Defeasance

Defeasance is the substitution of collateralized property with bonds. A borrower submits bonds, and cash, to release property or land. In such a predicament, bonds and cash are removed from the balance sheet. The provision comes in handy when a borrower wishes to sell mortgage collateral.

It is common in real estate and widely used in other financial transactions. The borrower has to ensure that submitted securities adequately equate to the cash flow generated from the entire loan; this includes both the principal and interest. Substituting property with bonds is a complex and time-consuming process, but in the end, it benefits both parties.

• Defeasance is when a borrower substitutes mortgage collateral by submitting sufficient funds and bonds. Borrowers substitute assets when they wish to pay off loans early or to sell the mortgaged property.
• Defeasance bonds are usually US treasury bills. Lenders prefer US bonds because they are backed by the US government and are considered risk-free.
• For lenders, real estate defeasance is a steady income stream as it replaces the collateral with a portfolio of US bonds.
• Most mortgage transactions include a defeasance clause. The clause states: once all the payments and legal terms are satisfied, the property title is transferred from the lender to the borrower.

Defeasance, at its core, is simply a form of prepayment. It is a mortgage arrangement between a lender and a borrower; a little complex but beneficial to both parties in the long run.

The borrower submits new collateral to a lender. This collateral comprises a portfolio of securities—treasury bonds, treasury bills, and treasury notes. This collateral (securities) becomes a regular income stream for the lender. In return, the lender removes the lien from the collateral (land or property). Typically, lenders prefer US bonds—they are backed by the US government—considered risk-free.

The defeasance definition points out a provision—a borrower can free up land or property by exchanging it with bonds and securities. Once the securities portfolio is submitted, the property is free; it is no longer stuck as collateral. Defeasance should not be confused with similar provisions like yield maintenance, where borrowers make actual payments to release collateralized property.

Typically, lenders are not eager to close loan obligations too soon—they will lose earnings from the interest that way. But in many day-to-day scenarios, borrowers need to use the collateralized property. For example, if a borrower wants to sell a property that is submitted as collateral, they can apply for defeasance. Once the property is released, they can sell it immediately. Also, the loan interest is a liability for the borrower, closing early could be a suitable option.

The borrower must ensure that securities and liquid cash, balance the collateral adequately. Also, the process involves multiple clauses, obligations, and fees. The fee is expensive. Some lenders accept other securities as well (non-US bonds). 

For all future transactions, the real estate market refers to the transfer of ownership title. The title is released to the borrower when they clear all liabilities and legal terms.

Let us look at a defeasance example to understand the application of this arrangement.

Caleb is a mortgage lender. He works alone and deals in real estate. Paul is a potential client—he wants to purchase a house. Paul borrows a home loan from Caleb. Therefore, the loan agreement mentions Caleb as the lender, and Paul as the borrower. Both parties sign the terms and conditions.

Within a few months, Paul visits Caleb and requests him to accept a repayment—in the form of securities, and bonds. Caleb agrees to the request. Once the formalities are completed Paul has complete ownership of the property. Meanwhile, Caleb receives regular premiums from the portfolio of bonds.

The income from the securities is equivalent to the profit generated from the original collateral. Further, Paul is free to sell his house. Most borrowers close mortgages for the purpose of selling the property.

Now, let us look at defeasance vs yield maintenance vs prepayment comparisons to distinguish between the terms.

• Defeasance is only the substitute for the collateral, whereas yield maintenance is an actual payment. In contrast, prepayment is a penalty imposed on a borrower for repaying too soon (before the completion of loan tenure).
• When borrowers substitute bonds for property, they are required to pay a heft fee. In contrast, yield maintenance is a simple process with no hidden charge. Prepayment is a hefty penalty, discouraging more borrowers from repaying too early. 
• The defeasance process takes 30 days or more. Yield maintenance is significantly quicker.
• Substituting bonds with property is a release process. In contrast, both yield maintenance and prepayment are pay-off processes.
• In the case of prepayment or yield maintenance, the loan terminates. In contrast, bond portfolios act as continuous repayments.
• Defeasance has a lockout period of 24 to 36 months. In contrast, prepayment and yield maintenance are available without lockout periods.

This article has been a guide to Defeasance and its definition. We explain it with an example and compare it with yield maintenance and prepayment. You can learn more about it, from the following articles -

• Tax Equivalent Yield
• Income Approach
• Preservation of Capital