In December 2009, Berkshire Hathaway (BRK.A) and Leucadia National Corporation (LUK) formed a new entity named Berkadia Commercial Mortgage in order to acquire (.pdf) Capmark Financial Group’s North American loan origination and servicing business. Berkshire and Leucadia each invested $217.2 million of equity capital to fund the Capmark transaction. In addition, Berkshire has provided a $1 billion five year secured credit facility to Berkadia, of which $580.5 million was outstanding under the facility as of December 31, 2009.
Warren Buffett had the following to say about the Berkadia venture in his annual letter to shareholders (.pdf):
At the end of 2009, we became a 50% owner of Berkadia Commercial Mortgage (formerly known as Capmark), the country’s third-largest servicer of commercial mortgages. In addition to servicing a $235 billion portfolio, the company is an important originator of mortgages, having 25 offices spread around the country. Though commercial real estate will face major problems in the next few years, long-term opportunities for Berkadia are significant.
Our partner in this operation is Leucadia, run by Joe Steinberg and Ian Cumming, with whom we had a terrific experience some years back when Berkshire joined with them to purchase Finova, a troubled finance business. In resolving that situation, Joe and Ian did far more than their share of the work, an arrangement I always encourage. Naturally, I was delighted when they called me to partner again in the Capmark purchase.
Our first venture was also christened Berkadia. So let’s call this one Son of Berkadia. Someday I’ll be writing you about Grandson of Berkadia.
While Berkshire Hathaway and Leucadia have equal ownership interests in Berkadia, the new venture is a relatively minor commitment for Berkshire but a much larger investment for Leucadia. As a result, Berkshire does not include much detail for Berkadia in the 2009 annual report. Fortunately, a significant amount of information is available in Leucadia’s recently released annual report (.pdf) for 2009. Let’s take a look at the details behind the Berkadia venture.
What is Berkadia’s Business?
Berkadia’s main business involves servicing commercial mortgage loans. A mortgage servicer is responsible for collecting payments from individual borrowers and ensuring that components of the payment (principal, interest, insurance, and taxes) are paid to the correct recipient in a timely manner. As of December 31, 2009, Berkadia had a servicing portfolio of nearly 33,000 loans with an unpaid principal balance of $236.7 billion.
Mortgage Servicing Activities
There are several types of servicing that Berkadia is engaged in:
- Primary servicers are the primary contact for a borrower and must provide billing statements to the borrower, handle all collections, and administer escrow funds for items such as property taxes and insurance.
- Master servicers provide administrative services in connection with securitization of a pool of loans. Master servicers coordinate with primary servicers and manage the overall pooling arrangement.
- Special servicers receive higher fees than primary and master servicers to handle loans that have defaulted. If a loan is over 60 days past due, a special servicer may take over from the primary or master servicer. Special servicers seek to bring the loan into performing status if possible or to handle foreclosures or loan modifications.
Berkadia also originates commercial real estate loans for Fannie Mae (FNM), Freddie Mac (FRE), Ginnie Mae, and the Federal Housing Administration (FHA). As long as Berkadia adheres to specific underwriting guidelines, the government entities are required to purchase the loans at face value plus accrued interest. Berkadia keeps the servicing rights on these loans and also assumes a limited first-dollar loss position on originated loans.
Escrow Accounts: A Form of “Float”?
One intriguing aspect of Berkadia’s business is discussed in the Leucadia annual report:
As a servicer, Berkadia is frequently responsible for managing, on behalf of its investors, the balances that are maintained in custodial accounts for the purposes of collecting and distributing principal and interest and for funding repairs, tenant improvements, taxes and insurance related to the mortgaged properties it services. Berkadia derives certain economic benefits associated with a portion of these balances. Such balances totaled in excess of $4 billion as of December 31, 2009. Leucadia Annual Report, Page 22
This sounds quite a bit like the familiar concept of insurance float that drives so much of Berkshire Hathaway’s value. While it is likely that the “float” in these custodial accounts must quickly be paid out to the recipients, a constant stream of funds will continue to come in over time as additional escrow payments are made. Perhaps a better analogy for this “float” can be found in the example of payroll processors such as Paychex (PAYX) and ADP, which collect tax payments from employers but benefit from holding such funds until the taxes are due to the government.
Sources of Value
While Berkadia is obviously exposed to a troubled part of the economy, mortgage servicing is a necessary function that must be performed. In addition, if Berkadia attracts additional higher fee business as a special servicer, it could benefit from an increased need for specialists who are experienced with resolution of delinquent loans. While the company has some “skin in the game” when it originates loans for government sponsored entities, presumably the experienced underwriting team should be able to mitigate risk.
From the perspective of Berkshire Hathaway, in addition to equity ownership of 50 percent of the Berkadia venture, the company will receive interest on the $1 billion secured credit facility, of which $580.5 million was outstanding on December 31 based on Leucadia’s disclosures. Leucadia has guaranteed Berkadia’s repayment of 50 percent of the credit facility when due.
To follow Berkadia’s results in the future, Berkshire shareholders should keep track of Leucadia’s quarterly and annual reports which are expected to continue providing much more detail compared to Berkshire’s periodic reports.
Disclosure: The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value. No position in Leucadia.