In a commercial mortgage-backed security, what is the concern that the bondholders have when there is a prepayment premium paid by a borrower?
What will be an ideal response?
Prepayment penalties and yield maintenance charges are referred to as prepayment premiums. When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders. In the case of loans with a yield maintenance provision, several methods are used in practice for distributing the yield maintenance charge and, depending on the method specified in a deal, not all bondholders in a CMBS may be made whole. Those less likely to be made whole will be more concerned.
Because there is a single-borrower, there is concern that the borrower can benefit by removing the best properties from the mortgage pool by prepaying the balance and selling those properties. This action would result in a deterioration of the structural protection afforded the bondholders. The objective of property release provisions is to protect the investor against such an action by the borrower.
Two examples of a property release provision are (i) a requirement that if any property is sold, the borrower must retire more than the initial mortgage balance in the pool (say, 125%) and
(ii) a sale may not take place if the DSC ratios after a proposed sale are less than prior to the sale.
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