Defeasance refers to the substitution of collateral in a loan agreement. It occurs when cash or bonds equivalent to a borrower’s debt is substituted for the collateral and used to service the debt. Defeasance often renders a loan void given that the borrower sets aside sufficient cash to offset the outstanding debt.
Defeasance is commonly used in a portfolio of U.S securities, it is a method through which a borrower replaces the collateral used in securing a loan with another collateral, often cash or bond equivalent to the loan amount. Defeasance reflects on the balance sheet, although it is not recorded, the outstanding debt is offset by the new collateral (cash).
A Little More on What is Defeasance
Defeasance is not only used in the context of loans and bonds, but it also has a broad application. Generally, defeasance refers to any instrument or provision that defeats an agreement in which it is used. This provision defeats any preexisting force, for instance, when defiance is used in the context of loan, it nullifies the preexisting collateral and presents itself as a substitute.
There are certain requirements that must be met in an agreement before a defeasance takes effect. Usually, borrowers set aside funds to cover a debt so that the lien placed on the initial collateral can be removed. A defeasance renders a debt null and void as the cash set aside offsets the debt recorded in the balance sheet.
Example of Defeasance
Commercial real estate is a peculiar area where defeasance is commonly used, in a commercial real estate agreement such as commercial loans, bondholders have certain obligations they must meet. These loans also attract prepayment penalties given that bondholders have a stake in the CMBS that carries the loan. Bondholders strive to avoid prepayment penalties in commercial loans by paying off the debt early enough through defeasance. This provision nullifies the prepayment penalties associated with the loan.
Creating Defeasance Accounts
To enjoy defeasance provision, individual borrowers are required to create defeasance accounts, given the complex nature of creating this account, borrowers seek the help of financial experts and lawyers to create it. While the lawyer handles the legal aspect of the provision, the financial expert ensures that the borrower’s portfolio is adequately structured so that a substitute can be made for the existing collateral. This is often done by setting aside enough cash or bonds equivalent to the amount needed to offset the debt obligation.
The Defeasance Clause
The defeasance clause enables a borrower to offset a debt amount by setting aside sufficient cash needed to settle the obligation. The cash or bonds set aside is substituted for the initial collateral in the loan. This clause also gives the borrower the right to secure the deed or title of the property after the mortgage has been paid in full.