Understanding The Substitute Collateral Portfolio

The basic description of a conduit loan defeasance transaction- a substitution of other income-producing collateral, in the form of a portfolio of U.S. government debt securities, in exchange for the release of a mortgage lien on real estate collateral- is fairly easily understood. An understanding of how such a portfolio of substitute collateral is modeled, and how it operates to pay a defeased loan over time, requires a more detailed explanation.

This article describes the process of modeling the substitute collateral portfolio and the operation of the portfolio through the maturity of the defeased loan.

Acceptable Securities

What types of securities may be included in the substitute collateral portfolio? This is the threshold question in every defeasance transaction. While United States Treasury obligations are always acceptable defeasance collateral, debt obligations of certain other government agencies or government-sponsored entities may also be acceptable, depending upon the language used in the defeasance provisions of the loan. As these obligations typically trade at a spread over the yields of Treasury obligations with similar maturities, if agency or GSE securities are permitted by the terms of the loan, using them in the substitute collateral portfolio will reduce the cost of the defeasance.

In many cases, REFCORP bonds-bonds issued by the Resolution Funding Corporation, with interest payments guaranteed by the Treasury and principal payments backed by zero-coupon Treasury bonds-are acceptable as substitute collateral. In a much more limited number of cases, obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Bank may be acceptable. The borrower's defeasance advisor will review the defeasance provisions of the loan documents and discuss this issue with the loan servicer.

Modeling the Portfolio

Once the defeasance advisor and loan servicer have identified the range of acceptable securities, the advisor will model a portfolio of specific securities sufficient to defease the loan. Assuming a defeasance with Treasury obligations, it may include an assortment of Treasury bills, notes and bonds, as well as Treasury STRIPS-securities that consist of only an interest or principal component of an underlying Treasury bill, note or bond. All of the securities in this portfolio will mature prior to the maturity of the loan. Over time, the portfolio will gradually convert to cash-in the form of periodic interest coupon payments on the securities and principal payments as the securities mature-and this cash will be used to make all of the remaining payments of principal and interest on the loan, including the balloon payment at the loan's maturity.

The conversion of securities to cash and the cash payments on the loan will not be perfectly timed. Upon the defeasance closing, an escrow account will be created with a third party financial institution known as the "securities intermediary". The account will be in the name of the "successor borrower" that assumes the obligations of the defeasing borrower. This account will hold the securities from the defeasance portfolio and the balance of the cash proceeds from that portfolio as those proceeds are received and loan payments are disbursed.

The successor borrower, with the consent of the loan servicer, will usually direct the securities intermediary to reinvest any cash balances in the escrow account in short term money market funds until the cash is required to make a loan payment. However, the regulations governing the pools in which conduit loans are held specify that any income derived from this reinvestment may not be considered in determining whether or not the portfolio is sufficient to defease the loan. Only the anticipated proceeds from the securities may be considered in verifying the sufficiency of the defeasance portfolio. As a result, after the final loan payment is made, there will be a residual balance in the escrow account consisting of the reinvestment interest earned on the cash balance in the escrow account over the life of the defeased loan. This residual balance will revert to the successor borrower.

Assuming that all other factors are equal, the cost of the defeasance portfolio is minimized by selecting securities that provide payments as close in time as possible to the corresponding loan payments, and by keeping the balance in the escrow account between payments as low as possible. This task becomes more difficult for loans with more distant maturities.

Timing of Securities Payments

With a two-year time period from the defeasance closing date, there are numerous Treasury investment options. Standard Treasury obligations and Treasury STRIPS will mature in each month during this period, so it is possible to create a highly efficient defeasance portfolio.

After the two-year horizon, it becomes more difficult to fit securities payments closely to loan payments. Treasury obligations with terms longer than two years mature in months that are staggered throughout the calendar year, so it may not be possible to fit each monthly loan payment to a corresponding Treasury obligation maturing or paying interest around the same time. Even this is not an issue if it only arises in the context of a few regular monthly loan payments. However, if it is not possible to fit a Treasury security to the balloon payment on the loan, a substantial chunk of cash may sit in the escrow account for as long as three months.

Pitfalls

If the corresponding security is fitted badly to the balloon payment on a loan, the defeasance advisor (which is likely to be an affiliate of the successor borrower) may offer an agreement to share the reinvestment proceeds on the balloon payment with the defeasing borrower when they are received in the future. If this is properly structured, it is an acceptable way to minimize the defeasing borrower's pain. This agreement may be sold to the defeasing borrower as a way to unlock "hidden value". We suggest that borrowers considering this type of arrangement remain aware of certain facts.

Scheduled proceeds from securities in the defeasance portfolio are known quantities, and the benefit of the investment in the securities in the defeasance portfolio belongs entirely to the defeasing borrower.

A prospective participation in reinvestment income from cash balances in the escrow account is purely speculative-interest will be earned on that cash at presently unknown future money market rates. And because this is a "sharing" arrangement, the defeasing borrower will not receive all of that speculative future income.

To minimize the cost of a defeasance, the portfolio of substitute collateral should be fitted as closely as possible to the payment schedule of the loan. To do this properly, the portfolio should be remodeled up to the date that the securities are purchased. Defeasing borrowers should be wary (1) of proposals with securities tied to balloon payments that convert to cash months before the payment is due, if other proposals show that securities with better timing are available, and (2) of any offer to "freeze" a certain portfolio in order to put an interest-sharing agreement in place, as new government securities become available on a regular basis. In almost every case, if a defeasance portfolio for a loan with a maturity within two years is properly modeled, the conversion of securities to cash should be closely timed to the corresponding loan payments for the life of the loan. There should be no significant cash balances in the escrow account for extended periods of time.

Conclusion

Borrowers that are evaluating proposals for the defeasance of their loans should review the proposed defeasance portfolios carefully, taking particular note of the timing of the securities tied to the balloon payment, and the representations of the prospective defeasance advisors regarding the proposed portfolios. It is impossible to completely eliminate a floating balance in the defeasance escrow account, but an advisor that is considering the best economic interest of its client will strive to minimize it.