Why would someone choose defeasance over paying pre-payment penalty directly?
Is it bc through defeasance (purchased securities to pay back interest difference) you can use leverage and borrow money to purchase those securities whereas by paying the pre-payment penalty you cannot use leverage to pay back?
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To note, I've only been on the "borrower" side of the world, and did debt placement type work a long time, so... I may be out of date with current practice... but..
I always thought that some would only use defeasance because they had to, meaning the loan was not pre-payable otherwise. Not all commercial loans have a "pre-payment option" until several years into the loan, thus only a defeasance can work (i.e. a collateral swap that replicates the payment steam of the mortgage). If you could just pay a "penalty" and walk away, I think you would do that unless the defeasance was a cheaper option (which I really doubt it would be).
I agree - defeasance and yield maintenance (YM) are types of prepay penalties, which typically follow a lock out for fixed rate loans. Defeasance is much more punitive to the borrower than YM (which usually is typically some sort of fixed or descending penalty scale), which is why choosing YM will typically come with some sort of extra up front fee. I can't think of any situation in which defeasance would be advantageous to YM, unless you are trying to pay off a loan with only a few months of remaining term.
If your only other option was a lockout than you would really only want to do the collateral swap if interest rates happened to significantly rise (these days it would have to rise 200-300bps+). Then, if I understand your question, you are asking if you can leverage your swapped collateral? I'm not sure if the lender would allow that as collateral is typically treasuries and leveraging treasuries would be subject to significant interest rate/spread risk.
My only addition is that while many refer to Yield Maintenance as a penalty, in fact it is a contracted fee. The provision was litigated by AIG back in 2007 and they ultimately won. In fact the court found “nothing to "convince" it that the prepayment provision was a disguised penalty.” “In reversing the district court, the Seventh Circuit began by noting that "prepayment clauses are nothing new." The court framed the question before it as whether an Illinois court would consider the prepayment provision in the note a penalty that is unenforceable or a contract for alternative performance.”
Where as a penalty may not be obligated to be paid by a borrower, but contracted fee is. So just a pet peeve of mine when people call YM a penalty BUT also something that could be used against a lender if they refer to the fee as a penalty, and borrower then argues that the lender says it’s a penalty and the penalty is unreasonable. So always best to refer it to a fee.
Sorry for side bar discussion and not truly on point of the OP.
https://www.duanemorris.com/articles/article2735.html
I may be wrong, but I thought on most loans the prepayment penalty is only an option in the final 1 or 2 years of the term, and if you prepay earlier you have to use defeasance. So its not really a question of which is preferable (prepayment is more preferable), its more about how long into the term you are looking to prepay.
Defeasance may not be an option. Lender can still restrict the period of time a loan can be defeased that can match or be different than the open period allowing the loan to be paidoff.
Generally defeasance is a requirement to pre-pay CMBS loans; there is not another "option" to choose from. This is because the loans have been packaged, sliced up and sold to investors that guaranty monthly payments. Defeasance is the mechanism that allows the bond holders to continue to receive those monthly payments.
I am unfamilair with any scenario in which you could choose to defease or "pay pre-payment penalty direct." Not really sure what you're asking.
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