Although prepayment rates in CMBS transactions are beginning to level off after climbing higher in 2006, Fitch Ratings said that the levels of prepayments occurring in transactions are beginning to eat away at the interest margin for the available fund cap (AFC), which is now a common feature of the junior notes in these transactions.
Interest payments on junior notes backed by an available funds cap feature won't get paid in the event of an interruption in cash flow. "Assuming there are five to six loans underlying the junior notes, if the worse ones prepay, then it's likely you won't have enough funds to cover the remaining notes," said Andy Brewer, senior director in performance analytics at Fitch. Brewer said that a number of Fitch-rated CMBS transactions that are prepaying are grappling with this issue.
"But it's really only a concern for the junior noteholders, and an element of this happening is almost self-fulfilling in a way," Brewer said. "Investors buy these notes with an available funds cap anticipating a wider margin, but when you hit the AFC, all claims to interest are extinguished." Fitch and Standard & Poor's do not rate the notes based on the timeliness of these interest payments. Moody's Investors Service, which rates the timely payment of interest, does not rate most AFC note classes.
Brewer illustrated how the agency deals with the possibility of an interest shortfall in the junior notes using the Italian CMBS transaction Taurus No. 2 S.r.l. Last month, Fitch completed a performance update on this deal. Since the last reporting period in October 2006, the Taurus transaction has had several loan prepayments. These include the full prepayments of the Leather, Little Domus and Bentra loans, and the partial prepayment of the Berenice loan. These prepayments have totaled 201.9 million ($265.3 million), and the issuer will use the proceeds to repay the notes in July 2007.
On the July 2007 payment date, the weighted average figure is expected to increase to 83 basis points from 64 basis points at closing, and if senior costs are added, the cost of funding will be close to the 90 basis point margin on the Berenice loan, Brewer said. "This means that the interest on the Class G notes may not be paid fully on future payment dates," he said. "This event will trigger the available funds cap mechanism, which reduces the Class G notes' claim on interest up to the amount of available funds." According to the available funds cap mechanism, every interest payment shortfall on Class G notes can be extinguished, and the Class G noteholders will have no further claim against the issuer. "In certain adverse prepayment scenarios, interest may remain unpaid," Brewer added. "Fitch's rating on Class G does not factor in the likelihood of interest repayment, but only the ultimate principal repayment."
In January, the largest 10 prepayments accounted for around 87% of all CMBS prepayments. Fitch raised the junior notes of Fleet Street Finance One (20% of the original pool outstanding) and Moody's upgraded Classes B, C and D of Titan 2004-1 (14% of the outstanding pool). These two deals highlight some of the potential effects of prepayments, including the available fund cap being triggered, negative selection and/or increasing concentration. Moody's has stated that the weighted average cost of capital of the remaining Titan 2004-1 notes has increased significantly, eroding excess spread and exposing Classes E and F to a possible AFC trigger.
Hans Vrensen, head of European securitization research at Barclays Capital, said that while investors risk not receiving interest on their bonds in the event of a shortfall, over the longer term, it doesn't necessarily signal a loss for them. "The interest typically accrues and will be paid at a later date, if and when sufficient funds are available from the asset pool," he said, adding that most conduit deals now have an AFC feature for the most junior classes of bonds. Conduits made up 56% of 2006 issuance, Vrensen said.
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