Credit Suisse Shows How Banks Couldn't Lose in Pre-Crisis Bondsby
Bonds structured to favor arrangers even when loans defaulted
Credit Suisse asking London court to rule on pre-crisis notes
Credit Suisse Group AG’s bid to recoup interest on soured commercial mortgage-backed securities is shining a spotlight on more than 14 billion euros ($15.2 billion) of pre-financial crisis bonds in Europe that were structured to favor arrangers.
The Swiss bank’s asset-management unit is requesting a London court determine the amount of interest owed on its holdings of a class of securities that were designed to pay out even after the underlying loans defaulted. These notes, known as Class X, are also part of deals originated before the crisis by banks including Bank of America Corp., Barclays Plc, Citigroup Inc., Deutsche Bank AG, Morgan Stanley and Royal Bank of Scotland Plc, according to data compiled by Bloomberg.
While standard structures have since been overhauled to stop payments to originators when deals stop performing, the case is a reminder to CMBS investors that the pre-crisis market was designed to ensure the banks didn’t lose. A collapse in real estate prices following the sell-off saw property values drop to less than outstanding debt, spurring losses for noteholders.
“When loans stopped performing during the crisis, investors realized pre-crisis CMBS structures are often skewed in favor of the originating bank,” said Erik Parker, an asset-backed securities strategist at Nomura Holdings Inc. in London. “Investors generally don’t have an issue with banks taking profits from deals they’ve originated so long as the excess spread payments are subordinated to all other noteholders or cease entirely in case of a default of an underlying loan.”
The Class X notes, disclosed to buyers in the deal documents, were created so originators could extract profit from their CMBS transactions and reduce tax.
Credit Suisse said it’s seeking to recoup “significant and material sums” of unpaid interest on its holdings of Class X notes in four transactions that were sold by its investment bank and have 742.6 million euros of debt outstanding. While it didn’t disclose how much money it is seeking, Bank of America analyst Mark Nichol estimates unpaid loan interest for two of the bonds -- Titan Europe 2006-1 Plc and Titan Europe 2006-2 Plc -- totals 33.7 million euros and 19.5 million euros respectively.
The court was also asked to decide if interest should be paid on unpaid amounts calculated at the Class X interest rate, which on three of the notes is more than 20,000 percent, according to Bank of America. The Class X rate tends to be very high because it’s calculated based on the relationship between the large amount of underlying loans and the smaller nominal balance of the Class X notes, according to Deutsche Bank.
Class X notes in legacy CMBS typically rank equal to senior notes. Last month 210,779.02 euros of interest was paid to the Class X notes in Credit Suisse’s Titan Europe 2006-1 deal, while the next most senior notes, Class B, received 36,294.66 euros of interest, according to a report from U.S. Bank, the CMBS trustee. Classes C, D and E, which remain outstanding, received no interest payments, the report shows.
Maya Kunz, a spokeswoman for Credit Suisse in London, declined to comment on the asset manager’s plans for the Class X notes.
Class X notes were included in 78 of the 290 European CMBS 1.0 deals sold between 1995 and 2010, including 14 deals from Credit Suisse, according to data compiled by Bloomberg.
“Nobody foresaw the real estate crash and the raft of ratings downgrades that would follow, ” said Anant Ramgarhia, a London-based senior investment analyst at Wells Fargo Asset Management/ECM, which oversees $480 billion of assets. “While the risks to CMBS noteholders were described in the documents, when it happened in real life that cash that could pay noteholders was diverted to originators, investors got upset.”
Executives of Bank of America, Barclays, Citigroup, Deutsche Bank, Morgan Stanley and RBS declined to comment on the Class X notes in their own deals.
European tax law prompted the creation of the notes, which don’t feature in the larger U.S. CMBS market. Whereas in the U.S., arrangers structured so-called interest-only strips to generate income, originators in Europe package the excess spread to create a listed bond, making them exempt from withholding taxes, according to Conor Downey, a partner specializing in real estate finance at law firm Paul Hastings LLP in London.
Banks take excess loan interest, which is the amount earned on the underlying loans backing the deal after subtracting the interest due on the bonds and the cost of the securitization. They also earn money from originating the underlying mortgages and providing swaps to borrowers to hedge interest-rate moves.
Since originating banks can sell their pre-crisis Class X notes to investors, including hedge funds, others may also be paying close attention to the Credit Suisse ruling.
The bank’s request for payment shows that while the overhaul of standard structures in 2012, dubbed CMBS 2.0, may help provide greater transparency to the way new deals are structured and managed, existing deals are yet to be renegotiated.
“New-issue CMBS deals have been structured to make sure these types of situations don’t occur again,” Paul Heaton, a CMBS analyst at Deutsche Bank in London, said in a phone interview. “The Class X notes have been rethought in new deals, which protects investors and gives them greater certainty over their positions.”