Why do floating rate loans have more forgiving prepayment penalties? Understanding the mechanics behind securitization...

Question

Most fixed rate loans have some sort of Yield Maintenance or Defeasance to make up for the yield promised during the securitization process. Why isn't the same held for floating rate loans?

CRESEA · Accepted Answer

I think that everyone brought up most of the points. The one thing that no one brought up is the difference in fee structures. On floating rate side, there are often points up front, points at exit and sometimes minimum interest. On the fixed rate side, the majority of the fees are baked into the deal to be repaid over the term of the loan. The idea on floating rate side is that even if the borrower repays the loan after 1 month, they would have paid a large amount of money in fees so that the lender is compensated for their work in originating the loan and they come out with a small profit.

Hölder · Answer

They would care because if it is prepaid then this is likely because interest rates went down so now the bank lost a high interest loan and it must now invest and rush into finding new investments that will inevitably pay a lower rate. Even if it isn't the case that the borrower paid early due to a lower interest rate being available, it is still the case that the bank lost safe cashflow that it was just sitting on and must now invest into replacing that loan with new ones.

Dupont29 · Answer

I think the answer here is that floating rate debt providers (banks and debt funds) primarily focus on transitional assets with a clear-cut business plan that gets them out of the loan in a relatively short amount of time.  The sources of capital are deposits for banks and equity / warehouse lines for debt funds meaning both of these liabilities are pegged to floating rates.  Floating rate deals allow the banks to earn a spread or profit over a floating-rate index (their liabilities) .

emceedrive · Answer

I think your securitization point is interesting, I think it really boils down to this:

Fixed-rate loans are for stable assets/sponsors in an environment where billions of dollars are chasing the same, low risk deals. The primary goal isn't being pre-occupied about getting paid back, the primary goal is to keep your money out for as long as possible. Hence, you'll often see minimum multiples in addition to whatever YM/Defeasance stips.
Floaters are (generally) for value-add plays that rely on the successful execution of the business plan.

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Why do floating rate loans have more forgiving prepayment penalties? Understanding the mechanics behind securitization...

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