The following statement was made in a special report, "Commercial Mortgage Special Report" (September 19, 2005, p. 2), by FitchRatings: "Defeasance of a loan in a CMBS transaction is a positive credit event." Explain why
What will be an ideal response?
The defeasance of a loan in a CMBS transaction is a positive credit event because it can make credit risk of a CMBS disappear. More details are given below.
Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed securities backed by mortgages on commercial rather than residential real estate. CMBS issues are usually structured as multiple tranches, similar to CMOs, rather than typical residential "pass-throughs." Many CMBSs carry less prepayment risk than other MBS types, thanks to the structure of commercial mortgages.
Commercial mortgages often contain lockout provisions after which they can be subject to defeasance, yield maintenance and prepayment penalties to protect bondholders. A defeasance in a CMBS is a provision that voids a bond or loan when the borrower sets aside cash or bonds sufficient enough to service the borrower's debt. By setting aside funds to pay off the bonds, the outstanding debt and cash offset each other on the balance sheet and do not need to be recorded.
For example, with defeasance, the borrower provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments. In structuring a CMBS, there are rules for the allocation of any prepayment penalties among the bondholders.
In addition, if there is a defeasance, the credit risk of a CMBS virtually disappears because it is then backed by U.S. Treasury securities. In fact, it is because investors like the defeasance feature for commercial mortgages used as collateral for a CMBS that defeasance has become the most popular type of prepayment protection.
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