Exam Review - Question 2 Question ID#: 88168 T-Table F-Table 5% F-Table 2.5% Chi-Table Durbin-Watson Z-Table Z-Table Alt -------------------------------------------------------------------------------- The strongest form of prepayment protection is: A) yield maintenance charges. B) defeasance. C) a one year prepayment lockout. Your answer: A was incorrect. The correct answer was B) defeasance. Defeasance occurs when prepayment loan proceeds received by the loan servicer are invested in U.S. Treasury securities. When the defeasance period ends, the U.S. Treasuries are liquidated and the proceeds are used to repay the mortgage. The collateral provided by the U.S. Treasuries is of higher quality than the underlying asset; therefore, defeasance represents the greatest level of prepayment protection for an investor. I really thought the answer was A because the whole point of a yield maintenance charge is to “make the lender whole” so he gets the whole interest payment he would have received had there been no call–so what could be better? Can anyone please explain what a defeasance actually means in simple terms and why it is better than yield maintenance charge? Also, can anyone address why a borrower would ever call if there was a yield maintenance charge–he’s got to pay off the amount of the lost interest anyway so it seems pointless to call.
if somebody makes a prepayment, that money will be invested in treasuries which provide you return from that.
isnt it better to be “made whole” with the yield maintenance charge (i.e. get more money than the simple prepayment amount) then invest in treasuries on your own
order of prepayment protection: Prepayment Lockout Defeasance Prepayment penalty points Yield maintenance charges Not sure that Schweser is right on this one, though. Book (CFAI) pg. 374 Book 5 definitely says the following: “Prepayment Lockout and defeasance are the two strongest forms of prepayment protection.” so definitely not sure where Schweser is coming from on this question.
CPK123, you inspire me you are the JoeyDVivre of the L2 board actually, no, that’s not nice to compare you like that, you’re in a class of your own
CPK, you are definitely a valuable asset to this board and I think sublimity would like an order of fresh grundle if you have any to spare.
I believe the reason the correct answer is “Defeasance” is because of the “one-year” prepayment lockout. After one year, people can start to prepay while the defeasance will continue.
nice catch jdane - The ans is indeed not C because of that 1 year phrase in the option choice, after 1 year they could really start dumping their payments back to the issuer.