Understanding Defeasance Transactions
By J. Paul Rieger, Jr., Esq.

A little background may be helpful. Securitized lending and the issuance of mortgage-backed securities have been part of the world of residential financing since the formation of Fannie Mae following the Depression. Fannie Mae was originally chartered to purchase FHA insured residential mortgage loans from local thrift institutions in order to generate more loanable funds for the thrifts. Fannie Mae (and later other government or government-sponsored entities such as Ginnie Mae and Freddie Mac) developed expertise in pooling together the purchased residential mortgage loans, which, along with guarantees and other credit enhancements, would be used to create mortgaged-backed securities. The sale of the securities would create more funds which could be used to purchase more residential mortgage loans.1

First on the scene were basic pass-through certificates, where the holder of the security owned a pro rata share of the interest and principal paid on the loan pool. Later, more sophisticated securities, such as bonds called "collateralized mortgage obligations" - "CMO’s", and later "real estate mortgage investment conduits" -"REMICS", offered the investor securities representing varying risk levels and maturities ("tranches").2 The 1980’s saw the beginnings of an explosion in the level of residential mortgage securitization. Presently, approximately one-half of all residential loans find their way into securitization pools.3

The securitization of commercial mortgage loans ("commercial mortgage-backed securities" – "CMBS") was fueled in large part in the early 1990’s by RTC’s mandatory sell-off of commercial mortgage loans held by failed savings institutions.4 According to an October, 2005 Issue Paper provided by the Mortgage Banker’s Association, CMBS’s are "now the second largest source of commercial and multifamily real estate financing, second only to commercial banks, and represent approximately 19% of the $2.4 trillion total debt outstanding."5 The development of the CMBS market from its marginal roots to its status as the second largest source of commercial mortgage funding is nothing short of remarkable.

Commercial loans, on the other hand, are generally not subject to consumer-based rules allowing prepayment. As a condition to making the commercial loan, the borrower could be subjected to lock-out periods where refinance/prepayment is not permitted and/or be subjected to substantial prepayment penalties. These restrictions would make the commercial loan more attractive to an investor, but would frustrate the borrower’s desire to refinance during periods of declining interest rates. In the early days of CMBS securitizations, the prepayment risk was, in fact, managed by requiring "lock-outs" of two to five years during which prepayment was forbidden. Even after expiration of the lock-out, most loan documents used in early CMBS’s called for prepayment penalties in the form of a "yield maintenance" fee, i.e., the borrower would have to compensate the lender for the present value of the difference between the original payment schedule and the new payment stream at the reduced interest rate.6

Taking the defeasance route is generally seen as a "win-win" for both the borrower and CMBS investor. The investor continues to receive its scheduled cash flows. The CMBS bond could even be upgraded because a riskier mortgage has been replaced with safer Treasury securities. The borrower can access its real property to take advantage of increased equity for favorable refinance, sale or development, presuming that the benefits of doing so are not outweighed by the cost of the replacement Treasuries and defeasance transaction costs.7 The defeasance alternative is now commonly included in the commercial loan documentation for deals targeted for securitization.

The logistics of a defeasance transaction can seem daunting. The borrower must initially coordinate with the CMBS pool trustee/servicer to confirm defeasance requirements. (Current REMIC rules prevent defeasance for a two-year period following the initial CMBS issuance.)8 The borrower will ordinarily employ a defeasance advisor to assist it in coordinating the defeasance transaction and identifying the necessary Treasury securities. There are now many defeasance advisors that will, for a fee, assist in selecting and coordinating the purchase of the necessary securities, (e.g. Commercial Defeasance, LLC, Newman & Associates, Chatham Financial Corporation, and Waterstone Capital Advisors). A few have web sites that include "defeasance calculators" to assist in determining the securities and transaction costs. Even Fannie Mae maintains a defeasance calculator in connection with its securitized, multi-family loan transactions.9 The defeasance advisor will ultimately coordinate with a securities broker to obtain and transfer the Treasuries. (The process may require putting out bids for the Treasuries).

The borrower may need to employ a CPA, acceptable to rating organizations, to certify that the substituted securities will generate the scheduled payments to the CMBS pool. Borrower’s counsel will likely be required to opine that the transaction will not cause disqualification of the CMBS Trust’s tax status as a REMIC, as well as to provide other opinions as to the status of the borrower and the priority and lien status of the replacement securities.10

Usually, as a condition to defeasance, the CMBS Trustee will require that a substitute borrower (a bankruptcy-remote, special purpose entity) be created to assume the original borrower’s obligations under the note. This structure shields the loan from possible trailing liabilities of the original borrower as owner or operator of the real estate.11 The defeasance advisor often forms the entity as part of its services.

Presuming all due diligence has been completed and all required opinions have been received, the defeasance advisor will initiate the purchase of the Treasuries in advance of closing, with the actual purchase to occur at the time of the refinance funding. Upon funding, the successor borrower executes a security agreement to secure the note obligation with the Treasuries. The borrower also executes an account agreement with a securities intermediary which provides for an account custodian to make the substitute payment of scheduled installments to the CMBS Trustee.12

J. Paul Rieger, Jr. © 2006

          12Mizner, Melvyn, Defeasance, LandAmerica Commercial Services, June 22, 2005;
              Litwa, Robin L., Defeasance – A Practical Overview, Mortgage Banking Magazine July,
              2000; Kilpatrick Stockton LLP, Defeasance – A Practical Guide, Jan., 2005 Newsletter