'Les Miserables,' or the state of the CMBS servicing industry. (Servicing).
CMBS bonds continue to demonstrate tremendous liquidity and superior performance among fixed-income investments. However, the CMBS business is supported by a shaky foundation. Future growth is dependent on servicers' ability to continue to expand their operations and invest capital in servicing rights and advances. Borrowers and investors are expressing their dissatisfaction with servicers, and the current economics don't support improvements in the quality of service.
The third-party commercial loan servicing business got started in 1990 to support the Resolution Trust Corporation's (RTC's) securitization of multifamily and commercial loans aggregated from failed thrifts. Fees were initially around 15 basis points, and the servicer was entitled to significant fees and float from the collection account and escrows. Investor reporting was minimal, and no advancing was required. Servicers had substantial operational responsibilities, but no capital at risk.
Servicing was critical to the CMBS industry's evolution from government sponsorship to private-label transactions. Servicing advances were essential to facilitate the structuring of rated bonds from illiquid mortgages secured by income-producing real estate. Additionally, to create liquidity and support investment in the unrated bonds, investor-reporting demands grew exponentially. Servicing fees, float and ancillary income provided sufficient profit to allow servicers to invest in personnel and technology platforms to build the infrastructure to support the burgeoning business.
As the CMBS industry evolved, competition expanded and servicing fees were compressed. The servicer of a CMBS transaction has significant operational responsibilities over a long time period, typically 10 years or more. Fees are fixed, and decline as the principal balances amortize and loans mature and pay off. A significant portion of the servicer's compensation is the interest earnings off float, which is a function of short-term reinvestment rates.
There is a lot of clamor from otherwise knowledgeable investors about CMBS servicing fees being too low. In fact, the problem is not that servicing fees are inadequate, but that the compensation is so valuable that servicers are paying too much to purchase the servicing rights. Sometime around 1996, issuers recognized that, similar to residential mortgage servicing rights (MSRs), CMBS servicing rights were valuable and servicers would pay to acquire them.
Initially, CMBS servicing rights were sold on a basis to yield significant returns. The market drew a wide variety of active bidders. However, over time competition drove servicers to pay increasing amounts to acquire CMBS servicing rights.
The value of float earnings has decreased dramatically as short-term interest rates have fallen by 500 basis points, but the bids for servicing rights have not decreased commensurately. The price for CMBS servicing rights has effectively risen by 25 percent to 40 percent, and very few competitive bidders remain.
The sale of CMBS servicing rights represents a major component of the profit generated from the origination and securitization of commercial mortgages. Issuers generate profits in fixed-rate securitizations primarily through the sale of interest-only (I/O) strips and servicing rights. Both are created from the same source--the difference between the mortgage and CMBS bond coupons. The larger the servicing strip, the less I/O the issuer has available to sell.
The servicing rights to a typical $1 billion conduit transaction may sell for 50 to 75 basis points or $5 million to $7.5 million. The sale of servicing rights represents as much as half of the CMBS issuer's profit.
The largest CMBS servicers have hundreds of millions of dollars invested in servicing rights. Additionally, servicers have outstanding servicing advances for delinquent debt service and property protection expenses that total hundreds of millions of dollars. The business has become very capitalintensive. With a low cost of capital and significant corporate leverage, banks have a long-term advantage in the CMBS servicing business.
In the current environment, it's not hard to understand why the commercial loan servicing business is consolidating. Scale and cost of capital drive the cost of a CMBS servicing operation. The largest servicers have portfolios with more than $200 billion in outstanding balances.
In 1997, the five largest servicers had a 38 percent market share; in 2002, it increased to more than 50 percent. Two of the five largest servicers are currently for sale. Of the eight original RTC CMBS servicers in 1991, only two are currently in the servicing business.
Are we headed for a catastrophe? The concentration of CMBS servicing rights among very few companies is a concern. Additionally, there are inherent conflicts associated with investing millions of dollars to provide a service for a fixed fee over a long time period.
The viability of the CMBS servicing business is receiving significant attention by issuers, investors and rating agencies. One alternative that merits consideration is to stop forcing CMBS servicers to invest in servicing rights. Hiring CMBS servicers on a fee basis with the right to terminate them without cause will increase competition and improve quality. I am confident that CMBS servicing quality and long-term viability are critical, and the market will find mechanisms to address these issues.
Stacey M. Berger is executive vice president of Overland Park, Kansas--based Midland Loan Services Inc., a provider of loan servicing and technology solutions to the commercial real estate finance industry. He can be reached at email@example.com.
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|Author:||Berger, Stacey M.|
|Date:||Jul 1, 2003|
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