CMBS Defeasance and Prepayment Lockouts

Residential mortgage borrowers can usually refinance whenever rates drop. Commercial mortgage-backed securities (CMBS) investors bought bonds priced on the assumption that the underlying loans would keep paying a fixed coupon for years, so CMBS loans are built to make early payoff hard. Two tools do this: a lockout period, during which prepayment is simply prohibited, and defeasance, which lets the borrower exit early only by handing the trust a replacement income stream that is just as safe and just as predictable.

How defeasance actually works

Suppose a borrower wants to sell a building five years before its CMBS loan matures. Instead of simply repaying the loan, the borrower buys a portfolio of Treasury (or agency) securities whose coupon and maturity payments exactly match the loan's remaining scheduled payments, dollar for dollar and date for date. That portfolio is pledged to the trust in place of the mortgage; a special-purpose entity takes over as the "borrower" of record; and the original real estate is released, free to be sold or refinanced by the actual owner.

Because Treasuries yield less than the mortgage rate, assembling this replacement portfolio typically costs more than the loan's outstanding balance — that gap is the real cost of exiting early, and it usually grows as rates fall (cheaper Treasuries mean a bigger portfolio is needed) and shrinks as rates rise. This is the opposite of a simple prepayment penalty, and it is why defeasance activity tends to spike when rates have dropped sharply since the loan was originated.