Stop Abusive Prepayment Penalties

When does your cooperative turn into a commercial building? The answer: whenever it applies for mortgage refinancing. Cooperative boards face this distinction every time they try to refinance and are confronted with egregious restrictions on prepayment or confiscatory prepayment penalties.

Banks have been allowed to make an artificial distinction between cooperative apartment loans and cooperative apartment building mortgages – to the detriment of the buildings – because boards have not been fully educated and the law has not protected them. To redress this serious problem, boards must begin to exercise their market power and corrective legislation should be enacted.

While loans on homes, condominium units, and cooperative apartments which are categorized as residential are all freely prepayable, usually without penalty, cooperative boards are increasingly tortured by lenders who may prohibit prepayment, extract enormous fees, and even exacerbate the difficulty and expense of the prepayment process, all without limitation.

Why this distinction? Isn’t a cooperative building mortgage really a loan on a residential property, paid by all the residents? Of course it is. In this case, the contrast between commercial and residential is a distinction without a difference. Treating cooperative shareholders as second-class citizens for purposes of refinancing a building mortgage is completely unfair and should be eliminated by statute.

Lenders eagerly take advantage of their edge. They repeatedly find new ways to profit from this phony legal distinction. Look at history. Years ago, for a five-year loan, a prepayment penalty would start out at five percent for the first year, decrease by one percent each year, and be reduced to zero at the very end. While unnecessary, the amount of the penalty was at least bearable.

Lenders subsequently switched to what is known as “yield maintenance.” The idea was that the lender, in exchange for making the loan, should be guaranteed its return even if the loan is prepaid. The risk of declining interest rates, which is the motivation for cooperatives to prepay, is thrust onto the cooperative. Through a complicated calculation, the cooperative makes an additional payment to the lender in an amount sufficient to allow the lender to reinvest the funds it receives at the interest rate in effect at the time of the prepayment so that the lender will earn the same amount of interest it would have earned if the loan hadn’t been prepaid.

Yield maintenance insures that the bigger the difference between the loan interest rate and the prevailing interest rate at the time of the refinancing, the greater the yield maintenance payment will be. This means that the very time that the cooperative wants to prepay is when the yield maintenance payment would be greatest. In order to get out of the existing loan, some cooperatives have been forced to pay hundreds of thousands – or even millions – of dollars to their lenders.

In addition to requiring yield maintenance payments, many lenders will prohibit a loan from being prepaid at all for many years. As a result, cooperatives may be forced to miss any window to refinance their mortgage, no matter how much they are willing to pay as a prepayment penalty. Sometimes the existing lender is willing to waive this provision only if the cooperative refinances with it alone. That allows the original lender to lock in more business, and although the interest rate might be reduced on a refinance, there is no compulsion on the lender to make the new rate competitive.

In New York, in the past five years, lenders have been able to introduce a new tactic called “defeasance.” This serves the function of a prepayment, although it is not actually a prepayment. With defeasance, instead of paying cash, the borrower replaces its existing mortgage loan obligation with collateral, such as U.S. Treasury securities. The idea is that after the transaction – just as with yield maintenance – the old lender is able to maintain the same level of interest payments it would have received had the defeasance transaction never occurred.
Defeasance has only been available in the past five years because, prior to 2000, it had potentially negative mortgage tax consequences. In 2000, the New York State Department of Taxation and Finance issued a ruling that resolved this issue, but which arguably made the process even more complicated than it already was.

Defeasance is extremely burdensome for the cooperative, and expensive as well. Among other things, the cooperative must usually retain experts to obtain the replacement collateral it must buy, have its counsel review and possibly prepare complicated documentation, pay to create a substitute borrowing entity, pay fees, and pay for at least one counsel’s opinion, and possibly also a separate tax opinion. The closing costs of defeasance alone could approach or even exceed the costs of the new loan closing with a new lender. One of the major advantages of defeasance for lenders is that borrowers won’t undertake it because the process intimidates them.
One wonders what lenders will think of next, and, also, when cooperatives themselves will become totally fed up with all this abuse.

The legal issues are not difficult to understand. When prepayment penalties on home mortgage loans became a problem, the New York legislature enacted Section 5-501(b) of the General Obligations Law which states, “notwithstanding any other provision of law, the unpaid balance of the loan or forbearance may be prepaid, in whole or in part, at any time. If prepayment is made on or after one year from the date the loan or forbearance is made, no penalty may be imposed.” This language specifically applies to homes of one to six families and cooperative apartments. Banks with federal charters argue it does not apply to them. However, to meet the competition, they have largely ended prepayment penalties on these loans already.

It would take only a little drafting to extend this law to cooperative apartment buildings.

This should be done immediately. There is precedent for the idea of including cooperative apartment buildings with residences, instead of with commercial buildings. For example, to require interest payments on lenders’ tax escrow deposits, General Obligations Law Section 5-601 provides: “Any mortgage investing institution which maintains an escrow account pursuant to any agreement executed in connection with a mortgage on any one to six family residence occupied by the owner or on any property owned by a cooperative apartment corporation ... shall, for each quarterly period in which such escrow account is established, credit the same with dividends or interest at a rate of not less than two per centum per year ....” (emphasis supplied)

Faced with legislation to limit their controls and unearned profits on prepayments, banks would no doubt argue that eliminating prepayment penalties would force interest rates higher and limit their ability to sell loans on the secondary market, both of which would reduce the availability of loans. Given how drastically interest rates have moved in recent years, however, they should be made to prove that this assertion is true. Right now, individual home loans have had low interest rates and are frequently resold on the secondary market. The lack of an abusive prepayment penalty hasn’t seemed to hurt much.

Furthermore, amending the statute to protect cooperative apartment corporations would not diminish loans; lenders would continue to fall all over each other to make loans in a favorable interest rate climate. Competition among lenders would actually increase if every cooperative building mortgage loan could be prepaid at any time.

The fact is, cooperative building mortgages are attractive to lenders because they are among the safest loans. One reason is that the amount loaned is usually a very small percentage of the value of the building. “Loan-to-value ratios,” as they are called, are normally tiny for cooperatives when compared with loans to true commercial borrowers, and the incentive on the cooperative to avoid default is huge. Although shareholders are not personally liable for these mortgage loans, the failure to repay them means the loss of ownership of each shareholder’s residence. In addition, if a shareholder has his own cooperative loan, the failure of the co-op to pay the building mortgage will not wipe out his own obligation to pay off his apartment loan. Each shareholder will be personally liable to repay the co-op loan even though he has lost his home ownership.

Cooperatives should be aware that their usual leadership in this field might not be willing to fight hard to help them on this issue. Many of their attorneys, agents, and experts have some relationship with banks, so it would be awkward for them to support legislation. It would take grass roots pressure on the legislature to get anything done, and this would require voluminous complaints directly by boards and shareholders in letters to their state senators and assemblymen.

In the meantime, cooperative boards should not assume all lenders are equally rapacious in their demands for prepayment penalties. In screening potential lenders, they should carefully evaluate what they will be faced with even before paying to make a loan application. In practice, avoiding an abusive prepayment penalty may be a more important factor than obtaining a slightly lower interest rate.