Defaulted CMBS Said to Trade as Report Sparks Bets on Recovery

Trading in defaulted U.K. real estate bonds has picked up after a report sparked investor speculation that a possible legal settlement would boost recovery values, according to a person familiar with the matter.

About 50 million pounds ($62 million) of senior notes from a 2006 securitization known as Fairhold have traded since mid-August, according to the person, who isn’t authorized to speak about it and asked not to be identified. The securities rarely change hands and are still priced at less than half of their face value, the person said.

Recoveries could be as high as 91 percent if the issuer reaches a favorable settlement with Lloyds Banking Group Plc and UBS Group AG over payments on a series of long-dated interest-rate and inflation swaps linked to the transaction, according to a report broker Imperial Capital LLC sent to clients. Fairhold, which is backed by ground rents from homes for the elderly in the U.K., is seeking to have the loss-making contracts ripped up and the payments nullified, claiming the derivatives were mis-sold.

“As the matter is now subject to legal action, it would be inappropriate to comment, other than to state that we do not believe the claims have merit and will be contested vigorously,” said Ian Kitts, a spokesman for Lloyds in London.

An official for Los Angeles-based Imperial declined to comment on its report and related trading. Dominik von Arx, a spokesman for UBS, also declined to comment.

Swap Losses

When the 443.5 million pounds of Fairhold notes were sold, the issuer entered into derivatives with Lloyds and UBS to hedge against future changes in interest rates and inflation, to ensure steady cash flows to the bonds and make future refinancing easier. The interest-rate swaps must be paid before any bond principal, while the inflation contracts rank equal to senior debt.

The swaps that were meant to protect noteholders ended up exposing them to huge losses when interest rates fell and long-term inflation expectations rose in the U.K. during the financial crisis, according to Fitch Ratings. The contracts now require payments of about 590 million pounds and Fairhold, with the backing of a majority of bondholders, is in a legal battle to determine how much money should be paid to the swap sellers.

Lenders in Europe’s $48 billion commercial mortgage-backed securities market frequently made buying swaps a condition of lending before the financial crisis, with the derivatives in many cases having to be repaid before the bonds.