An annulment is a rendering void.
a. The cancellation of a contract or deed. b. A clause in a contract or deed that allows it to be annulled.
When it comes to municipal bonds, a defeasance refers to the legal and financial processes for making an outstanding bond issue worthless. Although a defeasance is usually the result of a refunding transaction, it can also be done with cash rather than the issuing of any bonds. This article focuses on the concept of a defeasance and how cash can be used to accomplish it.
A defeasance is a financing instrument that allows outstanding bonds to be retired without having to redeem them or buy them back on the open market. Government securities are purchased using cash. The securities’ principal and interest collected are sufficient to cover all principal and interest payments on outstanding bonds when they become due.
Defeasance allows an issuer to secure outstanding debt with a portfolio of “risk-free government securities,” allowing the debt to be removed from the balance sheet immediately. This occurs because government securities create the cash flow required to pay all outstanding interest and principal on time. If a portfolio of assets only contains high-quality securities, such as US government direct obligations, the bonds are considered “defeased” or legally retired under generally accepted accounting principles. (See GASB Statement No. 7 and FASB Statement No. 76, Advance Refunding and Defeasance Policy.)
Defeasance is a legal term that refers to the payment of outstanding bonds, which relieves the issuer of all obligations to pay the bonds. The securities chosen and the terms of how and where the securities are held (see “Mechanics of Defeasance” below) must match the standards set forth in the instruments that authorized the outstanding bonds in order for a bond issue to be legally defeased.
The bonds shall no longer be considered as debt for accounting purposes or for purposes of computing any statutory or constitutional debt restriction if the defeasance is consistent with generally accepted accounting principles and complies with the outstanding bond document requirements.
Defeasance frequently provides more benefits than alternative debt-liquidation options. These advantages are detailed below.
1. Defeasance may enable an issuer to extinguish debt at the best feasible price, depending on interest rates and market conditions. If the government securities have a rate that is at least as high as the outstanding bonds, this will happen. The investments may not be subject to yield limits in some situations. Furthermore, there is no redemption fee.
2. The bondholder is not penalized for defeasance. Bondholders benefit since the bonds are not redeemed and are backed by a risk-free government securities portfolio.
3.Unlike tender offerings, defeasance does not necessitate protracted or costly litigation.
The issuer purchases government securities for deposit in an escrow account in a defeasance. The escrow account is held by an escrow agent, which is a bank or trust business. The government securities are irrevocably guaranteed to the payment of outstanding bonds under the conditions of an escrow agreement. The government securities have a principle amount such that the principal and interest gained are sufficient to pay off the outstanding bonds’ principal and interest as they mature. The government securities, as well as any defeasance fees, are paid with monies accrued in various accounts set up for outstanding bonds, or with other available funds.
Bond Counsel designs the escrow agreement and issues an opinion on whether or not the outstanding bonds have been legally retired (defeased).
Financial Advisor:WM Financial Strategies develops the financing plan, identifies the government securities to be placed in the escrow account, assists in the acquisition of the government securities, reviews the escrow agreement’s terms, and assists the issuer in transferring funds to the escrow agent.
Bond Counsel may get an opinion from an independent certified public accountant on whether the escrow account is adequate to retire the outstanding bonds.
The bank or trust business that retains the government securities and makes payments to the paying agent for outstanding bonds is known as the escrow agent.
When a loan is defeased, what does that mean?
Defeasance, in the broadest sense, is any clause that renders the agreement in which it is contained void. Before the seller is forced to release his interest in a particular property, the provision includes a number of requirements that must be completed, the majority of which are met by the buyer. Defeasance refers to a borrower setting aside enough money, usually in cash and bonds, to pay off his or her debts. This serves as a way to cancel the debt obligation without incurring any prepayment penalties. Because the amounts outstanding and set aside are equal, they are functionally removed from the balance sheet, and account monitoring is often unneeded.
What does it mean to have a pre-refunded bond?
What Is a Pre-Refunding Bond and How Does It Work? A callable bond is funded using a pre-refunding bond, which is a debt security issued to fund the callable bond. A pre-refunding bond is one in which the issuer decides to exercise its right to buy back its bonds before the maturity date.
What does bond defeasance entail?
DEFEASING OR BEING DEFEASED In line with the terms of the bond contract for an issue of securities, certain of the bondholders’ rights and interests, as well as their lien on the pledged revenues or other security, are terminated.
Is there a prepayment penalty for defeasance?
A borrower can potentially refund their lender for prepaying their loan in a variety of methods in the multifamily and commercial lending business. Yield maintenance, step-downs, and soft-step downs are all common prepayment penalties. However, defeasance, another prevalent type of prepayment penalty, is frequently available, especially for CMBS loans and some Fannie Mae and Freddie Mac multifamily loans.
Defeasance is the process of replacing a loan’s collateral with assets (usually fixed-rate government bonds) that provide a comparable return to the lender. To undertake defeasance, debtors will most likely need to purchase US Treasury bonds, while other types of government-backed securities may be used in some situations. The crucial issue is that the bonds offer at least the same amount of income as the loan. As a result, the lender will not suffer any financial loss as a result of the borrower’s early repayment. In most cases, a borrower chooses to prepay their loan because they wish to sell the property before the loan term expires.
Defeasance Generally Requires Expert Consultants
Most borrowers who want to defease their loan would employ a defeasance consultant to handle the entire process for them, just as a commercial or multifamily real estate investor in litigation would hire a lawyer rather than represent themselves in court. While the concept may appear straightforward, defeasance is a complicated topic in general. Bonds must be purchased in correct amounts, secured properly (usually in a custodial account), and registered and lodged as property for tax reasons. Additionally, during the procedure, a certain level of negotiation and communication with the lender will be required. While defeasance is tax deductible, a borrower (or their original accountant) may not be familiar with the type of paperwork and documents required to claim the deduction.
When is Defeasance a Good Idea?
Defeasance may or may not be the best option for a commercial or multifamily real estate borrower, depending on current interest rates and other variables. A borrower may actually earn from defeasance if market interest rates rise above the mortgage rate. The particular defeasance terms that a lender allows will also influence whether or not defeasance is a good idea for a borrower. For example, refinancing a mortgage using Freddie Mac, Fannie Mae, or Ginnie Mae bonds is usually much less expensive than refinancing a loan with U.S. Treasury bonds.
As you can see, whether defeasance is the greatest option for a particular borrower is dependent on their own circumstances; however, defeasance is virtually universally a good idea for lenders. This is due to the fact that bonds have a far lower prepayment risk than commercial or multifamily mortgages. While a borrower may default owing to low occupancy rates, legal challenges, fraud, or a variety of other reasons, the US Treasury, Fannie Mae, and Freddie Mac would need a major economic catastrophe to stop paying the interest on their bonds. In most cases, a defeasance expert will be able to provide you with a no-cost estimate to see if it’s right for you.
Deciding on Defeasance vs. Yield Maintenance
As loan prepayment penalties, a borrower will often have to choose between yield maintenance and defeasance. When it comes to CMBS loans, this is frequently the case. The particular provisions of a lender’s defeasance agreement play a role in deciding between these two possibilities. When bond interest rates are compounded monthly and payments are estimated until the maturity date, defeasance is usually the best option (and when the overall yield maintenance prepayment penalty is greater). When bond interest rates are compounded annually and payments are calculated to the loan’s prepayment date, however, yield maintenance is often more ideal (and when the overall yield maintenance prepayment penalty is smaller).
What’s the difference between defeasance and yield maintenance?
- Do I need to buy defeasance bonds to cover all of my remaining loan payments until maturity, or only the ones up until the early open prepayment date?
How does defeasance work?
The procedure by which a borrower is released from the financial obligations of its loan is known as defeasance. To secure the debt and provide the cash flows required to satisfy the regular payments of principle and interest remaining on the loan, the borrower purchases a portfolio of government bonds as replacement collateral.
The defeasance bonds are transferred to a successor borrower, a newly formed special-purpose organization that takes the original borrower’s debt obligations. The bonds are held in a restricted account by a securities intermediary, and the income from the bonds is sent to the loan servicer to pay the debt obligations. An impartial accountant examines the deal and verifies that the bond portfolio is adequate to cover the obligation.
The defeasance process takes 30-45 days and is coordinated by the defeasance consultant. The borrower starts the procedure by giving the loan servicer a notice of intent and a defeasance deposit. The loan servicer will generate legal documentation for the borrower to study and sign, as well as due diligence documents. The defeasance can be closed after the documentation are finalized.
The closing occurs in escrow over the course of two to three days, along with the underlying refinance or sale. The borrower locks in the price of the bonds and commits to purchasing them on the first day of the closing procedure. The borrower frequently deposits monies into escrow the day before the final closing date, usually with proceeds from the refinance or sale. The bonds are given to the securities intermediary bank on the final closing day, and money from escrow are disbursed to acquire the bonds.
What is Chatham’s role in a defeasance?
Chatham serves as the borrower’s defeasance consultant as an independent, experienced advisor. Chatham evaluates costs, advises borrowers on how to traverse the defeasance process, contacts counterparties, and ensures that the defeasance is completed on time and on budget. Chatham can also purchase the defeasance bonds and establish the successor borrower organization that will assume the loan at closure if the loan documents allow it.
The function of the defeasance consultant is unusual in that it is the only entity with in-depth understanding of the entire procedure who also acts as a borrower’s advocate. Chatham’s purpose as a defeasance consultant is to make the defeasance procedure as simple as possible so that our clients can concentrate on the real estate transaction at hand.
What is residual value in defeasance and where does it come from?
The cash in the defeasance account that is not pledged to make loan payments is known as residual value. The two sources of residual value are float value and prepayment value.
Float value builds up over the course of the defeased loan’s remaining term. It is caused by minor timing discrepancies between the bonds’ incoming cash collections and the loan’s departing cash payments. For brief periods of time, cash is held in the defeasance account, where it receives interest at money market rates. When the loan is repaid at maturity, the float value is released to the successor borrower.
When loan documents require the defeasance bonds to cover all remaining loan payments until the loan’s maturity date, but still allow the loan to be paid off on the early open prepayment date, prepayment value arises. On the early open prepayment date, the successor borrower will pay off the defeased loan’s principal balance. When the loan is paid off, the succeeding borrower receives the remaining bonds in the defeasance account, who promptly sells them on the market. The prepayment value is the difference between the sale price of the released bonds and the cost of repaying the defeased loan.
Chatham was the first corporation to offer residual value to its customers. We’ve restored over $170 million in residual value to our clients since 2000. Clients can get this value in two ways: as a present-value at the defeasance transaction closing date or as an actual-value at loan maturity. We always reveal the overall amount of residual value received and the full conditions of our sharing arrangements as part of Chatham’s ongoing commitment to transparency.
What is the overall defeasance timeline?
Allow at least 40 days for the defeasance process to be completed. The loan servicer will, in most situations, waive any stated notice time as well as any need that the defeasance close on a loan payment date. However, if the loan is closed in less than 30 days from the date of notice and deposit, the loan servicer may levy an expediting fee.
The closing date is changeable after the defeasance process has begun and can be adjusted until the defeasance bonds are purchased.
How accurate is my estimate and how often does it change?
The current market price of the defeasance bonds is represented on your estimate as the securities cost. Bond prices fluctuate often, so calculations made even a few minutes apart may yield different results. Between the time of the estimate and the time of the defeasance close, costs will almost certainly alter. The sensitivity, or DV01, measures how much the price of a security changes with each basis point change in yield rates. If interest rates rise, the cost of securities falls, and vice versa. Finally, Chatham aims to buy the cheapest bond portfolio possible by arranging a competitive auction among multiple banks (when allowed by the loan documents).
The third-party fees mentioned on your estimate are determined individually by the defeasance’s different parties. Any projection of these prices is based on previous experience and pricing schedules.
How does defeasance compare with yield maintenance?
Borrowers can unencumber the underlying real estate asset through yield maintenance and defeasance. However, the two procedures are fundamentally different from a legal and economic standpoint. Yield maintenance is the real prepayment of the loan, whereas defeasance entails a collateral substitution and the succeeding borrower’s legal ownership of the loan.
The unpaid principal balance of the loan and a prepayment penalty make up a yield maintenance prepayment. The present value of the remaining loan payments is commonly calculated using a discount rate equal to the current yield on the U.S. Treasury that matures closest to the loan’s maturity date to establish the prepayment penalty. The loan servicer charges a minor processing fee as the only transaction fee.
The cost of defeasance, on the other hand, is defined by the price of a bond portfolio sufficient to cover the outstanding loan payments, plus transaction costs to multiple third parties.
How are the defeasance bonds purchased?
The money needed to buy the defeasance bonds is usually obtained through a refinance or sale of the property.
The borrower may purchase the bonds from any securities provider if the loan documents allow it. Chatham has established a highly efficient auction process that ensures competitive bond pricing for our clients. Chatham runs the auction in real time, ensuring that all bids are competitive. Chatham is not a broker dealer and does not receive any bank incentives. We don’t get any fees, premiums, or profits from the bonds we buy. Our sole motivation is to obtain the best possible pricing for our customers.
Do I need to purchase defeasance bonds to make all my remaining loan payments through maturity, or just the payments up to the early open prepayment date?
Some loans have an early open prepayment window that permits the loan to be paid off in full before the due date. The loan documents specify whether the defeasance bonds must cover all remaining loan payments up to the early open prepayment date or only those up to the maturity date.
Chatham will attempt to arrange the defeasance bonds to the commencement of the prepayment window only if a prepayment window exists. The borrower can save a lot of money by doing so.
Who are the additional parties involved in a defeasance and what do they do?
- Loan servicer: A notice of defeasance and an up-front deposit are required by the loan servicer. Official copies of the loan documentation and the loan amortization plan are provided. They continue to service the loan after defeasance.
- Loan servicer counsel: The loan servicer hires a law firm to act as their defeasance representation. On behalf of the loan servicer, the loan servicer’s counsel creates the defeasance agreements, collects due diligence items, and approves certain components of the transaction.
- Rating agencies: Large defeasances may be reviewed by rating agencies to ensure that the defeasance will not result in the securitization pool being downgraded. The defeasance process could be extended by up to ten working days due to a rating agency evaluation.
- Securities intermediary (also known as a custodian): A securities intermediary (also known as a custodian) is a bank that keeps the defeasance bonds in a limited account and sends the cash receipts to the loan servicer to cover the remaining loan payments.
- Accountant: An independent CPA firm certifies that the cash receipts from the defeasance bond portfolio will be sufficient to cover all remaining loan installments.
- The successor borrower is a single-purpose, bankruptcy-remote LLC formed to absorb the borrower’s financial liability for the loan while keeping ownership of the defeasance bonds.
- Successor borrower’s counsel: The successor borrower’s counsel prepares the defeasance documents and files the necessary documents to incorporate the successor borrower corporation.
- The title and escrow for the defeasance are handled by the same title company that handled the underlying refinance or sale.
- Most borrowers hire an attorney to evaluate the defeasance filings and assist them in returning due diligence items to the loan servicer.
Who sets the transaction fees for these parties?
Fees are decided unilaterally by the parties involved in a defeasance. Any estimation of transaction fees is based on previous experience and charge schedules. If numerous loans in the same securitization are defeased at the same time, certain parties will reduce their costs.
How can I make debt extinguishment easier and less costly in the future?
Although defeasance may be required by the old loan, Chatham can help clients negotiate more borrowers-friendly defeasance and prepayment terms on new debt.
Defeasance provisions can be changed during the negotiation period prior to origination. Defeasance portfolio purchasing and successor borrower rights, as well as the form and composition of the bond portfolio required, are among the most important.
By picking a yield maintenance prepayment penalty or considering a floating-rate loan, Chatham gives ways to manage interest rate risk, defeasance can be avoided entirely.
Are pre-paid bonds secure?
Pre-refunded bonds appeal to some conservative investors since they are a safe investment; nevertheless, the yields on these bonds are quite modest. The issuer is not compelled to pay the whole interest amount to the bondholder if the bond is not callable.
What is refunding in advance?
Advance refunding occurs when the revenues of a new bond issuance are held for more than 90 days before being used to pay off (refund) the obligations of an existing bond issue. Pre-refunding, which requires the issue of a callable bond, should not be confused with advance refunding.
Governments refund bonds for various reasons.
State and local governments regularly use bond refinancings, also known as “refundings,” to reduce debt payment costs on outstanding bonds. Refunding bonds can also be issued to remove or revise harsh bond covenants or restructure debt service obligations, albeit they are less common.