Titanic legal CMBS battle could have X-rated results

Claim for unpaid interest may have serious implications for other deals, writes Paul Yandall

Investors in the troubled Titan Europe CMBS conduit could be hit hard if the Class X noteholder succeeds in its legal action to recover payments it believes it is entitled to.

Credit Suisse Asset Management, the Class X noteholder in the deals, believes it was underpaid in four Titan Europe CMBS deals, which all suffered defaults, because of a miscalculation in the interest due to it.

It is taking what is believed to be the first action of its type by a Class X noteholder despite Credit Suisse, albeit a different part of the bank, also being the originator of the loans sold to the securitisations.

In notices to the London Stock Exchange, Credit Suisse AM said it was entitled to default interest payments from the Titan Europe 2006-1, 2006-2, 2007-2 and 2007-CT1X deals, plus interest accrued at the Class X strip rate. “Both elements, as estimated by the claimant, are significant and material sums,” said Credit Suisse AM.

The part of the claim seeking interest calculated at the Class X strip rate could have serious consequences for investors, Deutsche Bank analyst Paul Heaton says.

In research note Class X risks Significant Tail Event in the Titans, Heaton said: “The second point has the potential to be of far greater significance to noteholders outside Class X, as the Class X strip rate historically oscillated between 20-30,000%. At these rates, small sums compound very quickly.

“We think there is a risk, should the Class X succeed in both parts, of the Class X being allocated substantially all future cashflows the CMBS deals generate.”

Credit Suisse AM’s action is the latest in a series of court cases testing the legality of certain aspects of CMBS deals and the first to spotlight the role and rights of Class X.

A contentious class

While Class X is widely accepted in CMBS transactions as a means for the originator to take profit, investors have found the tranche contentious.

Georgina Squire, Rosling King
Georgina Squire, Rosling King: “not convinced” of sympathy for Class X

“The position of Class X, what priorities they have and what rights they have, is always debatable,” says Georgina Squire, partner and head of dispute resolution at law firm Rosling King. “In this case, I think the Class X noteholders are being brave. I’m not convinced, in view of the rate of interest they’re seeking, that there will be a  huge amount of sympathy for their position.”

Paul Lewis, CBRE Capital Advisors’ senior director and head of special servicing, says such disputes are rare.“We’ve been involved in deals where we’ve successfully turned off the Class X payments. In part, they’ve been  situations where the originating bank may have felt it had an obligation to the previous investors, so has waived its entitlement to interest. It’s not always the case that you get this situation in legacy CMBS deals.”

Problems can arise when the Class X is sold to hedge funds or other investors, or in this case to a different division of Credit Suisse. “The new noteholders tend to be more aggressive parties,” says Lewis. “This reinforces the need for a degree of alignment of interests between the originating bank and the other noteholders.”

CMBS 2.0 is better prepared to handle the Class X issue through better structuring and drafting, says Solveig Loretz, an independent adviser on structured finance at Solo & Partners.

“Back then it came down to bankers not thinking carefully enough and lawyers not drafting well enough. People churned out deals in 2005-06, making their payment priority structures more and more complex; nobody stepped back and thought about the implications of certain things happening.”

A hearing in the High Court in London is scheduled for February 2016.

How Class X strip rate is calculated:

l Weighted average margin on the loans, which can run into hundreds of millions of pounds/euros;

l minus permitted expenses, such as special servicing fees;

l minus the note’s weighted average cost;

l all of the above divided by the balance of the Class X note, which is typically in the tens of thousands of pounds/euros.

The top half of the equation can run into millions and the bottom half only tens of thousands, so the calculated interest rate and payment if applied can, as Credit Suisse AM puts it, indeed be “significant and material”.