Defeasance

What Is Defeasance?

Defeasance is a way for a borrower to release the collateral pledged against a loan without repaying the debt early. Instead of paying off the outstanding balance, the borrower buys a portfolio of high-quality Treasury security|Treasury securities whose scheduled interest and principal payments match the remaining payments on the loan. The securities take the place of the original collateral, and the property or asset is freed from its lien. The borrower keeps the loan, but the lender is now secured by the securities instead of the property.

How It Works

The process generally follows a few steps:

• The borrower sets up a separate legal entity to hold the new securities.
• The securities are purchased so that their cash flows cover each remaining loan payment.
• The lender receives the securities' payments in place of the borrower's loan payments.
• Once the substitution is complete, the original property is released.

Defeasance is most common in commercial mortgage lending, where loans often include restrictions on early repayment. Municipal issuers use a similar approach when they place funds in an escrow account to pay off older bonds on a set schedule.

Trade-Offs for Borrowers

Defeasance can be attractive when a borrower wants to sell a property or refinance but cannot easily repay the loan early. Repaying early often triggers a large prepayment penalty or yield maintenance charge, while defeasance may preserve the original loan terms. The main drawback is cost. The price of the securities depends on current interest rates, so defeasance can be expensive when rates have fallen and less costly when rates have risen. Legal, administrative, and structuring fees add further expense.

The term also appears in accounting, where a company may describe debt as "defeased" if it sets aside assets to pay it off. Modern accounting rules are strict about when such debt can be removed from a balance sheet, so the label does not always mean the obligation has been eliminated.