The air travel transportation network is amazing. In the US alone, some 2 million passengers board more than 30,000 flights every day. Any given flight can seat us with hundreds of travelers coming from different locations and heading to various destinations. When we do finally arrive, we stand at the baggage carousel expecting our luggage to trundle by without typically giving much thought to just how remarkable it is that our bags managed to pass every screening point and make every connection in time to meet us at baggage claim. The fact that only 0.5% of all bags end up unclaimed, and that airlines are able to eventually return the majority of these bags is pretty amazing. Kudos to you, airlines.
But despite this impressive track record, there is still a fair amount of luggage that is never reunited with its owner. What happens to it all? As it turns out, Unclaimed Baggage of Scottsboro, Alabama is the only business that has been buying up used bags from airlines and reselling the contents since 1970. All of the stranded clothing, cameras, phones, tablets, sporting goods and whatever else people travel with ends up as money left on the table that, thus far, only one company has thought to claim.
While losing a bag is certainly an inconvenience, and the thought of someone else cashing in on your loss doesn’t feel great either, the reality is that the dollar amount that any traveler risks losing on any given flight is relatively small (except maybe on single-prop charter flights from Columbia). But what if the odds of leaving money on the table were high, almost guaranteed? And what if those amounts were materially significant? This is exactly the state of affairs surrounding defeasance, and we at Chatham don’t think you should ever leave your money on the table unawares.
When a loan is bundled into a securitization, investors in the securitization expect the loans they are buying into to continue to pay out till maturity. This means that, even should the borrower want to sell the underlying property or asset, prepaying these loans is often not an option. Instead, defeasance is required in order to maintain principal and interest payments till maturity of the loan. In defeasance, a borrower designates a Successor Borrower to take their place in the loan so that they can then sell the underlying property or asset. The Successor Borrower puts a basket of securities in place with a stream of coupon payments that match the remaining payments due on the loan, in essence replacing the collateral. Ideally, these securities would perfectly recreate the required cash flows, but in practice, this is rarely possible.
In building a basket of securities for a defeasance, the near-term payments are relatively easy to reproduce with short dated securities. But the further out the payments go, the more difficult it is to find securities that match up perfectly. This can necessitate receiving unbalanced payments from securities that are held over until loan payments come due. The excess coupon payments are typically held in a money market account, but what happens to the interest that this money generates?
An even greater windfall can occur when a defeased loan includes a prepayment window, as many often do. This window is relatively short, typically from 3 to 12 months before the maturity date of the loan. And while the loan is eligible for prepayment, the terms of defeasance require the security basket to cover payment through maturity. When a loan is prepaid within the prepayment window, a windfall is created from the securities meant to cover the remaining payments. This excess represents the present value of all interest payments that would otherwise have been due between prepayment and maturity. On a healthy-sized loan, this can mean big bucks, but what happens to that money?
The short answer to the question of what happens to all of this windfall is that it depends. Once upon a time, it was true that most defeasance consultants would not mention the possibility that inefficiencies could result in excess, and most borrowers didn’t know to ask. This money ends up back with the Successor Borrower who has been established to allow the original borrower to exit the loan. Since the Successor Borrower is typically set up by the consultant handling the defeasance, you can probably guess where this money goes. But when Chatham entered the defeasance game, they decided early on that they were not going play this way. We were the first defeasance consultant in the industry to not only disclose excess returns from security baskets to borrowers, but split them as well. Our belief is that every borrower deserves to know when Chatham, as Successor Borrower in their defeasance, comes into a windfall, and we continue to lead the defeasance industry in the percentage of that windfall that we return to the borrower.
Maybe you have been that unfortunate traveler who is left standing at the baggage carousel long after everyone you sat by on the flight has left with their luggage. It’s no fun; we’ve been there too, and we miss our business shirts and toothbrush, although perhaps not enough to drive to Alabama to rummage through bins and clothing racks looking for them. But missing out on amounts that can represent meaningful percentages of millions, tens of millions, or even hundreds of millions of dollars, if not more, goes beyond inconvenience. If you’re considering defeasance, talk to Chatham. We want you to know everything about what goes on from the time you hand over the reins to the Successor Borrower until the last loan payment is made.
Call 610.925.3120 or email us.