Payment formula to Bank of America Merrill Lynch ignores investors’ wish for subordination
The first new CMBS to be issued this year, Taurus 2013 GMF1, includes a couple of noteworthy features: detachable A coupons (DACs) and prepayment fees that go to bondholders.
DACs are notes that are used to reward the arranger, Bank of America Merrill Lynch. The US bank structured the CMBS to refinance €1.04bn of debt on a big portfolio of Gagfah’s German housing.
Pre-crisis, CMBSs used Class X notes, a formula that attracted considerable controversy when CMBS issues ran into trouble after the financial crisis.
Taurus 2013 is tranched into five classes of bonds and a slug of DACs. (See table). These notes pay BAML interest of 1% fixed on a notional principal, equivalent to Class A’s. “It’s Class X, but with some slight differences,” said a market source.
There is some surprise that investors were willing to accept such relatively low spreads on an issue that includes an X-note type arrangement. At margins of 105bps for Class A to 275bps for Class D, the spreads are considerably tighter than most had expected. “I would have thought investors would have held out for a higher spread,” said a market observer.
As Real Estate Capital reported last month, a group of 15 key European CMBS bond buyers drew up a wish list of features they wanted to see in new issues: they said that X notes should be kept subordinate and paid after other noteholders. “There’s a lot of pressure to deploy capital. Investors rush in and forget all the rights that they say they need,” noted another CMBS specialist.
Frenzy for German multi-family housing
Taurus 2013 provoked a feeding frenzy among investors. The €1.07bn CMBS issue, which refinanced Gagfah’s WOBA portfolio of previously state-owned housing in Dresden, was two times oversubscribed. The blood lust was particularly noticeable for the higher-yielding C and D classes.
This rush for the bonds reflects fixed-income investors’ thirst for yield and enthusiasm for German multi-family housing. Buyers were 44% asset managers, 26% insurance companies or pension funds, 23% banks and 7% central banks or supranationals.
Market sources also pointed to the scarcity of new residential mortgage-backed securities as UK banks have used the government’s Funding for Lending Scheme to source cheap capital. “Investors are desperate for RMBS product and have gone for Taurus as the next best thing,” said one.
DACs have been around for some time, but more typically in residential mortgage-backed securitisations. Like Class X notes, DACs rank at the top of the interest waterfall, alongside the Class A in priority for payments. In Taurus, they pay interest for the first three years and none thereafter; they do not qualify for principal payments.
Originally, Taurus’s DACs were due to run for five years, switching off at the loan maturity in 2018 or if it ran into trouble and had to be extended or put into special servicing. BAML tweaked this structure in response to pushback from investors. The earlier, 3-year cut-off on the DACs not only reduces the total payout on the notes by about 40%, but also addresses one of the major gripes that investors had about Class X, which was that noteholders continued to collect interest regardless of loan extensions or defaults.
Like Class X notes, Taurus’s DACs are basically a method that rewards arrangers for their work in structuring the CMBS with income which is spread out over time. And, because of accounting vagaries, arrangers can treat the stream of payments as though it were a lump sum, booking the net present value of the payments on day one.
The more novel feature of Taurus is the prepayment penalties which are passed to bondholders (see below). While these exit fees are not unusual in themselves, in pre-crisis CMBS arrangers kept them; it was rare for bondholders to get anything. This gives fixed income investors the comfort that they will not lose out if all or part of the loan principal is repaid early.