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The Virtue in Losing a Deal

This article illustrates key lessons from the financial crisis using a recent exercise in Real Property (EC course).

Over the past 14 months, we have had plentiful opportunities to study the financial crisis from afar. We have read cases dealing with the financial crisis and listened to a plethora of speakers provide their perspectives on the events that inflicted untold damage on our capital markets and broader economy.

Those of us in Professor Arthur Segel’s Real Property class, however, recently had the opportunity to experience-and even to reenact-some of the behaviors that indirectly contributed to the financial crisis. The exercise was a real estate purchase/sale negotiation simulation.

Our class was divided into groups of buyers, sellers and lenders. Each team was tasked with evaluating two different real estate assets and negotiating the purchase, sale and financing of these assets. Ultimately, each team could elect to either do a transaction or not do a transaction. In order to stoke our competitive juices, the exercise was graded.

Not surprisingly, the competitive fervor and compulsive need to be productive-both common traits among our HBS contingent-were obvious factors throughout this exercise. Teams of buyers and lenders may have begun the exercise intending to be prudent stewards of capital and to offer only stringent financial terms to sellers.

However, as the process unfolded and teams of buyers and lenders began to fear either “losing” the property to a competing bidder or, worse, the prospect of having done considerable analysis and negotiation with nothing to show for it, financial terms quickly became more generous. Proposed valuations of the real estate assets increased, leverage amounts increased (even at the higher valuations), and interest rates and lending fees decreased.

Before long, most deals proposed by buyers and lenders provided such little cushion that virtually any future real estate downturn in this negotiation simulation would have eliminated the buyers’ equity investment and severely impaired the value of the lenders’ investment. The buyers and lenders that “won” the deals in many cases actually became losers.

Fortunately, this was only a simulation, so no real damage was done. However, as this process unfolded, several of us in the class could not help but draw a parallel between the actions of the investors of capital in our simulation and the actions of real-life investors in the years leading up to the financial crisis. Proposed financial terms of various transactions-including mortgage originations and mortgage-backed security investments-became overly generous and imprudent. More introspective investors may well have felt concern about the direction of the world, but the pressure to keep up with competing investors made it too personally risky for the thoughtful investor to remain above the fray. After all, at year’s end, how would the investor justify his or her existence to the boss, who would want to know how the investor could have possibly worked hard all year and yet not “won” any transactions?

As John Maynard Keynes might have said, “The market can stay irrational longer than you can stay in your job.”

Before we knew it, virtually all investors-prudent and imprudent alike-became participants in the asset price and leverage bubbles that ultimately created havoc in our world.

Many of us entering finance-related careers after leaving HBS will likely face these similar dilemmas in the future. We may well be stuck in situations in which we identify that we are engaging in potentially reckless economic activity solely to keep pace with our peers, but feel as though refusing to join the crowd would result in negative real life consequences-less money, and maybe even the loss of a job.

It would be na’ve to suggest that there are easy answers to these dilemmas. In fact, there usually are no easy answers. The only victory that HBS students can win at this time is to leave HBS mindful of the temptations that we may face and to resolve that-without falling on our professional swords in a Pollyannaish way-we will do what is reasonable to avoid hazardous deals that may well enrich our standing in the near-term but damage our future firms and the capital markets in the long-term. The world does not necessarily need more people who are hell-bent on changing it. But the world of finance would surely benefit if the next crop of HBS graduates did what it could to embody a culture of discipline and long-term orientation.

What do we do? Strike the right balance between not committing professional suicide but also not following the herd. Try to commit to standing for a culture of prudence, discipline and long-range thinking in finance.

AUTHOR’S BIOGRAPHY
Tim Larsen was born and raised in the great state of Iowa. His hobbies include golf, exercise and wearing pastel-colored pants. Tim loves the Iowa Hawkeyes. He is a member of the HBS class of 2010.

December 7, 2009
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