What is Defeasance?
The borrower sets aside cash to pay the debt; thus debt and cash are balanced on the balance sheet and do not have to be recorded. A defect is a clause in a contract that invalidates a bond or loan on a balance sheet if the borrower has sufficient cash or bonds to service the debt.
For many CMBS loan arrangements, the borrower acquires an alternative security (such as a US government bond) to replace the collateral and interest income the lender loses as a result of the advances. In many cases, borrowers need to buy Treasury bonds to undertake a Defeasance, but other types of government-backed securities can also be used in this scenario.
The lender will provide the money provided that the borrower agrees to the loan terms and that the repayment terms must be met by the lender before the borrower must disclose his interest in a specific asset or property. Allows the loan document to have an independent expert or advisor buy the Defeasance bond and establish a successor debtor or institution to take over the loan upon completion. Allows the borrower to purchase a bond from a securities provider.
In this way, the lender does not suffer a loss of income because the borrower pays back his loan early. Defective accounts allow a borrower to set aside funds to repay loans by deleting the debt from their balance sheet. If the borrower has to repay what he has lost in the future in order to avoid the loss of the loan or loan, the prepayment penalty will be written off.
Borrowers can buy a portfolio of government bonds as replacement collateral to secure their debt and generate the cash flow needed to meet scheduled capital and interest payments on the remaining loan. Once the loan is repaid, the remaining bonds in the loss account are released to a successor borrower who can sell them on the market. The securities offered under the Defeasance procedure promise sufficient cash flow to pay the original commercial real estate loan and interest to the principal lender, but in the end they receive no less than if the original loan had remained intact.
When a loan is refinanced, the borrower replaces an existing collateral portfolio of US securities with US government bonds structured to reflect the debt service plan and the maturity date of the loans. The terms of the defeat require the subsequent borrower to acquire bonds in connection with the collateral and assume the borrower's obligations under the loan. If the existing borrower owns securities at the time of the pledge or releases the existing lender real estate as collateral, the new borrower assumes the new obligations to the securities through the refinancing and existing credit documents.
As is customary, a new promissory note allows original borrowers to terminate their financing by replacing the loan collateral with a distressed property or portfolio of securities. As a result the loan will remain in place, replacing a portfolio of US or Treasury securities structured such that the debt service plan matches the maturity date of the loans and offering CMBS bondholders the same future cash flow that they would have received if the loan had never been rejected. If the original loan documents refer to the purchase of the new bond, the lender may be willing to accommodate demands for such a structuring of the Defeasance transaction to help the borrower reduce the mortgage tax.
In general, a defeat is beneficial to the borrower if it involves replacing a risky asset (such as a commercial real estate loan) with a safer asset (such as a US government bond). In some situations, it can save the borrower money, at least in theory. For example, it may be more expensive for a borrower to repay a mortgage with Freddie Mac (r) or Fannie Mae (r) or Ginnie Mae bonds than to repay a loan with US Treasury bonds.
CMBS, conduit loans, and other types of securitized debt allow borrowers to choose between preserving returns and defaulting. Return protection is the actual advance payment of the loan, while defects result in the replacement of collateral and the legal assumption that the loan is the borrower's successor. In many cases, borrowers opt for yield protection instead of defects because the loan can be repaid without penalty.
Under a mortgage agreement, a deficiency clause gives the borrower the right to secure ownership (a deed of the property) when the debt has been paid in full. In the case of mortgage-backed loans, the Defeasance Clause promises to transfer the property to the buyer when the loan is fully repaid (principal and interest). With a secured mortgage, the borrower is granted a loan with default to repay the home title as long as he is able to repay his interest, principal and other payments as a condition.
One of the rights a borrower can have in a fixed-rate CMBS loan deal instead of an upfront payment is known as "defaulting.". The provisions may, among other things, require the duration of the lock-up period during which the borrower must be defeated (e.g. 2-3 years from the closing date of the existing loan) or the type of security replacing the above-mentioned real estate collateral, or state collateral within the meaning of section 2 (a) (16) of the Investment Companies Act of 1940 (in the meaning of Treasury Regulation section 1860g (2) (a) (8)). Borrowers can also defeat a designated successor debtor as part of the process, but the details of the type and security (including portfolio terms for a defect) found in their mortgage documents can vary from lender to lender.
Defeasance transactions allow the borrower to replace the collateral in the loan with an asset that provides the same cash flow as the borrower's original loan. In the event of a failure, the borrower invests the proceeds of the sale or refinanced transaction in securities that pay enough capital and interest to cover the remaining repayments on the original loans. Defeasance allows an issuer to take away outstanding debt from its balance sheet in a portfolio of risk-free government securities and remove the outstanding debt.