August 19, 2011 / 2:16 PM / 8 years ago

DEALTALK-European CMBS revival hurt by X-Note row

(For more Reuters DEALTALKS, click )

* CMBS investors angered by banks’ X-Note profits

* Industry to rethink role of X-Notes going forward

* Banks to ‘push back’ at investors’ X-Note demands

* X-Note row could be blocking muted CMBS issuance

By Andrew Macdonald

LONDON, Aug 19 (Reuters) - Europe’s muted commercial property debt securitisation market will not return to a multi-billion pounds business until a row is settled over controversial X-Notes, a bond used by issuing banks to protect their slice of profits.

“X-Notes are one of the biggest issues facing European CMBS, because (when the underlying loans fail) investors see the bank that issued the transaction still making a fortune, they’re actually quite hacked off,” one source told Reuters.

In the guarded world of securitised debt, few players speak publicly about X-Notes, usually held by issuing banks, such as ABN, Barclays , Citigroup, Credit Suisse, Deutsche Bank (DBKGn.DE), Goldman Sachs , Eurohypo, Merrill Lynch, JP Morgan, Morgan Stanley , and Societe Generale

In the heady economic times pre-2008 there was little noise about this type of bond, but the global financial meltdown saw property prices fall and business fail. Problems arose when loans in a CMBS started to fail, or defaulted.

CMBS are bonds backed by commercial property loans, which are held in a tax-efficient trust. Interest received by the trust is paid out to bondholders. The residue is covered by an X-Note and usually paid to its holder, most often the issuing bank, ahead of most other bondholders.

“Why should the issuer be receiving this excess spread (X-Note) when the loan has gone completely bad? It’s offensive,” a second source, a CMBS investor, told Reuters. “That’s where the crux of the issue really lies,” he said.

So far in 2011, $1.1 billion worth of European CMBS have been issued, markedly down on $5.6 billion issued in 2010, $21.5 billion in 2009, and $9.6 billion in 2008. The market peaked at 78.4 billion in 2006, CRE Finance Council data showed.

More deals are unlikely in 2011, leaving Europe’s debt-starved property industry hungry for new funding sources as it struggles to recover from its worst downturn in decades. One CMBS special servicer doubted a recovery until 2017.

“There’s desire for a decent (investment) return in this market, and if CMBS can offer that return they (banks and investors) will come to an agreement on X-Notes,” the second source said on condition of anonymity.

“Banks are always going to push back as much as possible to avoid having to relinquish anything,” he said.


As it stands, a CMBS issuance source said, both banks and investors had polarised views on the future of X-Notes, which was linked to their differing commercial imperatives and only aggravated by the commercial property market’s collapse.

“I think you have to accept that this is a necessary evil, and at the same time a storm in a teacup. Part of the problem is there is a lot of guys who have a lot to say about it, but don’t understand all the issues,” a CMBS special servicer said.

Three sources said some disgruntled investors holding bonds subordinate to X-Notes in failed CMBS loans had unsuccessfully asked banks to rethink their contractual X-Note entitlements.

“Banks can get away with a few (X-Note) tweaks here and there ... until someone says ‘This is never going to work unless you change, and nobody else out there is going to buy this (X-Note) stuff’,” the CMBS special servicer said.

The CRE Finance Council, noting the effects of securitised loan defaults on interest payments to CMBS bondholders, has set up a working group to identify best-practise guidelines for the future use of X-Notes.

Deutsche Bank’s 302 million pounds Chiswick Park CMBS in 2011 was arguably a sign banks could be swayed by investors. It agreed X-Notes in the CMBS would be subordinated to other bondholders if the underlying loan defaulted.

Other options for X-Note tweaks included investors being able to buy them, as in the United States. Other ideas included placing X-Notes at the bottom of the payments waterfall, or apportioning slices of them to each underlying bond class.

Yet another option was using value breaks, which meant that if a CMBS’ property loan-to-value rose, an issuing bank would have to place a corresponding percentage of its X-Note returns in to a reserve account for use within the securitisation.

“At day’s end you’ve got to incentivise issuing banks to issue CMBS in the first place,” the special servicer said. (Editing by David Cowell)

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