In a defeasance, if a borrower makes a relevant payment to the lender to invest in a portfolio of Treasury securities, and generate cash flows to investors… what benefit does this serve? Reducing prepayment risk and decreasing credit risk (since Treasuries are default-free securities)?
been sometime since I read / reviewed this… isn’t it something related to “external credit enhancements” on Commercial MBS?
Yup. Defeasance is actually related to the loan-level (or call-level) protection to Commercial MBSs when a borrower intends to make prepayments and provides sufficient cash to the lender to invest in a portfolio of Treasury securities such that the portfolio generates sufficient cash flows for the CMBS investors.
yea i know this is a form of prepayment penalty but i also never understand the purpose, as the lender can just take the money from the borrower and do as he pleases with it…what is the point of having the borrower put it into T-bills when the lender can do it himself—he’s getting the money back one way or another so not seeing how its a prepayment penalty
The amt you need to supply for a defeasance is the principle + Interest portion discounted at the t-bill rate. if you were to pay off a loan without a prepay penalty it would just be the principle you would need to pay off. stating this another way: To repay a loan without a prepay penatly = principle on loan To repay a loan with a defeasance prepay penalty = principle + int that would have accrued under normal payment/1+t-bill rate
Cash is less valuable to an investor , but it is a great credit risk protection . The lender can ( or should ) post the money into AAA or US Gov Securities to offset the risk . Also he would pay any gains in that investment to the borrower . This is a kind of collateral and it wouldn’t cover the entire amount of the loan obviously , just a sufficient amount to enhance the credit. This is commonly done in Securities lending , where securities are borrowed and collateral is posted to the extent of 50% of the value of the security. Borrowing + agency costs are payments to the lender , but for the posted collateral the lender actually pays the borrower back the interest accrued on the colateral
ninja youre right. i remember this now. the question then is, why would the borrower prepay? this seems like the most punitive type of prepayment penalty and it seems like he is in every case better off not prepaying so that he can make only principal payments. i guess there may be certain exceptions, for exmaple needing to get your debt ratio down for reg capital/rating purposes.
caught this question earlier today. its on the same topic as this thread so thought id post. lthe answer makes clear what defeasance is, although it is unclear to me why it is the strongest form of prepayement protection, because it seems like yield maintenance charge is the most punitive. does anyone have an idea? The strongest form of prepayment protection is: A) defeasance. B) yield maintenance charges. C) a one year prepayment lockout. Your answer: B was incorrect. The correct answer was A) defeasance. Defeasance occurs when prepayment loan proceeds received by the loan servicer are invested in U.S. Treasury securities. When the defeasance period ends, the U.S. Treasuries are liquidated and the proceeds are used to repay the mortgage. The collateral provided by the U.S. Treasuries is of higher quality than the underlying asset; therefore, defeasance represents the greatest level of prepayment protection for an investor.
Defeasance gives a higher quality asset to the loan servicer than the underlying asset (real estate, etc) with no credit risk of U.S. Treasury securities. Correct me if I am wrong.
Defeasance is a type of call protection for CMBS securities. There are several advantages to this, first as eighty said, because you’re investing in treasury securities you are increasing the credit of the pool of mortgages. Second, unlike the other call protection provisions, there is no distribution made to the bondholders when defeasance takes place. So, since there are no penalties, there is no issue as to how any penalties paid by the borrower are to be distributed amongst the bondholders in the CMBS structure.
How is defeasance call protection? I think it is credit risk enahnceent , not call protection. Call protection would be in the indenture to the securities , setting some minimum time before the issuer can make pre-payments . Defeasance is default related risk mitigation
Go check out the CFAI book. Says word for word. Call protection because it protects the bondholders from prepayments. It’s actually one of the main features that causes CMBS to trade more like a corporate bond security then a residential mortgage loan.
Thanks JP , I understand now.
It seems clear now that the use of defeasance is the strongest form of prepayment prepayment protection because it is the only one (out of prepayment lockout, defeasance, prepayment penalty points, and yield maintenance charges) that does not result in any payment being made to the CMBS tranches.
CFAI book rated prepayment lock out and defeasance as the top 2 protections for CMBS