Leverage + Volatility = ..........

The Extended Stay hotel chain, whose real estate empire was valued around $13,000,000,000 at its peak, has filed for Chapter 11 bankruptcy protection.

The hotel chain is now valued around $3,000,000,000. This figure represents barely 41% of the $8,000,000,0000 buyout price in 2007. The amount of the first mortgage is $4,100,000,000 (OUCH!!!).

This bankruptcy filing is a microcosm of what I talked about in my post "Where Did My Value Go".

The buyout group saddled Extended Stay with $7,400,000,000 in debt (that represents about 93% leverage). When the investors and banks underwrote the deal, Extended Stay was generating $545 million a year in earnings. The banks and investors based their underwriting assumptions on an annual earnings of $625 million. So much for Warren Buffett's idea of underwriting deals with a Margin of Safety.

From the WSJ article:

"Such optimistic assumptions were the norm in commercial real-estate during the bubble leading up to the current recession. Cheap debt was available because banks could easily sell it as commercial mortgage-backed securities, or CMBS, to investors chasing yields."

Let us not ever again forget the formula Oaktree Capital's Howard Marks gave us for leverage:

Leverage + Volatility = Dynamite