What is 'Defeasance'
Defeasance is a provision that voids a bond or loan when the borrower sets aside cash or bonds sufficient enough to service the borrower's debt. It is also referred to as "defease." The borrower sets aside cash to pay off the bonds; therefore, the outstanding debt and cash offset each other on the balance sheet and do not need to be recorded.
BREAKING DOWN 'Defeasance'In the broadest sense, defeasance is any provision that nullifies the agreement it is contained within. The provision includes various requirements that must be met, most often by the buyer, before the seller is required to release his interest in a particular property. Defeasance entails a borrower setting aside sufficient funds, often in cash and bonds, to cover his associated debts. This functions as a way to render the debt obligation null and void without the risk of prepayment penalties. Since the amounts owed and the amounts set aside offset, they are functionally removed from balance sheets as monitoring the accounts is generally unnecessary.
Example of Defeasance
One area where defeasance is used is with commercial real estate purchases. Unlike home mortgages, commercial loans may have significant prepayment penalties due to the obligations to bondholders with a stake in the commercial mortgage-backed security (CMBS) that contains the loan.
To avoid penalties, but functionally complete an early payoff, the commercial property buyer can build a portfolio with an equal value to the remaining obligations. The most common security within these portfolios is high-quality bonds with a yield that covers the interest rate associated with the loan. This allows bondholders to continue receiving payments but the buyer to functionally pay the loan off early.
Creating Defeasance Accounts
The process of defeasance is generally considered complex and is rarely undertaken solely by the buyer. Often, a variety of lawyers and financial experts is necessary to ensure the portfolio is properly structured and supplies the fund's need to offset the debt owed.
The Defeasance Clause
As part of a mortgage agreement, the defeasance clause provides the buyer the right to secure the title, or deed, for the property once the debt is paid in full. Prior to that time, the financial institution backing the loan has all rights to the title as it functions as collateral for the associated debt.
Similar arrangements also exist with a variety of other large-scale, financed purchases. This includes most vehicle loans. Once the debt is paid in full, the financing company terminates its interest in the property and subsequently releases the property to the buyer.