A primer to defeasance transactions

Canada: Defeasance Transactions
16 August 2007
by Robert Antenore and Stephanie M. Robinson

Full article here: http://www.mondaq.com/article.asp?articleid=51430

What is Defeasance?
In its simplest form, defeasance is the process whereby a borrower replaces real property security with personal property security. The mortgage is discharged from the property and the borrower is free to sell or re-finance the property as it wishes. All obligations under the mortgage loan, other than those related to the use, operation or ownership of the property, remain in place, such as the obligation to continue to make payments under the mortgage loan. In exchange for a release of its mortgage, the mortgagee receives a pledge of a portfolio of bonds from the borrower. The bonds are generally high quality, triple A rated, sovereign risk (such as direct, non-callable, Government of Canada bonds) and are purchased such that the proceeds from the cash flow of the bonds replaces the expected income stream under the mortgage. Each future payment under the mortgage is notionally matched to a bond which comes due on or prior to a payment date such that the remaining payments due under the mortgage are replicated. Defeasance is a form of mathematically precise yield maintenance at the current bond rate.

Documentation
The defeasance transaction is documented with two principal documents:
- Defeasance Pledge and Security Agreement - which governs the relationship between the borrower (pledgor), the conduit as mortgage lender (or more typically, the custodian acting for and on behalf of the investors of the conduit) and the master servicer (appointed as part of the securitization of the mortgage loan)
- Account Agreement - which governs the relationship between the pledgor, the mortgage lender and the master servicer

Defeasance Pledge and Security Agreement
In accordance with the terms of the mortgage loan, the pledgor agrees to grant the mortgage lender a security interest in a basket of securities that comprise the defeasance collateral - normally Government of Canada bonds. The grant of the security interest and the delivery of the defeasance collateral to the mortgage lender to hold (among other requirements) triggers the right for a pledgor to have the lien of the mortgage released from the real property. The security interest created by the pledge is perfected by various means, including by registration of a financing statement pursuant to the Personal Property Security Act in the applicable jurisdiction and by means of passing all rights to control the defeasance collateral to the mortgage lender.

Account Agreement
The Account Agreement has dual purposes. First, it sets out the instructions to the mortgage lender to hold the defeasance collateral in a pledged collateral account and to withdraw certain amounts from the income from the defeasance collateral each month and apply those amounts in satisfaction of the monthly payments due under the mortgage loan. Second, it further completes perfection by control under the Securities Transfer Act (Ontario) by placing all control over the defeasance collateral (the bonds) in the hands of the mortgage lender.

The Defeasance Collateral
Generally, the mortgage loan documents specify that direct, non-callable obligations of the Government of Canada are the only acceptable securities for use as defeasance collateral. In some circumstances, the various interested parties will permit the pledgor to use debt obligations which are of equivalent ratings, such as EDC and BDC bonds, each of which are debt obligations issued pursuant to the credit of the Government of Canada.

Ideally, the portfolio of bonds is structured so that each bond matures on or before a scheduled payment date under the mortgage loan, and the proceeds from the maturity of each bond are used to make the monthly payments due under the mortgage loan. In practice, Government of Canada bonds can be difficult to source, and in some cases, are not available for the required time period, leading to large cash balances being held in the pledged collateral account to cover many months of payments under the mortgage loan. Inefficiency in the bond portfolio raises the notional cost to the borrower, as cash sits unallocated and idle.

Misconceptions
It is important to note that once a defeasance is complete, the mortgage loan remains in place, except for (i) the registration against the real property and (ii) the promises relating to the ownership, use and operation of the land. In Canada, defeasance does not release the borrower from its obligations under the mortgage loan. The obligations of the borrower, including the obligation to pay and all covenants not specifically related to the property (such as all events of default) continue to be operative until the final payment is made under the mortgage loan.