The 2008 recession left behind a trail of breadcrumbs along with its trail of carnage, well worth remembering in the midst of the 2020 pandemic. Richard Georgi, no stranger to the devastation of recession, chronicled his experiences following the collapse of Lehman Brothers and the lessons learned in hopes that a new generation in the real estate industry may learn from his difficult lessons.
Mr. Georgi led an Alpine Grove Partner’s investment fund to take a curious and fairly atypical minority stake in a €400 billion German mortgage bank in 2008. After investing €500 million in the bank’s public equity, Alpine owned just under 25% of the bank. The now well-documented recession had severe effects here in the United States, and shockwaves found their way deep into the global economy. As we now know, Germany was not immune from this crisis and pfandbriefe ultimately became a primary reason for significant losses of Alpine Grove investor capital.
“Pfandbriefe are a type of covered bonds issued by the German mortgage banks that are collateralized by long-term assets. These types of bonds represent the largest segment of the German private debt market and are considered to be the safest debt instruments in the private market.” – Investopedia
For all intents and purposes, a pfandbrief is similar to the mortgage-backed security that shuttered the U.S. economy due to a rapid decline in value of the underlying assets—real estate mortgages—which at that time were highly overvalued, particularly in the United States. However, in Germany and much of Europe the underlying mortgage values did not appear to be so highly overpriced, relative to those seen in the United States. As a result, the pfandbriefe were evaluated and underwritten as considerably safe investments. These “covered bonds” remained on the balance sheet of the lending institution, meaning that the bond holder would continue to receive cash flows even in the event that the underlying mortgages began to underperform—which they did. Another reason to consider these securities were investment grade was that the lending institutions issuing pfandbriefe also had the ability to replace prepaid and defaulted mortgages with performing loans to ensure seamless cash flows. . Finally, this system had not defaulted in over 200 years, so many investors gave little consideration to their risks.
Mr. Georgi likens the life of this investment to Ernst Shackleton’s journey to traverse Antarctica in 1914. In fact, he presents the story through the parable of Shackleton’s decidedly impossible adventure. So, the story goes, Shackleton led his crew deep into the Weddell Sea through never-ending ice, which eventually consumed the ship, forcing Shackleton and his men to survive atop the ice flows for over sixteen months. In Georgi’s case, the total collapse of the pfandbriefe and subsequent failure of the bank—his investment—was a consequence from greater macroeconomic forces that took reckoning in a way not unlike the crushing Antarctic ice flows of the parable. At some point, Shackleton took a handful of his men onward towards Georgia Island, where a whaling station could provide supplies. He left behind twenty-two crewmen to await his return. Shackleton reached the whaling station only to set out again just three days later. He was intent on recovering his crew despite the unending despair which would have made submission to hopelessness perfectly justifiable.
Despite Mr. Georgi’s perseverance, his investment eventually collapsed, and the German government expropriated the bank, offering only 6% of the original value as a return to the Alpine Grove’s fund. This catastrophe left Mr. Georgi and his investors stranded during what had quickly became a global financial meltdown. Mr. Georgi, now finding himself at the proverbial whaling station on Georgia Island, decided to return once again to his investors in order to rescue them from the drift. Like Shackleton, Mr. Georgi did, in fact, rescue his crew. He waived all management fees associated with existing investments and sought to invest the $600 million of previously committed capital that had yet to be tapped. Excluding the loss of the bank, the initial investments that were still being held had once been written down to approximately 56% of the cost value. Mr. Georgi tirelessly worked to recover the losses and, eventually closed out this fund—ultimately achieving a modest but positive 1.1x equity multiple.
During his discussion, Mr. Georgi called for students to provide their personal insights on various aspects of the case. In his persistent character, Mr. Georgi asked what the Baker students felt some of the key takeaways were. One student volunteered that “honesty, sacredness of fiduciary responsibility, and unselfish performance” were the important lessons. Mr. Georgi quickly accepted but added the brash truth that “performance trumps everything”. To support this, he brought up the notion of a “circle of confidence”—a phase that had been referenced multiple times earlier in the discussion. He explained that this “circle” is the area in which an investor is an expert. The “circle” may broaden and shift over time, but the investor’s knowledge and ability to make informed decisions about that investments is ever diminishing as he toes the edge of that circle. Managing the balance of one’s ambition against self-discipline is a lifelong pursuit. As the Shackleton metaphor suggests, there are, perhaps, more prudent ways to traverse Antarctica.