What is Defeasance?
Defeasance is a provision in business law that renders an agreement void under certain conditions. In case of a debt agreement, defeasance provisions outline the needs that are to be fulfilled by the lender before the borrower is required to release their interest in a particular asset or property. Defeasance accounts enable the borrower to set aside funds for loan repayments and functionally remove the debt from their balance sheet.
- Defeasance accounts enable the borrower to set aside funds for loan repayments and functionally remove the debt from their balance sheet.
- It enables the borrower to avoid the risk of prepayment penalties.
- The account is only beneficial when the borrower can afford to pay attorneys, accountants, and defeasance consultants.
How Do Defeasance Accounts Work?
Usually, a borrower must set aside sufficient funds in the form of either cash or bonds in order to cover their associated debt. The fund comprises the amount owed to the creditor and the amount “set aside” for the purpose of covering their debt offset. Typically, defeasance is a process through which a lender’s claim on collateral is eliminated.
The borrower replaces the collateral with another security that is relatively risk-free, such as Treasury bills, or with a portfolio of low-risk securities. It provides an accounting method to functionally remove both amounts from the balance sheet of the borrower.
A similar principle is applied in the case of liability matching used by pension fund experts. In liability matching, the future obligations associated with an asset are matched with future income streams associated with that asset.
Defeasance clauses are prevalent in agreements related to the purchase of real estate. In cases of mortgage-backed loans, the defeasance clause promises the title of the property to the buyer only after the debt is paid in full (i.e., both principal and interest amounts). Until the repayment date, the title is held by the lender.
Advantages of Creating Defeasance Accounts
1. Reduces complexity in accounting
It negates the need to record everything related to the transactions in question. Once the debt is functionally removed from the balance sheet of the borrower, it decreases the complexity in accounting.
2. Decreases risk of prepayment penalties
Usually, when a borrower pays off a loan on its date of maturity, especially within the first five years, they incur a prepayment penalty. The penalties are levied in order to protect the investor from future income losses in the form of interest payments.
The penalty may also be levied based on the remaining mortgage balance. Thus, by invoking the defeasance clause, the borrower avoids having to pay prepayment penalties. Such payments are risky as prepayment models are generally subjective.
3. Avoids high interest rates
Defeasance is extremely beneficial in an economy where future interest rates are expected to rise. It allows the borrower to avoid higher interest payment obligations.
Disadvantages of Creating Defeasance Accounts
1. High cost
Defeasance accounting is extremely complicated and required practicing accountants and lawyers. Therefore, it is only worth pursuing in cases when the applicable prepayment penalty exceeds the amount spent on brokerage and consultation fees.
2. Capital requirements
The borrower must possess enough capital to substitute the cost of the collateral that is being freed by virtue of erasing the obligation from the balance sheet.
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