Defeasance

Definition

Defeasance is a financial provision that eliminates or reduces the liability of a party through a legal action. It often refers to when a borrower sets aside enough cash or bonds to service a debt to relieve the debt obligation. Essentially, it’s a strategy primarily used to avoid having debt appear on financial statements.

Phonetic

The phonetic pronunciation of the word “Defeasance” is: /deɪ’fi:zəns/.

Key Takeaways

1. Defeasance is a process where borrowers can release themselves from obligations associated with their debt by purchasing similar securities to replace their original collateral. This effectively lowers the lender’s risk, thereby releasing the borrower from their direct responsibility for the debt.
2. While Defeasance is advantageous for borrowers wishing to become free of debt obligations, it can also benefit lenders. Lenders replace the old collateral with new, like-kind collateral that often provides a more reliable source of income than the original collateral.
3. Despite its advantages, defeasance has its drawbacks. Chiefly, the cost of replacing the collateral may be high, potentially higher than the cost of keeping and servicing the original debt. As such, it is crucial for borrowers to carefully consider the costs and benefits before initiating the defeasance process.

Importance

Defeasance is a crucial term in business/finance as it refers to a provision that voids a bond or loan on the balance sheet when the borrower sets aside cash or bonds sufficient enough to service the borrower’s debt. This process is vital because it reduces the risk to lenders and can improve the borrower’s creditworthiness, apart from removing the debt obligation from financial statements. Additionally, defeasance provides borrowers the flexibility to effectively remove debt from their financial records without early payment of the debt obligation, contributing to more successful financial management and strategic financial planning.

Explanation

Defeasance is a provision often included in financial contracts, particularly in bonds or mortgage-backed securities, which nullifies the issuer’s obligations to the investor when certain conditions are met. The primary purpose of defeasance is to protect the investor if the issuer incurs new debt or if other significant changes occur that could potentially impact their ability to service the debt. Defeasance typically involves the issuer setting aside sufficient assets or cash into a separate collateral account, with the understanding that the funds will be used to repay the investor if the stated conditions are triggered. In practice, defeasance is commonly used in real estate and public finance transactions. In real estate, for example, a property owner might use defeasance as a strategy to refinance their existing commercial mortgage-backed security (CMBS) loan with a potentially lower interest rate loan from a different lender. Here, the primary benefit of defeasance to the borrower is freeing up property to secure the new loan, while providing assurance to the old lender that the initial debt will be serviced. This process not only benefits investors by reducing investment risk, but it also benefits borrowers by facilitating financial flexibility.

Examples

1. Defeasance in Commercial Real Estate – In the world of commercial real estate, defeasance is commonly used as a means of releasing borrowers from the obligations of their mortgages. For example, if a commercial real estate owner had a fixed-rate mortgage for a property, but later wanted to sell the property before the term of the loan expired, they can use defeasance. The owner will use defeased securities (usually government bonds) that generate enough cash flow to cover the remaining interest rate and principal of the existing loan. In this way, the owner can pass clear title of the property to a new buyer, without having to wait for the expiration of the original loan. 2. Defeasance in Corporate Bonds – In the corporate world, defeasance is often used in relation to corporate bonds. For example, a corporation could issue new bonds at a lower interest rate and use the proceeds to buy government securities, which would be held in an escrow account. The income generated from these securities would then be used to make the principal and interest payments on the older, higher-interest bonds. Once every payment obligation on the older bonds has been met, the bonds would be considered fully defeased – meaning the corporation no longer has any responsibilities associated with them – and the bonds would effectively be retired or extinguished. 3. Defeasance in Municipal Bond Refinancing – Municipalities also utilize defeasance when they want to refinance debt. A town might issue municipal bonds to fund a new infrastructure project, but later find that they could refinance the debt at a lower rate. In this case, the town could use defeasance to replace the old bond with a new, lower-interest bond. They would secure government securities to cover the remaining payments of the old bond, effectively removing the remaining payments from their balance sheet, and then issue a new bond at the lower interest rate.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Securitization
• Collateralized Debt Obligations (CDO)
• Prepayment Risk
• Escrow Account
• Debt Servicing

Sources for More Information

• Investopedia
• PwC
• WallStreetMojo
• Rocket Mortgage