MULTIFAMILY LENDING UPDATE

We have uploaded the latest independent bank default data for January into our Loan Pricing Model. While there is little change in either the probability of default ("PD") or recovery information, the one notable exception is multifamily underwriting. The PD on loans to apartment buildings across the nation has increased by 11bp since December to approximately 2.12% annualized. After almost 12 months of increasing rents, monthly prices for apartments have started to come down over the last 3 months. This drop in rents is a result of lower demand, caused by home affordability remaining at high levels and greater supply (driven by increased building). Net absorption has decreased while vacancy has increased. After hitting a near term low in early 2002 (of 2.3%), as of January 2007, independent bank multifamily vacancy rates came in at 6.1%. Keep in mind that the 1Q almost always wreaks havoc with independent bank rental unit statistics (as the first 3 months of the year are usually slow for lease up and net absorption usually turns negative until mid-March). One factor that is also affecting the multifamily market is condo conversions. Slower condo sales have resulted in more supply of rental units available in the marketplace. This has led many owners of these units to try renting them instead. These afore-mentioned factors not only affect cash flow, but also loss given default ("LGD") as the valuation for multifamily units is also dropping in many markets. In the last 3 months, capitalization rates for low, medium and high rise buildings have all increased, as have garden-style apartments. One year ago, we reported that capitalization rates were outrageously low. We pointed out that we believed it was only investor speculation (instead of cash flow) that was driving valuation. This has since abated a bit and regions where we saw 4.1% capitalization rates (in places like Sacramento and Portland), are now seeing rates back to the 6% level. Given all of this, however, the multifamily sector outlook remains strong. We are simply attempting to point out that the multifamily sector has become a little more risky (as lending risk reverts back to the mean). Our model shows stabilization of credit at its current level, with the exception of some key areas likely to deteriorate further, due to supply and demand imbalances. While many of these areas are in Florida (Orlando, Palm Beach, Miami, Broward to name a few), we also project credit weakness in Las Vegas and Seattle. Additionally, look for some further weakness in Los Angeles, Washington D.C./Maryland and Phoenix. For banks looking to maintain their risk-adjusted ROE and don't have access to our Loan Pricing Model, credit spreads should increase an average of 6bp in February in order to compensate for the higher projected PD and lower recovery rates. The average bank multifamily loan garnered banks an estimated 22.3% risk-adjusted ROE for the month of January and we look for that number to decrease slightly due to a weaker credit profile.