The emergence of European CMBS 2.0 can be directly traced back to Deutsche Bank’s Deco 2011-CSPK which closed in June 2011. Since that issuance, there have been several deals brought to the market by not only Deutsche Bank but also Bank of America Merrill Lynch and Goldman Sachs as well as three deals arranged by Cairn Capital, a non-bank. Given that CMBS 2.0 as a financing tool for commercial real estate is here to stay and we are fast approaching the fifth year of this new era, now would seem to be an opportune time to take stock of the CMBS 2.0 product and consider some of the defining structures of these new deals. Over the course of a series of blogs, we will therefore consider some of the features that can be considered unique to CMBS 2.0.
Class X – a Class Act!
No matter what the vintage of deal, an essential component of structuring a CMBS transaction is to ensure that the “excess spread” (i.e. the positive difference between amounts received on the underlying loans and the liabilities of the issuer) can flow to the originator or its nominee. Although skimming the margin of the underlying loans is one means by which the excess spread can be obtained, the more prolific mechanism and arguably the most controversial feature of CMBS 1.0 has been the utilisation of Class X notes.
In itself, an X note would seem rather innocuous, it is a class of notes that has a relatively low face value, it is cash collateralised and bears a variable rate of interest which is paidpari passu with interest on the most senior class of notes. Indeed, the right to receive interest is the only tangible right attached to an X note, given that holders of such an instrument have no controlling powers, no voting rights and no ability to direct the note trustee to take action.
As it is essential for the economics of CMBS that there is a mechanism for the originator to receive the excess spread, the mere existence of an X note in itself is not controversial however what is controversial, is the determination of what constitutes excess spread. In CMBS 1.0, the excess spread was determined to be the excess of scheduled interest due on the outstanding loans over the aggregate of interest due on the notes and ordinary administrative costs. With such a formulation of excess spread, an issue arises by the fact that it applies to interest actually due on the loans rather than interest actually received. The consequence of this is that given the presence of a liquidity facility that can be drawn on to make up the shortfall in amounts received under the loan, then despite a borrower failing to pay interest on a loan this in fact will have no impact on the amount of excess spread received by the holder of an X note.
The controversy of CMBS 1.0 X notes is further exacerbated by the presence of a non accruing interest (NAI) mechanism which provides that when a loss on an underlying loan is crystallised a corresponding amount of such loss is applied on a reverse sequential basis to the principal balance of the higher yielding junior notes. Assuming the interest on the underlying loan where the loss has been crystallised is less than the coupon of the impacted junior notes, then absurdly the holder of the X note is set to gain a greater amount of interest and therefore derive a greater benefit from a situation where there is an underlying loss on a loan. Finally, to compound these controversies yet further, given that the payment of excess spread ranks pari passu with payment of interest on the most senior class of notes, then the holder of X notes will always be entitled to receive excess spread before the payment of principal on any class of Notes.
In summary, although the structuring of an X note is a legitimate right of the originator, the structures employed were clearly distortive given that they allowed “excess spread” to be extracted from the deal when in reality there was no excess spread in existence. Further, losses on loans had no negative impact on X note payment stream and if anything given the presence of NAI mechanics, losses could in fact enhance payments under the X note. Unsurprisingly, X notes were one of the main structural features addressed in CREFC’s Market Principles for Issuing European CMBS 2.0, where they made the following recommendations:
- there should be clear and concise disclosure on how excess spread is calculated and who is entitled to receive such amounts;
- there should be greater disclosure around some of the X notes more controversial structural features such as their ranking in the priority of payments and the role of any liquidity facility; and
- X note should be structured to specifically take into account the loan default interest, modified interest (following a workout), loan maturity date and loan default.
The concerns raised by the CMBS 1.0 have clearly been taken on board in CMBS 2.0, and the new vintage of deals exhibit structural nuances that have addressed the potentially inequitable features highlighted above. Deutsche Bank’s Deco 2014-Bonn provides a great example of how these imbalances have been corrected, which first and foremost includes clear disclosure on how excess spread is calculated and its constituent components. In terms of structure, the Deco 2014-Bonn transaction provides that the liquidity facility cannot be drawn on to make good any shortfall in amounts received under the loan, thus any amounts received under an X note will solely emanate from income received from the securitised loan. Further, the amount that the Deco 2014-Bonn X holder is entitled to receive is capped at the excess of the amount of all available funds over all payment liabilities, with any X note amount that is greater than this capped amount deferred until the issuer has sufficient funds to make such payment. Finally, under certain circumstances (following the expected maturity date of the CMBS notes, the occurrence of a special servicer transfer event or service of a note acceleration notice), the right to receive excess spread is subordinated to payment of all interest and principal on the notes. These features are not unique to the Deco 2014-Bonn deal or indeed the Deco family of deals and a review of a number of other CMBS 2.0 transactions reveal the presence of similar structural features.
For the economics of CMBS, it is crucial that the originator of the loan is able to extract excess spread and the presence of X notes is integral to that. Between CMBS 1.0 and CMBS 2.0 there has been a clear structural shift in the structuring of X notes, from an instrument where holders could extract money out of a deal even when the loan or the deal is non-performing to the current situation where holders of X notes can only receive excess spread when there is indeed true profit and the deal is performing. The paradigm shift in the structuring of X notes is a real testament of the industry’s ability to listen to market participants, adopt recommendations and adapt the CMBS product so that it not only meets the needs of investors but also continues to safeguard the true economics of a deal – taking X notes from being suspect to a real class act!