Understanding Defeasance

CFA Level I Fixed Income
#1

So let’s say I am a borrower. I pay 6% interest on the mortgage I have on my commercial property. I decide to repay my loan balance say $100.

But because of defeasance provision I have to “provide sufficient funds for the servicer to invest in a portfolio of government securities to replicate the cash flows that would exist in the absence of prepayment.”

But then these government securities will pay a lower rate than the mortgage, say 2%? So that means that in order for the cash flows to be the same, I would have to provide $300 so that again $6 is the same cash flow.

Is that more or less the process? I am a bit confused.

What is the benefit to prepaying for the borrower in this case? As in the first case (no prepayment) he is paying 6% while in the prepayment case he has to give up $300 so that $6 interest is generated.

#2

You are only considering interest. Your example defeasance portfolio pays too much principal at the maturity date. Being short a zero-coupon for $200 at maturity would recoup a fair amount of the $300 spent, but it is fully expected that the value of the defeasance portfolio is going to be considerably higher than the loan amount, due to the difference in risk.