DEFEATING DEFEASANCE PREPAYMENT PENTALTIES

But defeasance is different. Rather than pay a set penalty, the amount due is tied to the market. And today's market is not favorable to someone with a mortgage made nine years ago when interest rates were about six or seven percent. "Defeasance is pretty much the worst possible prepayment penalty that a co-op can have," says Gregg Winter, president of Winter & Company, a commercial mortgage brokerage firm.

How It Works

Although defeasance is not common, many co-ops with loans made about 10 years ago through the National Cooperative Bank (NCB) have defeasance requirements. In order to pay off such a loan, the borrower must replace the principal and all the remaining interest due with a bundle of Treasury bills. But Treasuries are trading at a very low rate. So, a building that owes two years on a $10 million interest-only loan with a rate of six percent is going to have to buy Treasuries that are trading at just 0.25 percent. In this case, the co-op would be left owing $1.15 million on top of the $10 million principal, or a total of $11.15 million.

The process is also time-consuming. Paying off, or "defeasing," a loan takes about 30 to 45 days and involves a full three-day closing process, which means paying a group of experts – an attorney, an accountant, and a defeasance consultant — for three day' work. "It's painful," said John Ahern, a vice president at Commercial Defeasance, a company that, for a fee, helps handles such transactions for co-op boards. "Our job is to make it not painful."

Why Banks Invented It

Defeasance began showing up in co-op mortgages during the heady days of the real estate boom. As investment banks got into the co-op mortgage business, they began bundling the loans and securitizing them to resell to investors, just as they did with loans for single-family housing, college tuition, and municipal projects.

In order to make co-op mortgages a safe bet for investors, they added yield maintenance or defeasance clauses so the investors would be guaranteed a full return on the loan including all the interest, regardless of whether the borrower sold or refinanced the property. In turn, banks offered co-ops lower interest rates than they would have gotten for a mortgage with a less risky penalty. In a different market, where treasuries were trading at a rate closer to the interest rate on the loan, a borrower could break even or even make money off the deal.

"Everybody thinks they got a bad deal, but in reality at the time they got a great deal, but rates have gone so crazy the other way that people feel that they got ripped off," says Thomas Schissler, who sources and originates co-op loans as managing director of Wells Fargo Multifamily Capital.

For co-ops that opted for defeasance, many boards didn't fully understand what they were getting into. "At the time we negotiated the original mortgage nine years ago, this stuff was all there," recalls Racht. "But the reality of it is nobody understood. They didn't really have a handle on it, and frankly none of us had actually gone through one before."

In some cases, the penalty has been disastrous. When a New York City co-op went to refinance its $16 million, 30-year mortgage with a defeasance clause, the building got hit with a $6.5 million prepayment penalty because it still had 20 years left on the mortgage.

The building needed to replace its heating system, a capital improvement that was going to cost $14 million. The board couldn't afford to wait until the mortgage matured, but it also couldn't afford the $6.5 million penalty. So the residents turned up in front of the bank's Manhattan headquarters and staged a protest, forcing the bank to lower the penalty to $4.5 million, which was bundled into a new $40 million loan.

Defeasance "is an incredible windfall for the banks," says James Samson, a partner in Samson, Fink & Dubow and a real estate attorney who represented the co-op.

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