Conduit loans are pooled together and placed in a trust. Lenders can then issue bonds based on these loans, and sell them on the open market.
Investors who by bonds issued against mortgages pooled in a trust receive the income from the loans included in the trust. Investors holding bonds when they reach the end of their term receive the capital represented by the bonds, just like they would if they held standard treasury, municipal or commercial bonds. Pooling conduit loans and selling bonds backed by these loans frees capital for lenders who can then make other loans backed by the capital earned from selling bonds. A problem for purchasers of conduit loan bonds occurs when mortgage holders pay off the balance of their mortgages early. This results in a reduced income for bond holders. To counter this problem, most conduit loans include a loan condition known as a defeasance, which protects bond holders against loss of income due to early payment of mortgage debt.
Defeasance And Yield Maintenance
Most conduit loans are more restrictive than standard mortgage loans because they contain a lock out period, during which time you cannot prepay the outstanding debt. These lock out periods are usually two years or three years. After this time, conduit loans will allow you to prepay your mortgage but you will sometimes have to pay a fee, typically 1 percent of the loan amount in order to do this. This is known as Yield Maintenance, as it compensates the yield of the bond for the loss or mortgage repayment income. Many conduit loans contain clauses that insist that you purchase treasury bonds of equal value to the loan you are prepaying, that can be substituted for your loan as prepayment. This means that bond investors will continue to receive income, and in fact it makes the conduit loan less risky, as your mortgage bond is replaced with a treasury bond. You might default on your mortgage payments, but the U.S. Treasury is less likely to. This requirement to replace your mortgage loan amount with Treasury bonds to the same value is known as defeasance.
Non-Recourse Loan
Usually, if you take out a single mortgage secured against a property, the lender has legal recourse to the property if you fail to make the repayments you agreed to make when you took out the loan. The lender can foreclose on the property and sell it to recover the outstanding amount of the debt. If property prices have fallen, and the sale of the property does not cover the outstanding amount of the debt, the lender can apply for a legal judgment against you for the balance of the debt. Most conduit loans are non-recourse loans, meaning that the lender can foreclose on the property that secures the loan but cannot pursue you for the difference if the sale of the property does not cover the loan. Most conduit loan agreements contain “bad-boy” clauses which allow lenders to take legal action against you if you acted fraudulently in any when taking out the conduit loan.
Attorney Requirement
Most conduit lenders have strict requirements regarding the appointment of an attorney to oversea the conduit loan process. Most expect you to appoint an attorney who is licensed in the state where the property you are purchasing is located. If you are based in New York and you want to buy a commercial property in New Jersey, you would have to appoint an attorney registered in the state of New Jersey to handle the legal aspects connected with your loan application.