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When it comes to the nuts and bolts of commercial mortgage-backed securities (CMBS), one of the key features that will be at the very forefront of any Arranger’s mind will be the mechanism by which ‘excess spread’ (i.e., the positive difference between amounts received on the underlying loans and the liabilities of the issuer – or, in other words, profits) is not only extracted from structures in an efficient manner, but also in such a way as to maximise returns. Although this is a standard feature for CMBS, a review of recent transactions reveals a high degree of variance in extraction structures across deals.
Typically excess spread is distilled from a structure by the issuance of a Class X Note, which in essence is a class of notes that has a relatively low face value, is cash collateralised and bears a variable rate of interest which is paid (subject to certain credit events) pari passu with interest on the most senior class of notes. Indeed, the right to receive variable interest is the only tangible right attached to a Class X Note (if you ignore the standard entrenched rights relating to the note itself) 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.
Turning to the witnessed level of variance in the recent crop of deals, then in many respects a high degree of variance is inevitable given the complexities of what a Class X Note is trying to achieve and the myriad of different approaches that can be deployed by Arrangers in achieving this. Although at a basic level the Class X Note is simply structured to extract the arbitrage between interest payable under the loans and the coupon payable on the notes, the reality is that the financial engineering is complex when structurers also have to factor in the mechanics for skimming prepayment fees, default interest and deferred amounts while at the same time making allowance for the fact that its constituent components (namely, the administrative fee rate, and the weighted average interest of the underlying loans and notes) are at constant state of flux from one note payment date to another. In circumstances where the risk retention instrument comprises an issuer loan, this level of complexity and indeed variance across deals is heightened yet further.
When it comes to CMBS structures, one thing that is certain is that the market has never shied away from complexity and, accordingly, the product is no stranger to constant innovation and betterment, which although in Darwinian terms are worthy attributes, when it comes to Class X Notes a lot more prudence would be welcome. Indeed, historically Class X Notes have attracted negative press stemming from the inequitable way that these were structured in the CMBS 1.0 vintage of deals as well as the fact that they were the subject of a number of pieces of litigation that made their way to the High Court. Given this negative backdrop, the fact that Class X amounts are a significant monetary line item of any waterfall and that, after all, it is the Arranger that stands to benefit most from these instruments, then in our view if there is one structural feature of CMBS 2.0 that should be standardised across deals, the Class X Notes should surely be it.
There is credence to the view that variance in Class X structures is inevitable given that the structuring of a Class X Note is a moveable feast and accordingly ‘one size does not fit all’; however, for the greater good of the product, the standardisation of a Class X structure across deals would be a hugely positive thing for the market to achieve. Not only would such standardisation add both certainty and clarity to a historically contentious part of the structure, but it would also foster a higher level of trust and much welcome transparency for investors. While the CMBS 2.0 market moves from strength to strength, the standardisation of profit extraction should only be seen as a good thing. And who knows? The foundations of a Class X Note market could be the welcome by-product of such a development. Apart from anything else, given the volume of litigation that has graced the English courts in recent years that has specifically centred around the entitlement of Class X Noteholders and the importance of Class X to the overall economics and viability of a deal, market participants risk failing to take heed at their peril.