Lending Advice
by Mark Levine
Q. Why do lenders have prepayment penalties? Don’t they want their principal to be paid back? Are all prepayment penalties essentially the same or do concepts such as defeasance, yield maintenance and fixed penalties differ from each other?
A. If you are living in a box in the middle of nowhere and have no connection to the outside world whatsoever, you probably do not need to care about loan prepayments. Actually, you’d need to fully own that box and the underlying land in order to not care. Everyone else, I would argue, should care about mortgage prepayments.
You might protest that people who only rent their houses or apartments have no reason to care about prepayments. Or you might say that companies who own their corporate office spaces are not affected. But, ironically, while these people do not directly involve themselves with prepays, they are often the most affected. The explanation is complex and is worthy of its own column. However, the simple answer is that mortgage prepayment activity has a very pronounced effect on mortgage and interest rates throughout the world. As you all know, interest rates and borrowing costs have a significant and direct impact on real-estate prices globally, regardless of whether or not the specific real estate is encumbered by debt. Completing the circle, prices of real estate obviously have a direct impact on rental rates at both residential and commercial levels.
Now that we understand that there is a connection between mortgage prepayments and our own wallets, we can discuss why there is sensitivity to prepayments. In very general terms, anyone who owns a mortgage, as an originator or investor, does not want it to be prepaid. The holder or issuer of a mortgage wrote the loan for a certain specified term and expects to receive principal back at the end of that term, no sooner and no later. More importantly, perhaps, the holder or issuer of the mortgage expects interest payments above the principal payments throughout the life of the loan until maturity.
A prepayment of the principal could cause several problems, the most notable of which is that the expected interest payments that coincided with the outstanding principal will no longer exist. Not only does this result in an unexpected lack of revenue, but it also alters the long-term financial plans upon which so many institutions—both large and small—rely.
A simple, relevant example relates to insurance companies. Nearly all of the major insurance institutions in this country issue billions of dollars of mortgages in the aggregate each year. From experience and complex statistical analysis, these institutions can accurately predict when and how much they will need to pay for various claims. Obviously, there are exceptions, such as terrorist events and certain natural disasters, but even these catastrophes are now built into these complex models.
Working many years backward from these expected payouts, insurance companies invest a certain amount of cash in fixed-income instruments (like mortgages), which will pay the companies enough interest so that they can meet their expected claims in the future. Without prepayment risk, an insurance company can easily calculate how much principal and interest it will receive at the end of the mortgage term and would be able to match this up perfectly with expected payouts. However, with the risk of principal prepayment on the mortgages, it is possible that a portion of the expected interest would never be paid; therefore the insurance company would not have adequate means to meet its anticipated claims.
Of course, in an environment where interest rates have increased since the origination of the loan, the insurance company could reinvest the cash and meet or exceed its required return through active financial management. But in a declining rate environment, such as the one we have experienced until recently, there might not be anywhere to adequately or safely reinvest the money in order to meet necessary future capital needs. Unfortunately for mortgage holders, the large majority of prepayments occur during periods of declining interest rates, since this is precisely when the borrowers are motivated to seek lower interest rates.
Looking at the big picture again, we see that there is a conflict. Lenders do not want to be prepaid. It goes without saying that borrowers want at least the flexibility to prepay. The compromise: prepayment provisions, often referred to as “prepayment penalties” by borrowers.
Before continuing, it is important to note that there are still many sources of capital that do allow for free prepayment. But just as in most aspects of the capital markets, there is a direct financial cost for this. That cost is nearly always reflected in the interest rate offered for a particular borrower or property. Certain lenders are willing to take the aforementioned risk of being prepaid and foregoing interest revenue based on receiving a higher interest rate while the principal loan is still outstanding. Without getting into specifics, a clear example of this is seen when comparing originators of commercial mortgage-backed securities (CMBS) loans versus local banks making portfolio loans.
CMBS loans tend to have the lowest interest rates for a given property, yet are perceived as having the most stringent prepayment provisions. Banks, on the other hand, tend to have relatively inexpensive and flexible prepayment options but generally charge higher interest rates. There are exceptions in all directions, of course.
Now that we have thought about why lenders want to deter prepayments or be compensated if prepayments do occur, we will conclude this discussion with brief explanations of some of the more common ways that lenders achieve these goals.
First, and perhaps simplest, are fixed or scaled prepayment charges. These are the original forms of prepayment penalties and they are relatively easy to calculate.
Sometimes they are fixed at one rate during the loan term—more commonly they are based on a sliding scale—but in either case they just represent a straight percentage of the outstanding principal balance at any given point in time. For instance, a common fixed prepayment structure on a 10-year loan is “5,4,3,2,1”: a 5% penalty (of outstanding principal) is due if the loan is prepaid in the first year; 4% is due if prepaid in the second year; 3% is due in the third year, and so on. After the fifth year, some loans would allow for free prepayment while others might remain at 1% until maturity.
The second common prepayment provision is yield maintenance. This is similar to the fixed prepayment just discussed in that it represents a certain cash premium to be paid above the principal amount when paying off one’s loan. Yield maintenance, however, requires a more complex calculation, which is performed by the provider of the loan. Essentially it requires the borrower to pay an adequate penalty so that the holder of the mortgage becomes indifferent regarding the prepayment. In other words, the penalty received by the holder of the mortgage will theoretically provide the exact same investment yield as if the institution continued to receive regular principal and interest payments from the mortgage.
The third type of prepayment provision is defeasance. This is a popular concept with CMBS loans, yet is still widely misunderstood. Instead of a straight prepayment of the loan, defeasance is a substitution of collateral using government treasuries in place of real estate. Similar to yield maintenance, the goal is to provide the mortgage holder with payments that it would have previously received from the mortgage. Also similar to yield maintenance, the cost of defeasance is highly dependent on market conditions and treasury rates at the time of the transaction. If the subject mortgage carries a relatively low rate—like nearly all mortgages originated over the past five years—it will be relatively inexpensive to purchase government treasuries that provide this same rate. The cost of defeasance will continue to decline as interest rates continue to rise, due to the inverse relationship between bond rates and prices. In fact, it is possible that future defeasance transactions will actually be accomplished at a discount rather than a premium, meaning that borrowers could essentially earn money by defeasing their loans.
Last, as always, it’s wise to keep a watchful eye on Janet Yellen, the president of the San Francisco Federal Reserve Bank and a potential frontrunner for the national Federal Reserve chair position in the post-Bush era. She is already proving to be a highly-valued contributor to Ben Bernanke’s administration, just as she was a significant contributor during the later part of Alan Greenspan’s service.
During the Federal Open Market Committee meeting on May 10th, Chairman Bernanke announced the formation of a subcommittee on communications led by a very select group: Fed Governor Donald Kohn, Minneapolis Fed President Gary Stern and Yellen. The purpose of this subcommittee is to help the FOMC Committee “frame and organize discussion” of communications-related issues. I interpret this appointment as yet another positive step in Yellen’s career and another indication that she could be heading toward a more prominent role in the nation’s political and economic landscapes. If that’s the case, we should all gain by having a local Bay Area resident represent us and our priorities on a prominent, national level.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2006 by the San Francisco Apartment Magazine. All rights reserved.