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?
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In a fixed rate loan it is the lender who holds all the interest rate risk. In a floating rate loan it is the borrower who holds (most) of the interest rate risk.
That still doesn't really answer my question. Do banks not securitze floating rate loans? If not, do they just sit on their balance sheet?
That exactly answers your question.....
Good question. Ill give you why i think that is but if anyone else has better/more correct answers id be all ears to that -> FLT rate deals generally come with points upfront for the lender - meaning the lender gets compensated for the deal upfront and even if it pays off quicker, you still got some fixed economics from the loan day 1. -> No need for rate hedging for floating rate loans especially if your cost of capital (e.g. borrowing costs for the loan) are linked to libor (or some other index).
Doesn't it have more to do with securitization though? Better put; if a lender originates a fixed rate loan that sits on their balance sheet, why would they care if it is prepayed or not?
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. One single borrower getting out is not that big of a deal, but you can imagine the damage that can be done if many loans are paid at the same time leaving the bank with a huge hole.
However, this all holds true regardless of securitization. I'd say securitization doesn't really have that much to do with these policies but if I'm an investor buying these securities then I would definitely demand some hedge against insterest rate movements but so does the bank anyways.
Nope. They care if its prepaid because you dont want to do all that work for 2 months of interest...you want a minimum return (ROE if you are a bank) on a loan.
I guess I'm struggling to see why a balance sheet floating rate would be any different.
In the case of LifeCo's who often have high prepayment penalties, they originate loans and base their insurance plan offerings at a congruent rate. The prepayment penalty is often times the difference between the treasury rate and the rate paid in their plans, so even if their loan is paid off, they are not coming out of pocket to service their payments on plans.
Banks are only able to compete by having no prepayment penalties, as they will not win on term/structure (regulators won't allow them to push pass certain thresholds). As they are able to move capital around more fluidly than other debt providers, prepayments present the opportunity to redeploy that capital and generate more fee income. On the back end, their trading desks will hedge against any kind of rate exposure, so no real loss that they have to account for through some form of defeasance.
So then in the case of a Freddie Mac floating vs fixed rate loan, why do the floating rate loans have a measly 1% prepay penalty whereas the fixed rate loans are YM/Defeasance?
Believe it to be what they estimate their cost of holding uncommitted capital. Not so sure how agencies look at it, but that is the general premise behind prepayment penalties.
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. On the fixed rate side, prepayment penalties are usually the highest in the first years and the lowest in the final years. Most of the reasoning is tied to interest rate risk and hedging but some of it is tied to amortizing cost over the term of the loan.
Its all about cost of capital/yield. Anytime an investment is made, whether its an acquisition of a large company, or a loan, the folks doing the analysis will model the return (cash on cash yield/IRR/ROE/equity multiple) and compare it with their cost of capital. Often that that return is measured over a period of time.
The reason why certain types of products/lenders have different rates and pre-payment structures is...well...their cost of capital. A bank needs to meet a certain ROE threshold and will price their loan accordingly. This is via rate, the corresponding call protection and upfront points. A lender could have no call protection but they may have to charge more upfront fees for it, and that may not work for the borrower.
To answer your question about Freddie Mac/Agency loans, their bonds (pre COVID) price very tight and hence their pricing can be inside that of a multifamily non-agency CMBS deal (for an average property).
I would recommend taking a course or watching a few videos on fixed income to brush up on these general bond concepts.
So staying on the Freddie/Agency topic, why would their fixed rate loans have YM/Defeasance, but their floating rate loans have a flat 1% prepayment?
Is it a matter of balance sheet vs securitization?
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) . Debt funds borrow on a floating rate basis and are return focused meaning they are looking for attractive spreads over the risk-free rate. Both of these lenders are looking to recycle capital fairly quick and they earn higher fees / returns as a result.
LIfe cos. and CMBS and other fixed rate debt providers have totally different investment objectives and the sources of their capital is seeking long-term fixed cashflow streams. As a result they implement expensive pre-pay penalties / defeasance options.
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. This means that if things don't go well operationally, the asset won't stabilize at whatever projected value was underwritten. Here, the risk of non-payment is higher, so the focus is as much on getting paid back as it is on getting your money out and winning deals. So dis-incentivizing pre-payment isn't a strong focus - you've made your money on fees and spread anyway (especially since as base rates move so does your income stream) so you want to get your capital back and keep it moving.
Also, as a rule, no one ever pays back early anyway (especially on the high lift value-add product). Its way more rare than you would think (or I did for that matter before I was in capital markets).
This plays into the point that you're speaking of when it comes to securitization - selling a bond of cash flows is easier when you can guarantee the cash flows will continue to be there.
Floating Rate Loans are typically short term - 3-5 years. Fixed Rate Loans are "Permanent" and 10-30 years or longer in some cases.
Floating Rate Loans are priced over an index (typically 30-day LIBOR) and the index readjusts monthly, while the spread holds constant. Floating Rate loans do not have strict prepayment penalties because the index adjusts monthly. There is no interest rate risk for a floating rate lender (balance sheet or securitized) when the index adjusts monthly.
Fixed Rate Loans have harsher prepayment penalties because, consider the following example: Let's say you locked your interest rate for a 10 year term/25 year Am two years ago in April of 2018. The rate quoted by the lender was the 10 year US Treasury + 200 basis points, so your interest rate at the time would have been around 4.75%. Lenders want to count on that full return for 10 years. Lenders can always find replacement for the SPREAD part of the rate in the market depending on how risk is pricing, but what they can't replace is the yield on the index rate. Today 10 year treasury bonds are trading at 75 bps. That's 200 bps in yield the Lender is foregoing by letting you prepay the principal early, so you have to pay for that delta in what they would have made over time versus what the market is now yielding for a similar deal.
That's a simple justification for why YIELD MAINTENANCE penalties are substantial for perm debt versus floating rate debt.
Defeasance is similar, but instead of paying off as a lump sum, you're paying for the service of creating a pool of bonds/other investments that will pay off to the hundreds or thousands of investors in a CMBS pool counting on that return from the debt, but the justification remains the same.
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