Today, many homeowners considering a move face the prospect of replacing their low-interest rate mortgage of perhaps 3-percent with a new mortgage with a rate over 7-percent. Earlier this year, we published an idea that would allow homeowners to finance their move by unlocking the value of their below-market rate mortgage. The article generated a flurry of comments that said it wasn’t feasible, but we have since discovered that this idea has become reality. In April, Businesswire reports that Great Lakes Credit Union (GLCU) closed the first transaction in a new program that returns tens of thousands of dollars to homeowners selling their home and defeasing their low-rate mortgage.
The technique used to release the value of a below market rate debt contract is called “defeasance” and it is not a new idea. Municipalities have used it for decades—but it is new to residential mortgage finance.
In a defeasance transaction, the borrower posts US government securities as collateral with a licensed trust or escrow agent. The government securities must generate the cashflow needed to make timely payments of interest and principal on the debt being defeased. The trust or escrow agent uses the Treasury collateral to make the required loan payments. Generally accepted accounting principles recognize financial defeasance as a legal means of debt repayment [FASB 76, APB Opinion No. 26].
When we first floated the idea of residential mortgage defeasance, we thought that it might require legislation and that it would exclusively benefit borrowers. The GLCU program discussed below shows that we were wrong on both accounts.
A hypothetical example illustrates how defeasance monetizes the value of an existing below-market rate mortgage. A household is selling a home with a below-market rate mortgage. They purchased the home 5-years ago by borrowing $500,000 using a fixed-rate mortgage with an interest rate of 3-percent. After making 60 payments, their remaining mortgage balance is $444,532. Their monthly principal and interest payments are $2,108.
To make things simple, assume that Treasury securities yield 5 percent for all maturities. With Treasury rates at 5 percent, for $360,598 it will be possible to purchase Treasury strip securities that produce exactly the cashflows needed to make the remaining 300 monthly mortgage payments of $2,108 per month on time and in full.
A standard mortgage contract has a “due-on-sale clause” that requires the borrower to pay the mortgage loan balance of $444,532 upon sale of the house. If instead, the mortgage lender allows the borrower to defease the remaining mortgage payments, the borrower would use the proceeds from their home sale to buy the aforementioned Treasury securities for $360,598 and pledge them as collateral to a qualified trust or escrow agent. The trust uses the cashflow from the pledged Treasury securities to make all 360 remaining mortgage payments. Before transactions costs, defeasance unlocks $83,934 in value ($444,532-$360,598) that can be shared between the borrower and lender.
The following graph shows the cost of a Treasury securities portfolio, measured as a percentage of the remaining mortgage balance, that is required to defease the remaining 360 monthly mortgage payments on the 30-year 3-percent fixed rate mortgage for different levels of Treasury interest rates. The calculations assume the Treasury yield curve is flat for every rate level. The graph shows that defeasance unlocks a substantial share of the remaining mortgage balance at current Treasury rates.
The GLCU program shows that, when we first proposed this idea, we missed two critical points: (1) with an acceptable mortgage marketing and financial incentive, a lender can voluntarily agree to defeasance; and (2), defeasance is already a completely legal way to discharge a borrower’s debt payment obligation if the lender agrees.
For a lender holding a mortgage loan, including a bank or credit union, a defeased mortgage remains valued at amortized cost, exactly as before. Defeasance does not create an accounting loss. The institution recognizes principal and interest payments over time as they are paid by the defeasance trust, exactly as if the homeowner continued making payments. Moreover, because the mortgage will be collateralized by risk-free government securities instead of real estate, the loan will be eligible for reduced regulatory capital treatment [12 CFR §217.37(b)(3)(iii)(B)].
In the GLCU program, the lender receives compensation for agreeing to defeasance. In practice, the monetized defeasance value—$83,934 less transactions costs in our example—will be shared between the borrower and the lender, with the exact split a matter for negotiation.
Residential mortgage defeasance is not just a theoretical idea, it is a real option for existing homeowners with below market rate mortgages held by portfolio lenders. Should banks, credit unions, and savings institutions embrace this option—an option that benefits both lenders and their customers—mortgage defeasance will help reduce the lock-in effect now plaguing the housing market.
