What Is a Defeasance Process?
The defeasance process is a means by which borrowers can get out of a mortgage by substituting a portfolio of U.S. Treasury-backed securities for collateral. These securities must be of sufficient value to generate enough cash flow to cover the remaining principal and interest owed on the loan.
In the case of defeasance, the debt obligation does not go away, but the defeasance releases the mortgaged property from the lien against it. Thus, the borrower may refinance or sell the piece of real estate under the defeasance.
Defeasance generally requires that the borrower obtain legal and financial services from specialists well versed in the defeasance process. These will include a broker-dealer. This is because defeasance requires the creation of newly-formed entities, such as a successor borrower. With the help of knowledgeable specialists, a borrower can generally complete the defeasance process in just over 30 days. The number of parties involved and the cost of defeasance varies, as laws governing the process are different from state to state.
- Defeasance is a provision in a contract that voids a bond or loan appearing on a balance sheet when the borrower sets aside cash or bonds sufficient enough to service the debt.
- The defeasance process allows the outstanding debt and the cash reserve to offset each other on the balance sheet and, therefore do not need to be recorded.
- Defeased securities tend to carry lower yields than comparable securities because the fund backing it as collateral reduces credit risk.
Understanding the Defeasance Process
The defeasance process helps to guarantee investors in mortgage-backed securities the cash flow that they expected when purchasing these securities. If, for example, a borrower comes into a large amount of money and decides to pay off their mortgage in one lump sum, well ahead of their mortgage’s maturity, investors on the other end will not receive the interest payments they expected as cash flow.
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 their obligations to their bondholders. However, defeasance became popular in the world of real estate financing when securitized lending took off.
Conditions for Defeasance
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. These rules specify conditions that must be met for a borrower to qualify for defeasance.
The first rule prohibits defeasance if the mortgage is less than two years old. The rules define the day the loan was securitized as the beginning of the two years, rather than the day that 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 must be government securities, as these are considered to contain the lowest risk for investors. Finally, the mortgage against the property may only be released in order to facilitate property disposition such as selling or refinancing.