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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2007

4 Primary Defeasance Provisions

Your clients want to mitigate defeasance fees while your lenders want to avoid risk — here’s what to know

More than 2,500 commercial-mortgage-backed-securities loans — worth more than $20 billion in total — were defeased in 2006, according to Moody’s Investors Service. This was a dramatic increase from the 25 loans defeased five years before.

Defeasance is driven by commercial real estate borrowers’ desire to free themselves of an original loan obligation and to enter into a new underlying transaction (generally a sale or refinance). It occurs when these borrowers are prohibited from making a prepayment because of provisions in their original loan documents.

Why should loan originators be interested in the defeasance process? Because it is governed by the original loan documents, and it requires that the underlying transaction receive a completely new loan and another set of loan documents. This encourages a constant flow of new loan origination.

As more commercial borrowers contemplate defeasance, originators should be aware of the defeasance terms that are most acceptable to their clients. Often, borrowers wish to incorporate terms that allow them to retain the rights they’d be granted if they didn’t defease.

Typically, there are four main provisions borrowers seek to include in their loan documents to reduce the inherent cost of defeasing:

  1. The use of agency securities in the defeasance portfolio;
  2. The right of the borrowers to purchase their own portfolios;
  3. The ability of the borrowers to establish their own successor-borrower; and
  4. The right to prepay the loan after a defeasance.

Let’s look at these provisions in more detail.

Use of agency securities

Loan documents explicitly allowing agency securities in the defeasance portfolio will greatly decrease the upfront defeasance costs for borrowers. Agency securities are non-callable securities issued by government-sponsored agencies such as Freddie Mac and Fannie Mae. In general, agency securities yield 20 to 25 basis points over treasuries and thus significantly reduce the cost of the portfolio.

Although these securities are not directly guaranteed by the U.S. government, they are considered to have an implicit guarantee because they are issued by a government-spnosored agency. More to the point, to lenders, the risk of Fannie Mae or Freddie Mac defaulting is generally considered less likely than the borrower defaulting.

Right to purchase portfolios

The borrowers will look to retain the right to deliver the portfolio of securities. In effect, they want to choose who will purchase the securities.

By retaining this right, the borrowers are able to guarantee that a competitive auction will be held for their securities. These auctions allow the borrowers to ensure fair pricing on the portfolio as the difference between banks’ bids can range greatly — sometimes in the hundreds of thousands of dollars.

This right would produce no additional risk for the lender because the securities are traded over-the-counter and the portfolio is always approved by an independent accountant.

Ability to establish successor

The successor-borrower is the bankruptcy-remote legal entity that assumes the responsibilities of the loan after the defeasance. A company in a corporate group is considered bankruptcy-remote when its solvency doesn’t affect any other company in the group.

Because of timing mismatches inherent in a defeasance portfolio of treasury securities, interest may be generated by these inefficiencies. This interest will remain in the successor-borrower trust account until maturity. The successor-borrower retains any rights to the interest generated in the account once all loan payments have been made.

Clearly, most borrowers would like the ability to determine who will be given those rights. This is especially true now that many third-party providers are willing to return some of this interest to the original borrower at loan maturity.

The lender is not damaged by this provision because the interest in this account would not be available to the lender had the borrower not defeased. Additionally, any successor entity must meet certain legal specifications to ensure its capability as a substitute borrower. This is certainly favorable for the lender.

Right to prepay

Most loan documents allow borrowers to prepay the loan without penalty one to six months before the maturity date. If the borrowers established the successor-borrower or have an agreement to share the residual value with a third-party provider, prepayment will allow them to recoup some of the initial money spent to purchase the securities. If the loan were not defeased, the borrower would have the ability to prepay. The lender is not exposed to any additional risk by allowing prepayment after a defeasance.

An increasing number of loans now allow borrowers to structure the portfolio to fully mature on a payment date of the borrowers’ choosing (within the open prepayment period). This can reduce upfront costs for the borrowers. In addition, it would not change the economic agreement the lender originally entered into with the borrowers.

•  •  •

As the number of defeasances continues to skyrocket, borrowers are understandably more conscious of the defeasance language in their loan documents. Additionally, with defeasance penalties often climbing into the millions of dollars, borrowers are more aggressively pursuing ways to mitigate these costs.

Brokers who work with lenders that understand defeasance provisions can find terms that are favorable to borrowers and that don’t expose the lenders to additional risk. This can create an overall competitive advantage for brokers.


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