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NEW YORK CITY-For the first time since the inception of the US CMBS market, CMBS servicer capabilities will undergo rigorous testing this year. So says a recent report from locally based Fitch Ratings.

Fitch believes that highly rated commercial mortgage servicers will be better able to withstand a volatile market. While servicers faced and overcame challenges which occurred in recent years, including Sept. 11 and various natural disasters, this is the first significant capital markets driven stress which servicers have undergone. The limited liquidity available will affect all sectors of commercial mortgage servicing including primary, master and special servicing.

The report notes that in Q4 ’07, as new deal issuance slowed and commercial real estate CDO issuance virtually stopped, investors more closely scrutinize their structured finance bond portfolios. Servicers, whose focus had been on managing the flow of new transactions into their portfolios, often including complicated multi-note loans and insurance issues, now faced an additional new set of challenges and operational risks, including: increased inquiries from investors, including those who had never interacted with CMBS servicers prior to these events; fewer securitizations creating increased bidding competition in an already competitive market; and potential for the need of additional staff, redeployment of staff or creation of specialized groups to address shifting areas of concern.

On the flip side, the report says that because of the credit crunch, fewer loans are defeasing or pre-paying. “Therefore, master servicing portfolios have remained relatively constant as loan inflows and outflows decreased. Master servicers are focusing on the maturity risk associated with the 1998-2000 vintages as planned but are now managing these refinancing challenges in a less liquid market,” the report states.

Fitch says that CMBS master servicers are not the only ones facing increasing operational challenges. Over the past few years, CMBS special servicers have been able to reap the benefits of a strong real estate capital market. Since real estate fundamentals remained strong, the volume of specially serviced assets remained stable, or in many cases, has decreased over the past two years. When assets did transfer to special servicing, the vast amount of real estate capital available in the market helped asset managers dispose of assets quickly, often at better than expected prices.

“Due to the current liquidity environment, it will no longer be as easy to dispose of real estate owned assets,” says managing director Stephanie Petosa. “Although there is still capital in the real estate market, the profile of the buyers has changed and individual real estate investors are less likely to be able to purchase property because their financing options are limited. Therefore, successful buyers of REO are more likely to be institutional investors or opportunistic real estate funds, which have the ability to buy property free and clear without seeking financing.”

The report concludes that “special servicers may end up holding assets for longer periods of time, increasing losses to the trust due to the cost of maintaining the properties and the potential for declining real estate values. If the credit crunch continues for an extended period, special servicers will likely see an increase in loan defaults at maturity; some servicers have already noted a delay in borrower refinance timing. An increase in loan transfers may tax the resources of special servicers and therefore, the surveillance function of the special servicer is more important than ever. Special servicers who closely monitor watch lists with the named master servicers regarding the potential pipeline of specially serviced assets should be better prepared to handle the increased workload.”

With the current situation in the real estate structured finance market, it appears that the challenges faced by servicers will continue to increase. Although delinquencies remain low, currently at 31 basis points, Fitch expects delinquency activity to double in the next year.

Through its CMBS surveillance and servicer rating processes, Fitch plans to enhance its scrutiny of servicer performance, through scheduled, frequent interaction with its rated servicers, including quarterly calls with active master and special servicers to discuss market trends, operational challenges and other servicer issues.

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