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Defeasance Clause

DEFINITION

These are provisions in a mortgage that record a borrower taking a properties title after payment terms in the mortgage have been met. That is a defeasance clause.

EXPLANATION

Defeasance clauses are based on defeasance which is a concept that nullifies a contract or deed. This clause is usually not needed or required in the majority of the states. This is mainly utilized to sum up the finished processes for a mortgage contract loan for a property that has been secured as collateral.

Defeasance Clause Considerations

Defeasance clauses, in some situations, can be used as an order to transfer an alt collateral. An example: a borrower can include this clause in case they want to build up different assets that they would swap with real estate collateral at some point in the loan. This basically makes it so the borrowing party can obtain an ownership title before an expiration of a loan through swapping alternative collateral. Options for alternative collateral would be money market accounts, investment securities, or other types of investment assets.

Defeasance Theory

The need for a defeasance clause was created by English Common Law system. The arrangement was created to provide security for the lender. This practice is not followed in the lien law theory, only in common-law mortgage systems. The lender is then given a deed that has defeasible fees for the property, and if the borrower does not pay, then the property is placed under the control of the lender.

Example of Defeasance Clause

An example of a defeasance clause would be a property that has been purchased jointly using commercial mortgage-backed securities.  A property that is still subject to its original conditions, that has a loan amount which was initially $30 million, a new buyer would obtain leverage of a little more than 50%. In this situation, defeasance would allow the person to purchase the property at a lower leverage amount. The benefits will increase for the buyer if the loan restricts true payment.

Risks for Lenders

There are a number of risks with defeasance for lenders. Here is a break down of the risks involving defeasance for lenders.

▏            Concept of defeasance forces the lender to lend prepaid capital again, which no reinvestment is gained.

▏            Lenders are stripped of newer lending opportunities due to defeasance substituting as collateral.

▏            The risk for reinvestment is eliminated with defeasance.

▏            In Treasury bonds and real estate deals cash flow is kept, and an investment adjustment is made.

▏            When market rates significantly rise, it eliminates reasons for borrowers to pay the differential rate.

Mortgagor Issues and Advantages

There are several issues and advantages for a mortgagor with this clause. Below is a break down of these issues and advantages.

▏            Borrowers benefit from this clause as it does not affect them if there is a rise in market rates.

▏            Bonds and Trusts make this clause more useful.

▏            When the rates for the market rise, fixed-rate investments drop in price and borrowers can invest more in less expensive bonds.

▏            Investment rate soar when market rates fall causing a problem.

▏            Yield Management can be a major issue due to the borrowers are obligated to pay.

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