If mortgage rates decline significantly, borrowers may decide to prepay the principal on their loan even if they face prepayment penalties. One way that lenders protect themselves from prepayments in such circumstances is by requiring the borrower who prepays to purchase for the lender a set of U.S. Treasury securities whose coupon payments replicate the cash flows the lender will lose as a result of the early retirement of the mortgage. This process is referred to as:

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This process is commonly known as defeasance, which involves setting aside collateral to ensure that the lender's cash flows are not adversely affected by the borrower's prepayment of the mortgage. The collateral typically takes the form of U.S. Treasury securities that produce cash flows similar to those of the retired mortgage. Yield maintenance and lockout are also methods of protecting lenders from prepayments, but they refer to different approaches. Curtailment, on the other hand, refers to the voluntary or involuntary reduction of principal payments on a loan.

If Mortgage Rates Decline Significantly, Borrowers May Decide to Prepay