The GEMSA model

IN AUGUST 2001, L.J. MELODY & CO., HOUSTON, AND GE CAPITAL REAL ESTATE (GECRE), STAMFORD, CONNECTICUT, shook up the normally staid commercial mortgage servicing industry by consolidating their loan servicing operations into a new entity, a limited partnership called GEMSA Loan Services LP, Houston. * While portfolio sales are common (some of the deals being very large, as a number of big financial companies have left the servicing arena), there ally haven't been very many full mergers of mortgage servicing companies. That's why the GEMSA formation is fairly unique-at least for the moment. The question is, will it change the industry? At this point there's no consensus that it will, and by early 2002 no other companies had decided to go the same route.

Still, as Stacey Berger, an executive vice president with Kansas City, Missouri-based Midland Loan Services Inc., says, "In the past there have been more acquisitions than mergers, but from our perspective we are certainly seeing much more interest in consolidation-especially as technology is such a big issue."

Asked if Midland had received any overtures from other companies, Berger answers neither yes nor no. Instead, he says, "We have been approached by a wide variety of institutional players and third-party servicers looking to get access to our technology in a variety of different ways."

Prior to the elopement, L.J. Melody, part of CB Richard Ellis Inc., Los Angeles, and GE Capital Loan Services Inc., the loan servicing unit of GE Capital Real Estate, had one important thing in common: They were both headquartered in Houston, and that made even the consideration of a merger easier.

"Melody's servicing business was in Houston. We were in Houston, and we were very familiar with each other," says Michael Hudspeth, program manager with GE Capital.

Brian Stoffers, L.J. Melody's chief operating officer and executive managing director, concurs, adding that the two companies had quite a bit of history. "L.J. Melody has been one of the larger producers for the GE conduit program and has a long history of originating various types of business within GE Capital Real Estate," he says. "And as we are both based in Houston, we talked over the years about different types of joint efforts. For a variety of reasons, last year the talks seemed to gel."

As individual companies, both had been top-10 "total master and primary servicing" companies, as reported in an annual survey by the Mortgage Bankers Association of America (MBA). Taken together as one company, MBA's year-end 2001 rankings show GEMSA as the third-largest master and primary servicer with a portfolio valued at $54.467 billion. In the first two slots are Midland Loan Services with $68.010 billion and CapMark Services LP, Atlanta, a division of Lend Lease Real Estate Investments Inc., New York, with $64.369 billion.

In terms of the top life company servicers, again as ranked by MBA's annual survey, GEMSA checks in as No. i with a portfolio of $34.630 billion, followed by CapMark Services at $28.223 billion and Dallas-based Prudential Asset Resources at $15.686 billion.

Ann Hambly, president of Prudential Asset Resources and a managing director at Newark, New Jersey-based Prudential Financial Inc., the parent company, views the post-- GEMSA servicing market a bit differently than Midland's Berger. "I'm not sure the industry as a whole has made any radical changes as a result of GEMSA. I'm not aware of any of the top-lo servicers looking to make a change, although probably smaller companies are-they are always evaluating opportunities."

To the servicing side

Servicing has become a huge business. According to MBA, the total amount of commercial mortgage-backed securities (CMBS) servicing at the end Of 2001 was approximately $219 billion, versus total CMBS outstanding of approximately $280 billion. In addition, life company servicing totaled $195 billion, Fannie Mae and Freddie Mac servicing totaled $79 billion, and Federal Housing Administration (FHA) servicing totaled $30 billion.

"Business has been good," says Jeffrey Whitlatch, a principal with CapMark Services. "We went to over $64 billion last year from $46 billion the year before. None of it was [by] acquisition. While we do have a Fannie Mae and Freddie Mac origination arm, the rest of it was commercial mortgage-backed securities and life company," he says.

The top 13 servicers as charted by MBA do sio billion or more in business and, therefore, in and of themselves dominate the industry. However, there are almost 120 companies that do some sort of third-party servicing-although, as Hambly points out, a lot of companies can call themselves third-party servicers because they originate loans on behalf of entities such as Fannie Mae. In effect, these 120 companies are really just servicing what they originate.

The main arguments for consolidation-- that companies need size to be efficient and the cost of technology in the industry is too great to be borne by a smaller company-are valid, but also ignored by these smaller companies. The reason, says Hambly, is that originators place great importance on being able to keep their customers. If they retain the loan, they can keep that customer for the life of the loan. Hambly has become famous in the industry for her quote, "Outsourcing servicing is like taking someone on a date and then letting someone else drive them home."

And that is why there are firms such as Seattle Mortgage Co., Seattle, which boasts a servicing portfolio of $200 million, or Republic Mortgage Commercial LC, Salt Lake City, which is doing its own servicing on a portfolio valued at $169 million.

"We court these borrowers for a long time to get their business and confidence, and it is absolutely a shame when you do all that and then turn around and put them out to someone else," says Hambly.

This is not to say there haven't been big departures from the business-in particular, a number of major banks such as Mellon Financial Corporation, Pittsburgh; Fleet-- Boston Financial Corporation, Boston; and J.P. Morgan Chase & Co., New York, which have gotten out of the third-party commercial mortgage servicing side of the industry.

A lot of players have come and gone, CapMark Services' Whitlatch says, and one of the reasons is the cost of technology. "It is definitely a factor. If a company wanted to enter the business right now and be significant player, it would either have to purchase a platform that already has the technology or invest a significant amount of money to get up to speed," he says.

As good a reason as any

Before the merger to form GEMSA, L.J. Melody was in a quandary. It wanted to go to the next level in servicing, but to do that it needed a lot of process refinement in its system. "We were known as a handson, customer-oriented type servicing operation," says Robert Vestewig, who had been a managing director of L.J. Melody's loan servicing group before becoming GEMSA's chief operating officer. "Even though we were doing $18 billion in servicing, we couldn't take the next step without a lot of change and a lot of expenditure-it was the technology link that we had trouble with."

Vestewig estimates it would have taken L.J. Melody on its own another three to five years to catch up to where GE Capital Loan Services was at that moment.

Technology improvements are expensive but necessary on the servicing side of the business-especially today, as Web sites need to be established, document imaging becomes important and, for large processors, automation is a necessity.

On top of all that, there is the issue of information.

"There will be continued consolidation as the reporting requirements [and] information requirements get more demanding," says Whitlatch. "This is becoming an information-delivery industry versus just a servicing industry. Over time, there will be more consolidation as people have difficulty keeping up with the technology that is necessary to provide the level of information desired by the investors," says Whitlatch.

Tom Church, managing director of structured product services for Wachovia Securities Inc., Charlotte, North Carolina, breaks down the individual jobs of servicing into three categories: cash, risk management and information. "I have been working in the structured world since the early 1990s, and it had gone from kind of a boutique business to an information business," he says. "The key is turning information into knowledge and knowledge into intelligence."

With a servicing portfolio of $48 billion, Wachovia Securities now ranks as the fourth-largest third-party master and primary servicer. It's a bit different than the other companies in the top five rankings, in that most of the other firms run life insurance portfolios while Wachovia is mainly focused on CMBS. Its clients include a lot of Wall Street investment banks such as Lehman Brothers Inc., New York, and Credit Suisse First Boston, New York.

"There are not many mergers in this business," Church says, "but you saw the GE Capital/L.J. Melody merger. It takes scale to run a servicing business because it costs a lot of capital. If you are not investing the money, then you shouldn't be in this business."

Wachovia Securities intends to remain a dominant player in the business and, as Church says, it will continue to buy portfolios-and even sell them when necessary.

That is a bit of a different approach than that of L.J. Melody or GE Capital. Before the merger, GE Capital Loan Services was the larger of the two companies, and its growth was mostly organic through loan originations by GE Capital. "It was not out there aggressively bidding on portfolios," says Vestewig. It also did a lot of conduit business. Similarly, the growth in the L.J. Melody servicing portfolio was through loan originations by L.J. Melody. GEMSA will continue to service loans originated by both partners.

Because L.J. Melody worked the life insurance side of the business, the two companies didn't have many clients in common. What struck L.J. Melody about merger possibilities, says L.J. Melody's Stoffers, was that each company had some strengths that were complementary. Besides source of business, operations were different as well.

"GE Capital Loan Services was very strong in technology," Stoffers says. "L.J. Melody had a history of doing high-touch, customized loan servicing for life companies, pension funds and Fannie and Freddie. We thought we could bring together the high-touch service aspects and supercharge it with some significant technology."

Before the merger, L.J. Melody ranked around eighth in terms of servicing total master and primary assets. "Was this big enough to really develop the technology as quickly as we needed? Probably not," says Stoffers. "GE Capital Loan Services had the technology we could move and match to the L.J. Melody book. We had been undergoing development processes for technology, Web sites and the like, and we were probably a couple of years behind where GE Capital was. We felt that a combination would give L.J. Melody a jump-start in that area."

And GE Capital's view of the deal? Not much different.

"We had technology ... that we had spent a lot of time developing and [that] we thought was state-of-the-art," says Hudspeth. "L.J. Melody, of course, had a high-touch customer focus with their life company clients. We thought that would benefit our business. They thought our technology would benefit their business."

The fundamental reason why the GE Capital Loan Services/L.J. Melody deal was put together, Hudspeth says, was that it notched up GE Capital Loan Services' ability to service its customers "and provide them with things they would not have otherwise had without this venture. We realized if we could combine GE Capital's loan servicing technology, Web-based customer service, flexibility in reporting [and] 24-7 features with L.J. Melody's high-touch type service, we could be at a service level in the industry [that] stood alone."

Does size really matter?

It's important to recall that GMAC Holding Corporation, Horsham, Pennsylvania, had been the largest commercial servicer in the MBA rankings for the prior two years, but no longer participates in the MBA survey so does not appear in those rankings. Yet GMAC is still widely considered the largest commercial mortgage servicer, which means its portfolio is bigger than even Midland's $68-plus billion. The current MBA survey shows there are now 23 companies servicing a portfolio of $5 billion or greater, 13 firms with a portfolio of at least $10 billion and seven servicers (not including GMAC) with a portfolio of more than $25 billion.

Mortgage servicing portfolios are getting larger, but there are, as noted, a lot of smaller companies that have found a way to remain in the business as well. So does one really need to have considerable size to remain competitive?

There are two ways to look at the issue, says Prudential Asset Resources' Hambly. In the third-party market, there needs to be "certain efficiencies, so to some degree size does matter." However, she adds, if a merger just means getting a larger slice of the pie, then there really is no driving reason to make that kind of move.

"For the last couple of years, the servicing industry has been focused on becoming more efficient, and individual companies are trying to deliver better service," Hambly says. "If XYZ company offered something different-something that Prudential didn't have, so together we could be more efficient-then that kind of deal would be looked at. If there was nothing to be gained other than getting bigger, I don't see that happening."

Midland's Berger says he doesn't expect to see much in the way of mergers in the servicing sector, although he predicts more portfolio deals as companies consolidate platforms, take the redundancies out of operations and get more efficiencies and economies of scale.

The issue is really about capacity management, says Wachovia's Church. "If you have the scale, you can drive the per-loan cost down. As you get larger, your cost per loan goes down and you can leverage functionality within your business. One person doing one thing on one loan is more expensive than doing the same thing over a number of loans."

Church also doesn't expect to see a lot of mergers. This doesn't mean consolidation won't continue as portfolios move to the bigger servicers, he adds. "Probably the top 10servicers will get the majority of the business," says Church.

Outsourcing changes everything

There are two other diametrically opposed views about future prospects for mortgage servicing consolidation. The first speculates that consolidation will happen by default as large financial institutions continue to merge into still bigger companies, as they have over the past decade. When that happens, existing servicing portfolios will combine.

On the other hand, the nascent trend of outsourcing may make moot the whole issue of having to sell portfolios because they are too expensive to service. Improved technology in the servicing sector now allows bigger companies to service the portfolios of smaller companies for a fee without them having to give up relationships maintained through servicing.

The reason why there are so many companies still acting as servicers, Hambly says, is that these companies recognize the long-term benefit of maintaining direct contact with customers and being able to keep them happy. So when borrowers need a loan again, the first place they will turn is the current provider.

Recognizing this factor, Prudential Asset Resources offers a private-label outsourcing service. The client has the ability to stay in a position of control over the loan, but the back-office piece is done at Prudential. The loan remains in the name of the servicer even though the technology maintaining the loan comes from elsewhere.

Wachovia is another company doing private-label outsourcing. "Depending on the role the mortgage banker wants us to play, we offer extreme flexibility," says Whitlatch. "We can do the whole servicing short-term, just back-office operations, payment, collections, taxes and insurance. We can answer the phone in their name. We can do all that on a private-label basis, and we are being contacted fairly regularly by people who are considering it."

The key to this technology, "which we are presently installing at insurance companies," says Midland's Berger, is that it allows lenders to maintain their customer relationship without having to do nuts-and-bolts processing. The platform and servicing is done on a private-label basis, so the lender is not visible to the borrower.

Berger claims that at least four major insurance companies have outsourced either all or a significant portion of their servicing portfolios, "and there is more of that in the works," he says.

No ripple effect

A beneficial aspect to the way that GEMSA was created is it allows GE Capital Real Estate and L.J. Melody to continue to market and conduct new loan origination business separately. GEMSA also gives GE Capital Real Estate space to focus on expanding its third-party servicing contracts, internationally and domestically, and for L.J. Melody to expand services to new and existing clients.

GEMSA continues to be rated a CMBS master and primary servicer, recently receiving a Fitch rating of C1-- minus for master and Ci for primary servicing. Additionally, L.J. Melody will continue to maintain its six regional service centers for what it calls "high-touch asset management."

"Our goal in creating GEMSA was to combine the best of each partner's businesses-cutting-edge technology and the highest level of personal customer service," says Vestewig. "We think the model is unique in the business, and we expect it will be of interest to lenders and perhaps other commercial mortgage banking firms."

Does GEMSA create a possible model going forward? Probably not. As Hambly notes, "there are probably good reasons within the respective companies why they had to merge, but I haven't seen any ripple effect on the rest of the industry."

Using the limited partnership format as GEMSA did has piqued some interest, though. "It is very interesting the way GE Capital and L.J. Melody did it," says Berger, "but it's a little too early to know how it will work out."