwriting principles and walking the tightrope between financing the dreams of credit-worthy customers and protecting the bank from credit risk. What I was witnessing…and a part of…made no financial sense. That’s when the idea for what became Castle Rock first entered my mind. First, let’s set the time machine backward to 1991…my first job out of college.
A walked out of college with a fresh new accounting degree with no intention of being an accountant. Between my junior and senior year of college, I had an internship with General Electric in Bloomington, IL. The people I worked with there were wonderful people, but I had to force myself to stay awake. It turns out that the job I had prepared myself for in college was boring me to tears. My mother had worked for a small-town bank throughout my childhood and I had always looked up to the bank president and loan officers at the bank. People in the community would turn to them as advisors and sages when they needed a car, house, or put a crop in the field. They were the “go-to” people and, when an opportunity opened up in St Louis with a finance company, I jumped at the chance.
There was a steep learning curve. It turns out that I left college knowing everything, but a few weeks later I learned that I knew nothing. They started me off learning the basics of their computer system and then calling customers that were 15-days late on their loan payments. Soon I was taking loan applications and learning all I could about making and managing loan portfolios. We had to collect our own loans, so learning what doesn’t work was the most valuable lessons we took from the experience. Those four-and-a-half years molded me into a strong lender.
When I moved to Indianapolis in 1995, I was way ahead of the curve. I accepted a position as a mortgage originator with a large bank’s sub-prime mortgage division. Over time, I was promoted through the ranks until I headed up a portion of their central processing department called operations support. Getting a behind-the-scenes look at how the sub-prime mortgage industry worked opened my eyes to just how much of a shell game our mortgage system is. Until that time, I had no idea how the real system worked. It didn’t matter whether or not the loan was a good loan for the borrower or even the institution. The mortgage company was going to sell it off to wall street traunches anyway. For the record, a “traunche” is a large pool or loans that wall street entities set up. They gather capital from their investors in a “safe”, mortgage-backed pool of loans. Even if loans default, the conventional wisdom at the time stated that the investor need not worry as real estate was held as the collateral. Of course, many of these traunches were holding loans that were not as strong as advertised, had very high ratios of the loan balances vs the collateral value supposedly protected the loans (sometimes greater than the collateral value), and in many cases the loans in the traunches were put up as collateral to borrow more money to lend out to new borrowers. Those new loans were added to the traunche and those new loans were once again “leveraged” or used as collateral for even more money for new loans. That cycle would repeat itself over and over until you had many layers of leverage to the onion. This made for a house of cards that would eventually come crashing down.
Eventually, I worked my way into traditional banking in Florida working in retail banking, commercial banking, and private banking. It was doing special assets work, however, that I really got to learn how the underbelly of lending worked.
There is a saying in lending “every loan is a good loan when you make it.” That refers to the fact that borrowers’ circumstances change over time. People get sick and lose jobs unexpectedly. No banker can be expected to predict random and extraordinary events. Loans do, from time to time, go bad for uncontrollable reasons. Banks simply need to diversify their loan portfolios so that the law of large numbers comes into play. If a lender follows sound underwriting principles, a certain percentage of loans will go bad…it’s inevitable, but as long as the institution is making many, many loans and not concentrating a large portion of their capital into any one or group of loans, the law of large numbers would dictate that losses would be kept to a manageable and relatively predictable amount. Now…back to “every loan is a good loan when you make it”.
As I started working portfolios of “bad loans”, known as “non-performing” or “non-accrual” loans in industry jargon, it became readily apparent that many of the defaults were not due to an unexpected tragedy, but an easily foreseeable event. In the underwriting comments of many of these loans, there was mention of concerns that were discovered in the due diligence phase that ended up coming true. The pressure to make loans and increase revenue for the lenders was tremendous. Loan officers were under great pressure to make loans…a lot of loans…or face losing their jobs. To achieve this, lenders would often ignore sound underwriting principles in order to make loans that they knew were risky. This was just one reason for the rise in defaults in the late 2000s. If you recall recent articles where employees of large institutions would open bogus bank accounts for customers so they could meet the tremendous goal pressure that they were under. That pressure on employees is real and, when faced with the real possibility of job loss, good people tend to do shady things.
In early May of 2006, I received a Sunday evening call from my boss at Wachovia. When I saw who was calling, I answered the phone “who did we buy this time?” Any call I would get at that time meant that the powers that be were about to make an announcement to Wall Street first thing Monday morning and they wanted all the bank officers on an early morning call to include them in on the announcement. It was pretty routine. The call was not unusual. “I have no idea, but we are supposed to be on a call at 8am tomorrow.” The next morning a bit prior to 8am I was sitting at my desk on the eighth floor of the Wachovia building in downtown Tampa looking at all of the new condos going up in the Channelside district while I listened to the normal rah-rah fanfare that always proceeded these conference call announcements…and then the bomb dropped. “We are so happy to announce that we have entered into a deal to merge with Golden West Financial to make us one of the largest originators of mortgages in the country.” I was stunned.
Golden West was the parent of World Savings, a lender with $122 Billion…yes billion…in “Option ARMs”. To the average person in 2006, what I am about to tell you would seem like a good thing, but now that you as a reader have the luxury of living through the ensuing crash, you might say to yourself “what a dumb thing to do.” World Saving’s option ARM product, called “Pick-a-Pay,” was a loan that was created to provide borrowers with options as to how to make payments. It was an adjustable-rate product with would allow for a lower initial rate so that the borrower could afford to buy a larger home for their money. Each month they would receive a statement with four options as to how to pay it. They could make a payment as if it were a 30-loan, a 15-year loan, an interest only loan, and…the doozy…they could pay only a portion of the interest and tack the remainder of the interest onto the loan balance. This way, they could afford even more of a home for their money. Sure, the loan balance would go up, or “negatively amortize”, but don’t worry, real estate always goes up! We’ll revisit this concept when we discuss Asset Classes later in this book.
I was floored. To me, the Pick-a-Pay product was one of the most ill-conceived products ever to be offered to consumers. We would make fun of the product all the time in my unit and it was actually written into Wachovia’s underwriting guidelines at the time that we could not make a second mortgage loan behind a World Savings mortgage. Here we were buying them now. You must understand that many of the people that run banks at the top of the house have absolutely no retail lending background. They got their undergraduate degree from a highly regarded school, their MBA at this other highly regarded school, and then daddy new someone a bank that could get them into the management training program. There are, of course, a few exceptions and I am not indicting them as people, but the truth is that many of the people at the top of the house have not knocked on doors and collected on loans. For crying out loud, the guy that ran Bank One’s Sub-Prime division was a smart, wonderful man, but he came from Procter and Gamble! Just because someone runs a bank doesn’t mean they know what they hell the are talking about. I had met the people that ran Wachovia on several occasions and they were wonderful, well-meaning, smart, and gifted people, but for the most part they were never day-to-day consumer bankers. The people that ran World Savings new exactly what they had in the portfolio and they saw the suckers at Wachovia as a way to cash out before the crash. Wachovia took the bait.
After the conference call was over, I sat at my desk stunned for about 5 minutes. I knew that this was the end of Wachovia. It was inevitable that those $122 billion worth of loans would blow up as the market began to correct. I picked up the phone, dialed my wife, and said those words that I will never forget…”It’s time to get out right now.”
Over the next few weeks, I worked as normal at my day job while planning my exit. I wrote the business plan that later would become Castle Rock. We would gather private capital and, as the crash occurred, I would use my connections and influence at banks throughout the country to purchase their non-performing loans at a discount from the value of their underlying collateral. We would either get them to start paying again or get the property back through a foreclosure action or a deed in lieu of foreclosure.
Banking is an incestuous business. Banks are always cannibalizing talent from one another and bankers spread throughout the country like dandelion seeds in the wind. The guy that once sat in the next office was now the president of XYZ Bank. The woman that was in the office down the hall was now the chief credit officer of ABC Bank. Hardly a day went buy where I didn’t receive 5 or 6 calls from real estate investors with no clue of what they were doing who going to “make my dreams come true” by buying my bank’s bad debt for 30 cents on the dollar. The calls were constant and annoying, but I had an advantage. Rather than make the same call that they did, I could pick up the phone, call my friends and old co-workers in high positions at banks across the country and say “dude, let’s grab a beer.” Thus, Castle Rock was born. It was now time to take on the world and build an empire.