David Stockman: Extended Stay And The Wall Street Meth Labs

Budget Director under President Reagan and partner at private-equity firm Blackstone Group, David Stockman skewers the Fed-induced LBO of Extended Stay America that amounted to a scam. This is the second installment of the Extended Stay debacle, from Chapter 26 of his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.

The details of the capital structure were daunting, the purpose crystal clear

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 lowestrate 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.”

By the time of the Wall Street meltdown it was all over but the shouting, and Extended Stay America did file for bankruptcy in June 2009. What the latter process revealed was the true essence of bubble finance. A court-ordered appraisal showed that the hotel company assets were worth just $2.8 billion, or only 35 percent of the $8 billion purchase price.

What this finding meant was that Extended Stay America was not worth even the $4.1 billion of secured mortgage debt which had financed the deal. The entire $3.3 billion in the mezzanine tranches was purely bottled air, and yet it was the latter which had financed Blackstone’s famous $2.1 billion payday on the eve of its IPO. By David Stockman, author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.

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