What is Defeasance?
Defeasance is a strategic provision in a contract that nullifies a bond or loan on a balance sheet when the borrower sets aside an adequate amount of cash or bonds to cover the debt. Through this process, the borrower systematically accumulates cash to service the bonds, effectively canceling the outstanding debt and removing it from the balance sheet.
Defeasance Demystified
In essence, defeasance is any contract clause that renders the agreement void once specific conditions are met. Typically, these conditions are outlined to protect the seller until the buyer fulfills certain obligations. By setting aside sufficient funds—commonly using cash and bonds—the borrower can declare the debt obligation as fulfilled without triggering prepayment penalties. Consequently, the balance sheet reflects neither the debt nor the offsetting secured funds, eliminating the need for continuous monitoring of these accounts.
Defeasance in Action: A Real Estate Example
Defeasance finds widespread use in commercial real estate transactions. Differing from home mortgages, commercial loans often involve hefty prepayment penalties to protect investors in commercial mortgage-backed securities. These penalties exist to ensure bondholders receive a predetermined number of interest payments for revenue purposes. To navigate these penalties while achieving an early payoff, commercial property buyers may assemble portfolios equivalent in value to their remaining debt obligations. Typically, these portfolios feature high-quality bonds whose yields align with the interest costs of the loan. This strategy allows investors to keep receiving payments while enabling borrowers to effectively pay off their loans ahead of schedule.
Building Your Defeasance Account
Setting up a defeasance account is intricate, requiring input from legal and financial experts to correctly structure the portfolio that offsets the debt owed. This meticulous planning is reminiscent of liability matching used by pension funds, where the income stream from current securities is orchestrated to cover future obligations.
The Defeasance Clause in Mortgage Agreements
A pivotal element in mortgage agreements is the defeasance clause, which permits a borrower to obtain the title or deed to the property once the debt is fully satisfied. Prior to repayment in full, the loan provider holds the rights to the title, using it as collateral for the borrowed amount.
Similar provisions apply to other financed acquisitions, such as vehicle loans. Upon repayment, the finance company relinquishes its claim to the property, formally transferring ownership to the borrower.
Related Terms: liability matching, prepayment penalty, commercial mortgage-backed security, title deed.
