Dan Thomas Managing Director,  Client Solutions Group

Commercial Market Overview

       The current global financial crisis has impacted all lending markets with most of the media attention in 2008 focused on the steep decline in residential real estate as a result of the steady rise in delinquencies and foreclosures throughout the country. The FDIC and Treasury were in triage mode for the greater part of 2008 with stabilization of the financial system being their top priority. As a result, the growing problems within the commercial real estate market were placed somewhat on the back burner until further notice. However, the commercial real estate marketplace is under great duress with AAA CMBS spreads approximately 1200 basis points higher than December 2007 levels, a CMBS securitization market at a virtual standstill, and the steady uptick in commercial delinquency rates.  The January 19, 2009 Commercial Mortgage Alert tables highlight just how bad the CMBS securitization market was last year where there was approximately $230 billion in domestic new issuance in 2007 versus only $12.1 billion of new issuance for all of 2008!

Commercial Servicing

       Even with the overall problems facing the commercial real estate industry, the demand for commercial servicing was largely unaffected in 2008. Transaction volume in the commercial servicing market in 2008 was the lightest we have seen in eight years due mostly to the lack of new CMBS issuance. Approximately $4 billion of Agency and Life company correspondent CMSRs were sold during the year, consistent with the volume levels over the past several years. Merger and acquisition-related MSR transactions were mainly the result of Bank consolidation, the most notable being the merger of Wells Fargo and Wachovia, the result of which was the creation of a mega commercial servicing operation with over $600 billion in CMSRs.

       Demand for commercial servicing was strong in the first half of 2008 for all investor types. Demand was strong for two main reasons: the lack of new issuance CMBS servicing available and the strong demand by Banks for any type of deposits (i.e. escrow, replacement reserves P & I deposit balances). The lone exception for demand in commercial servicing was the FNMA DUS sector.  The market for DUS servicing has traditionally been the least liquid of all commercial servicing mostly due to the credit exposure aspect and the higher capital costs for Banks. With the overall mortgage market in turmoil, credit-sensitive instruments have been hit the hardest and demand for DUS servicing has been extremely weak. Another negative for FNMA DUS servicing was the uncertainty surrounding the future of FNMA and the DUS program.

Market Values

       A recent commercial servicing market assumption survey completed by MIAC this summer showed that many of the major buyers of CMSRs utilize fairly similar assumptions for valuing commercial mortgage servicing rights. The five major factors influencing commercial servicing values ranked by importance to cash flows are prepayments, the cost to service, the earning rates on escrow, P&I and reserve balances, discount rates, and ancillary income. Listed below is an approximate range for each assumption based upon the survey results.

       As expected the large servicers that are owned by depository institutions continued to be at the more aggressive end of the range for every assumption category. This will continue to be the case until actual cash flow behavior no longer supports these market assumptions.

       With the credit markets drying up and spreads widening for commercial loans, prepayments were not a big factor in commercial servicing market values in 2008. Likewise, servicing costs remained relatively stable throughout the year. The big negative factor affecting the commercial servicing market throughout 2008 was the steep drop in overall interest rates. Buyers of CMSRs historically used earnings rates assumptions for float, escrows and reserves in the in the 3.00-4.50% range.  Depository institutions as a general rule were typically on the upper of that range. As the second half of the year progressed, market participants started to become more conservative in their earning rate assumptions. Once it became apparent that the Fed would continue to drive down the overall level of interest rates for the immediate future the majority of the buyers assumed a more conservative posture with respect to the amount of interest income being generated from balances. This change was reflected in the bid results on several bulk portfolios that MIAC had auctioned in both the third and fourth quarters of 2008. The table below details the month end of rates for some benchmark instruments: 1 month Libor, 5 year constant maturity swap and 10 year constant maturity swap.

Earnings Rates Sensitivity

       All commercial servicing is not created equal. However, all other loan characteristics being equal, the big separator in market value can many times be attributed to the Principal and Interest payment, the Tax and Insurance constant, and the Reserve balances that one loan has versus another. As shown in the table above, interest rates were very volatile throughout 2008 with a severe drop occurring during October, November and December which negatively impacted the actual cash flows generated by the CMSR asset. The table below illustrates the market value sensitivity to the changes in these earnings rates for the end of each quarter during 2008 for a typical Agency commercial servicing portfolio.

Outlook for 2009

       Servicing prices should remain stable for all types of commercial servicing for the first quarter of 2009. MIAC believes that market demand will remain strong for the majority of the asset classes in this sector provided that earnings rates do not drop to zero! We expect that default risk will be looked at very closely during 2009 and it may have a significant impact in the CMSR market place. MIAC will look at the effect of these rising defaults on servicing costs and the loss of servicing income from the involuntary prepayments in our next MIAC Perspectives in April 2009.

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