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Defeasing Loans and Bonds – Defeasance Clause Definition

Defeasing Loans and Bonds

DefeasingDefeasing outstanding loans or bonds is simply substituting collateral that is sufficient to meet all payments of principal and interest on the outstanding securities as they come due.

In a contract, a defeasance clause is a provision that voids a bond or loan on a balance sheet when the borrower sets aside enough cash or bonds to service the debt. Because the borrower sets aside funds to pay off the bonds, the outstanding debt and cash balance each other out.  As a result, there is no longer a need to record the original debt on the balance sheet.

In a mortgage contract, a defeasance clause indicates that the property’s title or ownership will be transferred to the borrower (mortgagor) after the lender’s payment conditions are met. However, real estate rules and terminology differ from state to state based on the type of mortgage theory used.  As a result, not all mortgage agreements will have a defeasance clause. A defeasance clause transfers title upon debt fulfillment.  Therefore, these clauses are normally used in jurisdictions where the bank retains ownership of the residence until the mortgage is paid off.

Defeasance – A Closer Look

Defeasance, in the broadest sense, is a provision that renders the agreement in which it is contained null and void. However, there are a number of conditions that must be completed.  These steps are typically required from the buyer before the seller is required to renounce his interest in the property in question. In practice, defeasance involves a borrower setting aside enough funds, usually in cash and bonds, to cover his or her connected debts. This serves to satisfy the debt and render the obligation null and unenforceable without triggering prepayment penalties. Because the sums owed and set aside are offset, they are essentially erased from the balance sheet.  Any further monitoring of the account becomes unnecessary.

The defeasance clause in a mortgage agreement gives the borrower the right to obtain the title, or deed, to the property once the debt is paid in full. Prior to that point, the financial entity sponsoring the loan holds complete ownership of the title.  This serves as security for the accompanying debt. A variety of other financed acquisitions have similar arrangements, including the majority of car loans.  When the debt is paid in full, the finance company relinquishes its interest in the property and releases it to the buyer.

In the broadest sense, defeasance is any provision that nullifies the agreement in which it is contained. 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 or her 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 are offset, they are functionally removed from the balance sheet as monitoring the accounts is generally unnecessary. 

Defeasing a Bond

Defeasing a bond after its issuance requires that the outstanding debt be collateralized by cash equivalents or risk-free securities. The funds used as collateral must be sufficient to meet all payments of principal and interest on the outstanding bonds as they become due.

In a defeasance, the issuer purchases government securities for deposit in an escrow account. The escrow account is held by a bank or trust company that serves as an escrow agent. Under the terms of an escrow agreement, the government securities are irrevocably pledged to the payment of the outstanding bonds. The government securities are in a principal amount such that the principal and interest earned are sufficient to retire the principal of and interest on the outstanding bonds as they come due. The government securities and all costs related to the defeasance are paid with funds accumulated in the various accounts established for the outstanding bonds or with other available funds. (Source: munibondadvisor.com)

Defeasing CMBS Loans

Commercial loans, unlike home mortgages, may carry high prepayment penalties.  This is due to responsibilities to bondholders who have an interest in the revenue stream that comprises the loan. In these cases, prepayment can be a concern because investors expect a particular amount of interest payments to produce revenue. Investors lose future money streams if borrowers off their debts early.  Therefore, certain bonds and loans have a prepayment penalty. Avoiding penalties while effectively completing an early payoff, the commercial property buyer can construct a portfolio with a value equivalent to the outstanding liabilities. The most prevalent securities in these portfolios are high-quality bonds with a yield that covers the loan’s interest rate. This structure allows bondholders to continue receiving payments while also allowing the borrower to effectively pay off the loan early.

Defeasing commercial mortgage-backed securities (CMBS) is possible when a borrower invests the profits of a sale or refinancing transaction in securities.  Of course, these securities must pay enough principle and interest to meet the remaining debt-service payments on the original loan. In turn, the securities replace the property that was originally pledged as collateral, and the property is free of the mortgage lien.

Despite the rebound in defeasance transactions over the past two years, defeasance remains an unfamiliar topic to many professionals in the commercial real estate and finance arenas.  Most often used in commercial real estate as the prepayment penalty on conduit/CMBS loans, defeasance is the process of releasing a commercial property from the lien of the mortgage and replacing it with a portfolio of U.S. government securities. Once a loan is defeased, the securities portfolio effectively replaces the borrower’s payment stream and makes the remaining mortgage payments on the loan, allowing the borrower to either refinance or sell the property free and clear. (Source: ccim.com)

Defeasing Municipal Bonds

Defeasing a municipal bond refers to rendering an outstanding bond issue null and void, both legally and financially. Although a defeasance is typically the result of a refunding transaction, it can also be achieved using cash rather than the issuing of bonds. In a legal sense, defeasance means that the outstanding bonds have been paid.  This relieves the issuer of any duty to pay the bonds. However, to be legally defeased, the securities chosen, as well as the parameters of how and where the securities are kept must match the standards set forth in the papers that authorized the outstanding bonds. The defeasance must be compatible with generally accepted accounting principles (GAAP) and meet the conditions of the outstanding bond agreement.  Then, the bonds will no longer be considered as debt for accounting purposes.  Also, they will not be used to calculate any statutory or constitutional debt limits.

Essentially, defeasance allows an issuer to collateralize outstanding debt with a portfolio of “risk-free government securities”, thereby instantly removing the debt from the issuer’s balance sheet. This occurs because the government securities generate the cash flow needed to pay all interest and principal on the outstanding bonds when due. Under generally accepted accounting principles, if the portfolio of securities includes only high-quality securities such as direct obligations of the United States Government, the bonds are treated as “defeased” or legally retired. (Source: munibondadvisor.com)

Defeasing a CMBS Loan – Example

Commercial mortgage-backed securities (CMBS) often prohibit mezzanine financing and true prepayment.  As a result, defeasance can be the only mechanism borrowers can use for extracting equity. Extract equity due to increased property values may outweigh the costs incurred from defeasing the loan.

For example, consider a multi-family property, which was purchased using a CMBS loan and was worth $10M.  Further, assume that the loan was 80% or $8.0M).  The same property 7 years later and in a hot market may now be worth $16M. A purchaser may buy the property subject to the existing loan if the original loan documents allow it.  However, the new buyer may be unhappy with a loan with only 50% leverage. If the loan prevents subordinate or mezzanine financing and prohibits true prepayment, then defeasance may be a solution.

The borrower would need to invest some of the profits of a sale or refinancing transaction in securities.  These securities would pay enough principle and interest to meet the remaining debt-service payments on the original loan. In turn, the securities replace the property that was originally pledged as collateral, and the real estate is free of the mortgage lien. This arrangement would allow the new buyer to obtain a loan with better leverage. However, the owner/seller has to weigh the costs of defeasing the original loan against the desire to extract equity from the property.

Creating Defeasance Accounts

Defeasance is generally a complicated process that is rarely done entirely by the borrower. Often, a team of lawyers and financial specialists is required to guarantee the portfolio is correctly formed.  Further, it must provide adequate funds required to pay down the debt. This is analogous to the liability matching strategy employed by pension fund specialists.  The future revenue stream connected with existing securities must match the future payments required.

The process of defeasance is highly coordinated and involves an array of professionals, including accountants, attorneys, brokers, consultants,  agency personnel, and trustees. Defeasance consulting firms have become a standard component to defeasance transactions, retained by borrowers to help maneuver the process and minimize costs.  (Source: ccim.com)

Up Next: What Is a Crossed Check?

Crossed CheckA crossed check with two parallel lines across it or in the upper left corner can not be cashed.  It may only be deposited in the Payee’s account.

A crossed check is one that has two parallel lines crossing it.  The lines may either be across the entire check or across the top left-hand corner. This two-line statement indicates that the check can only be deposited into a bank account. As a result, such checks cannot be cashed quickly by a bank or other credit institution.

A crossed check is one for which payment is not made at the bank’s counter. It is only credited to the payee’s bank account. A crossed check is created by drawing two transverse parallel lines across the check.  It may include the words Account Payee or Not Negotiable.  Lines are frequently drawn on the left-hand upper corner of a crossed check. In the case of a crossed check, the proceeds must be credited exclusively to the payee’s account and not to any other account. If the collecting banker credits the profits of a crossed check to another account, he or she will be exposed to a wrongful conversion of funds action and will be found negligent.

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