Yield Maintenance vs. Yield Defeasance

Banks and insurance companies have come to rely on "yield maintenance" clauses, to protect against losses when borrowers prepay to take advantage of declining interest rates. These provisions require the borrower to make a lump sum payment to cover the lender’s potential loss from reinvesting prepaid sums. Mortgage loans originated for sale through commercial mortgage backed securities (CMBS) typically only allow prepayment through defeasance. Under defeasance provisions, prepaying borrowers must provide Treasury obligations exactly matching the cash flow of all scheduled mortgage payments.

The yield maintenance concept is to assess the borrower a one-time fee sufficient to enable the investor, reinvesting at current rates, to earn what it would have earned had the borrower not prepaid. The fee equals the difference, usually discounted to present value, between the original contract rate and the current market rate multiplied by the amount of the prepayment.

In the CMBS market, defeasance allows a prepaying borrower to replace a real estate mortgage with a carefully assembled package of noncallable and nonprepayable U.S. government obligations as substitute collateral for the loan. The prepayment option is typically only available after a two year lock out period, a period of time during which prepayment is absolutely prohibited, to preserve the CMBS status as a REMIC (real estate mortgage investment conduit). We feel that defeasance is worse for borrowers than yield maintenance for three reasons.

First, the borrower is substituting a Treasury obligation for a mortgage, with no commensurate reduction in its loan obligation even though this over compensates the lender to the extent that investors favor Treasury obligations over mortgages. Second, under a yield maintenance clause, the borrower pays nothing when the original yield exceeds the current yield. Regardless of the relationship between the original contract rate and prevailing rates at the time of prepayment, the defeasing borrower always incurs the expense of purchasing Treasury obligations.

Third, the cost of organizing a defeasance is considerable. Accumulating a matching set of Treasury obligations is complicated by the fact that mortgage payments usually call for monthly amortization and Treasury obligations do not. Most prepaying mortgagors will require the services of a bond trader. Prepaying borrowers will also be charged by the rating agency for its opinion, the master servicer for its processing fees, a Certified Public Accountant’s comfort letter that the cash flow from the substituted collateral will meet all scheduled mortgage payments on time, a legal opinion that the borrower has fully complied with all defeasance requirements, and the costs of forming a special purpose entity to act as the successor borrower.

Defeasance saves the CMBS issuer struggling to devise an acceptable formula for allocating yield maintenance payments fairly among competing classes of bondholders by assuring that all the investors in the securitized pool continue receiving their payments on schedule. The cash keeps flowing but from U.S. Treasury obligations, not a mortgage, increasing the value of the investment by the amount by which investors prefer government bonds to mortgages. The only other means of assuring an uninterrupted cash flow is through a lock out, an absolute prohibition against the borrower prepaying for the life of the loan. Clearly, borrowers would prefer defeasance to a life-of-loan lockout. Further, banks and insurance companies will consider substituting defeasance for yield maintenance to preserve the option of securitizing their commercial loans.