What types of prepayment protection provisions result in a prepayment premium being paid if a borrower prepays?

Question

What will be an ideal response?

Answer 1

For residential mortgage loans, only prepayment penalty mortgages provide protection against prepayments. For commercial mortgage loans, call protection can take the following forms: prepayment lockout, defeasance, prepayment penalty points, and yield maintenance charges. The latter two result in prepayment premium being paid if a borrower prepays.

When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders. Prepayment penalty points are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance. For example, 5-4-3-2-1 is a common prepayment penalty point structure. That is, if the borrower wishes to prepay during the first year, he must pay a 5% penalty for a total of $105 rather than $100; in the second year, a 4% penalty would apply, and so on. It has been argued that the prepayment penalty points are not an effective means for discouraging refinancing. However, prepayment penalty points may be superior to yield maintenance charges in a rising rate environment. This is because prepayments do occur when rates rise. With yield maintenance, the penalty will be zero (unless there is a "yield maintenance floor" that imposes a minimum penalty). In contrast, with prepayment penalty points, there will be a penalty even in a rising rate environment.

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. The yield maintenance charge makes it uneconomical to refinance solely to get a lower mortgage rate.

The simplest and most restrictive form of yield maintenance charge ("Treasury flat yield maintenance") penalizes the borrower based on the difference between the mortgage coupon and the prevailing Treasury rate.