Would you please help me to understand this concept using an example? The texts from the curriculum seem difficult for me without an example.
Thanks in Advance
I’ll have a shot.
For investors in a RMBS, they are subject to prepayment risk incase the borrower prepays early. If this happens, then there are no mortgage payments, and hence no cash flows to fund coupons. We don’t want this. Some features in commercial loans stop this, for example, having a huge penalty when you prepay (because if you prepay that affects the investors in the CMBS).
So then the question becomes: how do you, the borrower, prepay early without actually prepaying? Defeasance.
You set aside enough money now so that you can service all the future payments to the loan (you would probably invest that money in high-quality debt as opposed to letting it sit in a bank account). That way, you have effectively paid off your debt early, without prepaying the loan. You have defeased the loan.
To give a very simplified example, imagine you borrow $1 million, and have to make 12 $90,000 payments each month to pay off the debt. If you prepay early, you pay a $200,000 penalty, so you don’t want that. But you want to get the loan off your balance sheet. So you set aside just enough money so you can make those 12 $90,000 coupon payments as they fall due. You wouldn’t set aside $1,080,000 however, because you can earn interest on that money (by investing in high quality debt), but you would set aside a bit less than that, and structure your investments such that you can service those 12 coupon payments without a surplus left-over.
Hope that helps.
Thanks, Huntling. You have explained it smoothly. I think the author of this reading should get a shot for not providing an example.