What Is the Defeasance Process?
The defeasance process is a means by which borrowers can substitute securities, typically bonds backed by the U.S. Treasury, for the existing collateral on their mortgage, such as a home or similar property. It can also be used in other kinds of financial transactions. The securities must be of sufficient value to generate enough cash flow to cover the remaining principal and interest owed on the loan.
This article explains how the defeasance process works with mortgages.
- In the case of mortgages, defeasance refers to the point at which the borrower will receive title to the property after making all of the required payments.
- A defeasance clause is typically found only in mortgages issued in certain states, known as “title theory” states.
- If specified in the mortgage contract, the defeasance process can also be used to substitute other collateral (such as government bonds) for the original collateral (the home or other property).
- The defeasance process can also apply in more complicated financial transactions, such as loans involving large commercial properties.
How the Defeasance Process Works
With defeasance, the debt obligation does not go away, but the defeasance process releases the mortgaged property’s title to the borrower. That allows the borrower to refinance or sell the property before the loan has been fully paid off.
Defeasance clauses are common in certain types of mortgage contracts, particularly those in states that follow what is known as title theory. In title theory states, the lender holds title to the property until the mortgage ends, at which point the property belongs to the borrower. In other states, borrowers acquire title to the property right away, but the lender holds a lien against it in case the borrower defaults on the loan.
Steps in the Defeasance Process
If your mortgage contains a defeasance clause, it should specify how to proceed. You will, of course, need to purchase the alternative collateral to use as a replacement unless you already happen to have it.
In more complicated instances (such as commercial real estate), the borrower will generally need to obtain the legal and financial services of specialists who are well-versed in the defeasance process. That’s because the defeasance will require the creation of new entities, such as a successor borrower. The number of parties involved and the cost of defeasance will vary, as laws governing the process differ from state to state. The process will normally take just over 30 days.
Defeasance and Securitized Loans
Defeasance originated in the bond market as a way to help ensure that investors would receive their expected yields in the event that the bond issuer decided to prepay its obligations to its bondholders. However, defeasance became popular in the world of real estate financing when mortgage securitization took off.
Securitized loans are generally held by entities known as real estate mortgage investment conduits (REMICs). These entities operate under a controlled list of rules set forth by the Internal Revenue Code, which specify the conditions that a borrower must meet to qualify for defeasance.
The first rule prohibits defeasance if the mortgage is less than two years old. The rules define the day when the loan was securitized as the beginning of the two years, rather than the day when the loan was closed. Some loans will specify that the loan must be even older than two years for defeasance.
The rules also state that the loan documents must explicitly permit the borrower to seek defeasance. Documents may not be amended later to allow for defeasance. The securities used as new collateral typically must be government securities, which are considered to represent the lowest risk for investors. Finally, the mortgage against the property may only be released to facilitate the disposition of the property, such as through selling or refinancing.