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The Economic Front Lines: Lessons for Philadelphia’s Business Lawyers Facing an Economy of Change

Stephen Foxman, Esq. on 1/8/2009

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As we conclude 2008 and look forward to 2009, the unstable and declining economy will undoubtedly impact many lawyers and law firms.

During my legal career over the last thirty-five plus years, I have seen these economic shifts before. When I started in private practice in 1972, the securities market was hot, and business for lawyers was booming. I jumped on the bandwagon and became a securities and corporate lawyer. This practice went south after the oil shock of 1973, which greatly impacted the economy and brought public offerings practically to a stop in 1974. Interest rates jumped in this period because of anticipated inflation. I had the opportunity to begin a real estate practice representing a Real Estate Investment Trust (REIT), and many of my clients became involved in litigation arising out of the financial distress. I then added litigation to my areas of practice, because securities work was practically dead, and there was not enough transactional work available to fill the vacuum.

The economy recovered slowly in the late 1970’s, only to have another crisis develop at the end of 1979, with interest rates approaching 20% in early 1980. My telephone stopped ringing in December 1979 and I used this opportunity to go back to my original home, Cleveland, and visit my family there for several weeks because I had nothing else to do.

Then came the go-go 1980’s. Merger and acquisition activity increased, and many creative (and beyond “creative”) tax deals were done to take advantage of the desire of high income individuals to shelter income with highly leveraged aggressive tax shelters. The demand by syndicators for real estate “product” led to apartment buildings, office buildings, shopping centers, etc., becoming greatly overpriced. I had the opportunity to expand my commercial real estate practice, and I represented real estate syndication clients. Guys like Michael Milken and Ivan Boesky were making tons of money on Wall Street, and it looked like this gravy train would never end … until it did with a great “thud” in 1987 after the passage of the new tax code, which killed most aggressive tax shelter structures.

Many of these shelter deals were built on anticipated ever-rising real estate values. Once the tax shelter demand for real estate product ended, these very high property values collapsed. Because financial institutions had cashed in on this boom by financing over-valued properties and unneeded new construction, many of these institutions failed when the bottom fell out of the real estate market. Not to be left behind, I developed a new work-out practice representing borrowers and guarantors negotiating with financial institutions, the Resolution Trust Corporation, and wastepaper buyers (entities that purchased loan portfolios from defunct financial institutions and the government).

The line I remember from the late 80’s was “stay alive until 95”, supporting the belief of real estate professionals that prices would rebound, and the real estate market would come back to life by 1995. And, to a significant extent it did.

Next came the Internet boom in the late 1990’s. Hottest thing since they built the railroads in the late 1800’s! Having been a computer hobbyist since the early 1970’s, I again retooled and became a computer software and Internet lawyer. You know what comes next. After rising like a skyrocket in 1999 and 2000, the Internet boom burst in early 2001, the stock market crashed, and many Internet millionaires lost their fortunes.

After 2002 the economy again recovered. The word on the street was that millions of baby boomers were putting away money for retirement, and these funds were fueling a massive investment boom. With all that money chasing a limited number of investments, how could investments, including real estate, not keep going up? The government also continued to promote homeownership, and mortgages became available on amazingly favorable terms – if you could breathe and had an income (or if you could create the impression that you had an income), you were financeable. Money again poured into residential and commercial real estate, based on cheap and readily available financing.

So, here we go again. The financial world discovers (again) that real estate values cannot rise at a 10% per annum rate forever, and that every boom has its bust. (I don’t have to retool this time; it is déjà vu all over again.)

Unfortunately, this bust looks bad. Globalization has led to the world’s economies being more closely intertwined, and a loss of trust among the world’s largest financial institutions has created a massive drop in credit availability. This lack of credit has brought most new business development and expansion to a stop, leading to a drop in employment, and the ripple effect of this drop in employment on retail businesses. With unemployment rising, and consumer credit becoming tight or unavailable, consumers have lost confidence and are buying less. This has led to business failures and further layoffs. This ratchet is likely to continue to push the economy downward until we get to the floor – that level of employment and economic activity necessary to sustain the basic infrastructure and services necessary for the functioning of our economy (food, shelter, healthcare, government services, etc.) Government stimulus may prevent the economy from actually hitting that floor (we hope).

As lawyers, we are always needed when there is disruptive change. Litigation and disputes may rise, and bankruptcy and insolvency practice should rebound. However, lawyers who depend on transactional work are likely to see a substantial drop in business. Many younger lawyers may face layoffs, or even declining pay scales. Clients will be looking for ways to avoid additional legal costs, or to cut costs. Collections likely will become more difficult.

We can hope that the massive infusion of capital into the financial system by the government may provide a soft landing for our economy, but this is far from assured. The new Obama administration and the brain trust he assembles will have many challenges in dealing with this crisis. My view is that the economy will rebound, as it always has, but that we do need to follow some better practices to allow our economy to recover quickly, and to be better insulated against such a rapid decline in the future.

First, financial institutions should know more about the assets that collateralize debt obligations. Banks and other financial institutions have invested in assets without really knowing the value of those assets. While the documentation may be valid and legally enforceable, this is of little import if the underlying assets are of unknown value. This applies to both real estate that collateralizes mortgages, and to the fundamental financial soundness of entities that write insurance contracts backing financial instruments.

Second, the financial markets must develop better mechanisms to price and manage risk. To some extent, this is ancillary to the first point – if we do not really know the value of the asset behind an instrument, the risk attached to that instrument must be much higher than the risk taken in connection with an instrument backed by an asset that we understand and can value. Where the risk is high, the price should be high for an institution to accept such a risk, or the asset should not get financing. A bank should not be making a home equity junior mortgage loan where there is little assurance that the underlying real estate would bring enough in a distress sale to pay off the loan balance. Also, we do not want to encourage the future creation of high rate predatory loans to unsophisticated borrowers who do not have the financial ability to repay the loans.

Third, the government must be cautious in supporting entities that did not manage their risks well, and it should not undermine existing contractual obligations. This raises the law of unintended consequences. Whatever good you think you are doing, there will be consequences that you never anticipated, and that will undermine your supposed good deeds. If entities believe that there is always a government willing to print money to get them out of trouble, by bailing out failing businesses, buying toxic mortgages or providing unlimited guarantees of financial instruments, then there is little incentive to avoid or minimize risk. This may lead to entities making poor business judgments regarding risks, or investing in more bad investments. If the government, in its politically understandable desire to protect homeowners, changes the enforceability and sanctity of mortgage notes, this could lead to mortgage lenders being less willing to make home loans because of concerns regarding the lenders’ ability to enforce these loans as written, and investors being less willing to invest in securitized mortgage instruments, thereby drying up capital to support mortgage lending.

Obviously, there is a balancing act here – we need creative answers to help homeowners stay in their homes. Philadelphia’s successful residential mortgage foreclosure diversion program, developed with input from our local Courts, the Bar Association, the Volunteers for the Indigent Program, and lender and borrower attorneys, supports homeowners by providing an opportunity for lenders and borrowers to agree on restructured loan terms without the government imposing terms on the parties.

Fourth, we need government to work with lending and other financial institutions to develop a financial system that provides adequate credit for economic growth, without creating inappropriate incentives to make risky investments. Although some blame “greed” and excessive executive compensation for the current financial meltdown, I think that the true culprit is the system that provided incentives to make unsound loans. These incentives encouraged all the participants to make bad judgments – the original borrower, the mortgage and real estate brokers facilitating the real estate sale process, the appraisers, the originating lenders, the governmental entities insuring or providing a market for securitized packages of loans, and the entities that tried to create and use derivative instruments to supposedly insure the value of these packaged loans.

Finally, I believe we need to simplify and streamline our financial regulatory structure. We now have multiple regulatory agencies that have overlapping authority regarding our financial institutions. The regulations are extensive, difficult to interpret and apply, and beyond the understanding of most lay people and lawyers. We need a system that will encourage the delivery of more extensive and accurate information about the asset value backing financial instruments, and better control of the quality of assets that are permitted to back securitized instruments.

I hope that we all will find ways to cope with the difficult financial and economic circumstances each of us (and for some of us, our firms) may face over the next year. I believe that our services and skills are greatly needed to help shape the new regulatory structure that will emerge, and to assist our clients in dealing with this new structure and to survive the economic challenges that we and our country face.

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