Overview of Mortgage Loan Defeasance

In the context of a mortgage loan, defeasance means a substitution of collateral. Specifically, it means an exchange of the real property collateral for a securities portfolio designed to produce cashflow matching the remaining principal and interest payments on the loan, through the loan’s maturity date. The mortgage loan borrower pledges the securities portfolio to the mortgage lender, a successor entity assumes the borrower's obligations under the loan, and the lender provides a release of the mortgage lien on the borrower's real property and a release of the borrower from its continuing obligations under the loan.

Mortgage loan defeasance is not a prepayment of the loan. While the borrower and the real property collateral are released, the original loan continues as an obligation of a successor entity through the loan’s maturity date. A lender will not issue a payoff letter for a defeasance. Instead, a defeasance transaction will be documented like a loan assumption— it will be an entirely separate transaction from the refinance or sale transaction associated with the defeasance.

The mechanism of defeasance protects the holder of the loan from the risk that the loan will be prepaid prior to maturity. Prepayments occur more frequently in declining interest rate environments. If a loan is prepaid and interest rates have declined, the holder of the loan will not be able to reinvest the prepaid principal in a similar investment at the same yield. Prepayment protection— whether in the form of a defeasance requirement, or otherwise— therefore has value to lenders.

Under a traditional loan structure, the lender’s prepayment protection would typically come in the form of a yield maintenance requirement. Yield maintenance imposes an additional cash penalty on the borrower upon prepayment. This cash penalty is calculated at the time of prepayment assuming its reinvestment in specified low-risk securities, such as U.S. Treasury securities. The amount of the penalty, reinvested as specified, would preserve the lender’s original anticipated yield on the prepaid principal.

Prepayment protection in the form of defeasance requirements appear almost exclusively in the context of loans that have been securitized in conduit pools. Interests in these pools are broken up into many different classes of securities, each with different levels of risk and different yields. The holders of the beneficial interest in a particular conduit loan are the various investors in these securities. The securitized structure of these pools and the Treasury regulations that govern the types of assets that they may hold make yield maintenance requirements a less desirable solution to the issue of prepayment risk or “call risk.” The Treasury regulations specifically permit the defeasance of the loans with government securities.

Figure 1. Conduit Loan Structure

A loan servicer, or group of loan servicers, administers each conduit loan pool on behalf of the pool trustee and the investors. The servicer has a contractual obligation to the trustee and the investors to administer the conduit loan pool in strict accordance with the Treasury regulations and the governing documents for the conduit pool. A conduit pool servicer therefore does not have a traditional lender’s discretion in consenting to loan modifications.

When defeasance is required, a conduit loan borrower will provide notice to its loan servicer in advance of the anticipated transaction date. The borrower’s defeasance advisor will model a portfolio of securities to defease the loan on that date. The sufficiency of this portfolio will be preliminarily verified by an independent accountant. The advisor will also identify a successor borrower entity to assume the borrower’s obligations under the loan documents and the defeasance documents. The servicer’s counsel will review the necessary due diligence from the borrower and the successor borrower, and will prepare and finalize the defeasance documents.

A defeasance will ordinarily occur in the context of another transaction— either a sale of the real property or a refinance of the loan. All of the requirements for this parallel transaction must be satisfied prior to the beginning of the defeasance closing process.

The defeasance closing takes place over a period of days. On the first day, all documents for both the defeasance and the sale or refinance transaction must be executed and in escrow. Upon confirmation that all requirements for both transactions have been satisified, the defeasance advisor will direct a securities broker/dealer to “circle” the securities in the previously modeled and approved substitute collateral portfolio for delivery on the intended closing date. Although the borrower will not be required to pay for the securities until the closing date, upon circling, the borrower will have effectively purchased the securities and will bear the risk and cost of reselling them in the open market if the transaction does not close. Subsequent to the circling of the securities, the independent accountant will produce a final verification of their sufficiency, and the sale or refinance transaction will fund into escrow.

On the defeasance closing date, the securities will be delivered to the designated custodian. The purchase of the securities will be settled by the escrow agent and the escrow agent will be authorized to record the release of mortgage.

Figure 2. Defeased Conduit Loan Structure

After the defeasance transaction has closed, the original borrower and the real property are no longer encumbered by the defeased loan. The successor borrower is now the loan obligor and the substitute collateral provides the source of funds for all remaining debt service payments.