Defeasance is the process through which a borrower is released from the obligations associated with its debt through the purchase of a portfolio of high quality bonds. This portfolio serves as replacement collateral to secure the debt and generates the cash flows required to meet the future obligations of the debt.

While the process can be summarized in just a few lines, in practice it is very complex, involving a large number of parties with competing interests. Chatham Financial has a successful track record of assisting its clients in defeasing their loans since 2000.

A Brief History

The concept of defeasance was first created in the municipal market and has since been adapted to the real estate market. However, while defeasance in the real estate market uses some of the same concepts as municipal defeasances, there are significant structural and legal differences.

Loan originators provided the impetus for defeasance in the real estate world. The loan originators' business model is to issue a series of loans and then to securitize them, issuing bonds. The loans are placed in a Trust and the cash from the sale of the bonds allows the loan originator to recapitalize and repeat the process.

These bonds are known as Commercial Mortgage Backed Securities (CMBS) and a Real Estate Mortgage Investment Conduit (REMIC) Trust is established to service the bonds.

A significant concern of investors buying fixed rate CMBS bonds was whether the bonds would be prepaid before their stated maturity. Prior to the adoption of defeasance in 1998, this risk reduced the overall value of the securitization to the loan originator. Defeasance created a structure that protected the bond holder's cash flows and loan originators eagerly adopted it. Removing this risk increased investor's confidence in the expected cash flows from the bonds and allowed loan originators to realize more value from the bond issuances. While defeasance may be seen as a step forward for loan originators and bond-holders, it has placed an expensive and complex burden on the borrower.

How does defeasance work?

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As described in our overview:

Defeasance is the process through which a borrower is released from the obligations associated with its debt through the purchase of a portfolio of high quality bonds. This portfolio both serves as replacement collateral to secure the debt and generates the cash flows required to meet the future obligations of the debt.

The loan's Servicer typically requires that a Successor Borrower take the place of the original Borrower. The original Borrower purchases sufficient collateral to service all remaining payments of principal and interest. The REMIC Trust places a lien on this collateral which replaces the lien against the borrower's property, thus allowing the property to be released. Once the Successor Borrower takes the place of the Borrower, the original Borrower is released from its financial obligations under the loan.

The collateral is a portfolio of bonds that generates cash flows (coupon payments and maturing bonds) that match the loan obligations as closely as possible. This portfolio of bonds is known as the Defeasance Collateral. The cash required to purchase the defeasance portfolio usually comes from the proceeds of a refinance or sale of the property.

The two diagrams below illustrate, at a high level, the role of the Successor Borrower in a defeasance.

Immediately prior to defeasance

(Click on the image for a larger view)

Following the defeasance.

(Click on the image for a larger view)

Who structures the defeasance collateral?

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Structuring the portfolio of bonds for a defeasance is a complex task: strict guidelines govern how much cash may be included; month-end cash balances have limits throughout the life of the loan; and a large universe of bonds is available from which to construct the portfolio. Chatham Financial uses proprietary optimization techniques to structure portfolios of bonds such that they meet the Servicer's requirements at the lowest possible cost to our clients.

What bonds can be used to structure the defeasance collateral?

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The Servicer will look to the definition of allowable securities in the loan documents. Typically, loan documents generally allow U.S. Treasury Bills, Notes and STRIPS (Separate Trading of Registered Interest and Principal of Securities). However, depending on the specific language used, it may be possible to use fixed-rate bonds issued by the Resolution Trust Corporation (REFCOs), Government Sponsored Entities such as Fannie Mae or Freddie Mac, and less commonly, bonds issued by entities such as the Federal Home Loan Banks (FHLB). Fannie Mae, Freddie Mac, and FHLB bonds all trade at a spread over Treasuries making it less costly for the Borrower to purchase a portfolio of these bonds rather than US Treasuries alone.

Chatham Financial (and our legal representatives) are familiar with the language used to describe allowable securities and will work with the Servicer to allow the use of higher yielding bonds if it is possible.

Where does the residual value of the Successor Borrower come from?

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As mentioned elsewhere in this FAQ, mismatches exist in timing between cash receipts from the defeasance collateral (coupon payments or bond maturities) and cash payments (loan obligations) over the life of the defeased loan. The rules governing the structuring of the defeasance collateral stipulate that interest earned by the Successor Borrower due to this mismatch in timing cannot be applied toward scheduled loan payments (zero reinvestment income must be assumed when structuring the portfolio). These interest amounts accumulate over time and represent the residual value of the defeasance transaction.

The largest part of the residual value typically arises from the mismatch of the loan maturity date and the maturity date of the Treasury that matures closest (but prior to) that date. In some cases, this may be a mismatch of several months. This large balloon payment may sit in the Successor Borrower account accumulating interest for several weeks or even months.

Recover the residual value of your Defeasance with Chatham Financial

Chatham Financial pioneered the practice of returning a portion of the residual value to its clients. The actual amount of the residual value is not known until the loan has fully paid, although it can be estimated at the time of defeasance. The exact value will depend on short term interest rates over the life of the defeasance.

To facilitate the defeasance and the recovery of the residual value of the Successor Borrower, Chatham Financial establishes and maintains this entity until the maturity of the loan or earlier, if prepayment is possible (the residual value can be increased substantially if it is possible to prepay the loan following a defeasance). Please use our defeasance calculator (insert link) for an estimate.

Can the residual value be paid up front

To what date is the loan defeased?

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Yes! Chatham Financial has pioneered the practice of paying borrowers the present value of the expected residual value at defeasance closing.

To what date is the loan defeased?

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A significant factor in the defeasance of a loan is the date to which it is defeased (the date the final payment is made from the defeasance collateral). Many loans have a prepayment window or "open period" a certain number of days prior to the loan's maturity date. During this period, which is typically anywhere from 0 to 180 days in length, the loan may be prepaid at par without any penalty.

When a prepayment window exists, Chatham Financial will attempt to structure the defeasance collateral to the start of the prepayment window only. This usually has significant value to the borrower since the borrower would save on the final months' interest. For example, in the case of a 90 day prepayment window, the borrower would save the present value of 3 months of interest.

Please note that this right depends on the interpretation of the language in your loan documents by the Servicer's Counsel. If this right is not specifically contemplated by the loan documents at inception, the request will typically be denied; therefore it is important to address this issue at the time of closing on any new fixed rate financing. Chatham Financial reviews defeasance provisions in the term sheet of new financings as a complimentary service.

What if we can't defease to the start of the prepayment window?

If the Servicer's Counsel decides that we are not able to defease to the earlier date, we will:

• Work with the Servicer's Counsel to ensure that this open period survives the defeasance process.

• Attempt to prepay the loan when that date arrives.

Although we have been successful in prepaying defeased loans in the past, this is no guarantee of future success. The terms of the original loan document may not specify a prepayment window or may be worded such that this right to prepay does not survive the defeasance process. The Servicer may also raise concerns at the time of attempted prepayment that prevent or delay prepayment.

Please note that market conditions could be such that it is preferable to not prepay this loan. Chatham will not pursue this possibility if it will reduce the value of the Successor Borrower to our clients.

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Due to the securitization process, multiple parties become involved in the defeasance process. In addition to the Borrower and their legal representative, the Borrower's Counsel, it is common to see the following:

• The Servicer is the party responsible for administering the trust (usually a REMIC) that holds the pool of loans and pays the bondholders. They will charge a defeasance processing fee, often paid as a deposit prior to starting the defeasance process.

• The Servicer's Counsel is the party that will examine the loan documentation and draft the core defeasance documents.

• If the borrower has had past problems making loan payments, any previous defaults, or there are issues with the property that secures the loan, then the Special Servicer may also be involved. In some cases, the Pooling and Servicing Agreement will require that the Special Servicer review all defeasances for a given securitization.

• The Defeasance Consultant advises their client on how to navigate the defeasance process with all other parties and also takes on three key roles:

  1. Structuring the defeasance collateral (the portfolio of bonds) that both generates the cash flows required to meet the future obligations of the loan and also serves as replacement collateral (in place of the property) to secure the loan.

     Who structures the defeasance collateral?

  2. Coordinating the purchase of the securities for the defeasance collateral.

     What do I need to know about the defeasance closing process?

  3. Setting up a Successor Borrower entity to hold the defeasance collateral and assume the future obligations of the loan.

     How does defeasance work?

  The Defeasance Consultant has a unique role because they are the only party that is both completely familiar with the defeasance process and is acting as an advocate for the borrower.

• The Successor Borrower will also retain Successor Borrower's Counsel in order to ensure that the Successor Borrower entity is set up correctly and is in compliance with the Rating Agencies' and Servicer's requirements.

• Once the defeasance collateral has been structured by the defeasance consultant, the Servicer will require that it is checked by an independent Certifying Accountant. This accountant will verify that the cash flows generated by the portfolio will meet the future obligations of the loan and also that the portfolio complies with the requirements of the Servicer with regard to minimum balances and other rules.

• During a defeasance, a Securities Intermediary or Custodian is required. Upon the close of the defeasance the Custodian holds the defeasance collateral in a segregated account and ensures that the ongoing monthly loan payments are made on behalf of the successor borrower.

• In the case of a property sale, it is important to make sure that the Purchaser and Purchaser's Counsel are briefed on the defeasance closing process. Similarly, if it is a refinancing, the Refinance Lender and Refinance Lender's Counsel should be similarly briefed.

  What do I need to know about the defeasance closing process?

• Depending upon the size of the loan, one or more Rating Agencies may be involved in the defeasance process to ensure that the Successor Borrower complies with their requirements. An example of recent criteria is as follows (any one of these criteria may trigger the requirement for Rating Agency approval):

  Threshold Criteria for Rating Agency Review	Moody's Threshold	S&P Threshold	Fitch Threshold
  Ranking of loan within the securitization in terms of size	Top 10	Top 10	Top 10
  Percentage of securitization that this loan represents	> 2%	> 5%	--
  Current principal balance of loan	> $25,000,000	> $25,000,000	--

• Finally, as with the majority of real estate transactions, a Title Agent and Escrow Agent (these are often the same entity) will be needed to facilitate the closing process.

Who sets the transaction fees for these parties?

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The parties involved in a defeasance set their fees independently and are typically non negotiable. One of the very few situations in which a discount is possible is in the case of the defeasance of a portfolio of loans. If these loans were originated with the same lender and were subsequently placed in the same securitization, the Servicer and other parties may be willing to discount their fees.

Finally, the fees stated by the various parties are given assuming that the parties involved with the transaction are familiar with the defeasance process. If the defeasance fails to close due to mistakes made by parties unfamiliar with the process, these fees may be increased.

What do I need to know about the defeasance closing process?

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Typically you should expect your defeasance to close within a 30 day timeframe. If Rating Agency or Special Servicer review is required, you should ideally allow 45 days to accommodate their need to review the details of the defeasance.

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A standard defeasance closing process takes place over a period of 3 days. Normally this three-day sequence occurs in the same week, although occasionally it may span the weekend.

It is critical that you plan the closing on your sale or refinancing to align with the closing of the defeasance transaction. The table below outlines the sequence of events:

Day	Event
Day 1	Following approval from Borrower and Servicer Counsel, Defeasance Consultant purchases securities for defeasance collateral.
Day 2	New loan funds and proceeds go into escrow with Title (or Escrow) Agent. Closing for property (sale or refinance) takes place. Defeasance documents delivered into escrow.
Day 3	Securities for defeasance collateral transferred to Securities Intermediary by bank Cash for defeasance collateral transferred from Title/Escrow Agent to Securities Intermediary Both the securities and cash must be delivered to the Securities Intermediary by 2pm Eastern or the defeasance will not close and the securities will be returned. Securities Intermediary wires cash to bank from which securities were purchased. Notice delivered from Securities Intermediary to Servicer stating that Securities and Cash have arrived. Lien on property released by Servicer. Securities transferred to Successor Borrower's defeasance account. (Pledge of securities as collateral to REMIC Trust executed by Successor Borrower prior to Securities Purchase)

How are the securities for the defeasance collateral purchased?

Chatham Financial has developed an auction process that guarantees our clients efficient pricing on the securities purchased. This auction is conducted live, ensuring that all bids are highly competitive.

Chatham Financial is not a broker dealer. We have no interest in providing "flow" to specific banks, we receive no incentives from any banks, and we do not make any profit on the securities purchase itself.

What happens to the securities if the defeasance fails to close?

If the defeasance fails to close (for example, if the cash for the securities is not wired to the Securities Intermediary) then the securities for the defeasance collateral will be returned to the bank from which they were to be purchased. In the interim, it is likely the market would have risen or fallen to some degree. If the securities have fallen in price since the securities auction, the borrower may be held liable to make the bank "whole" for any change in the value of the securities.

Close Answer

• It may be possible (and preferable) to defease to an earlier date.

  What date is the loan defeased to?

• It may be possible to use securities other than US Treasuries for this defeasance, which would affect the defeasance collateral cost.

  What bonds can be used to structure the defeasance collateral?

• This estimate does not comprise a quote for an optimized portfolio of securities. This is particularly important for the defeasance of loans with a maturity greater than 5 years from today due to the availability of allowable bonds in that timeframe.

  Who structures the defeasance collateral?

• This estimate is subject to market movement between today and the date of your defeasance. Movement in the market could cause this estimate to diverge from actual market conditions.

How sensitive is this estimate to changes in the market?

Can I lock the price of my defeasance collateral?

In brief, yes. Depending on the size of the transaction there are a number of approaches to hedging the price of the collateral that may be feasible, including:

• A Treasury lock on a representative security to partially hedge the price you can expect to pay at the time of closing.

• A Forward Starting Cash Settled Swap to partially hedge the price you can expect to pay at closing.

• Option strategies to act as disaster insurance against major moves in the market.

Please call to discuss the feasibility of these approaches to your particular situation.

Close Answer

To estimate the sensitivity of this defeasance portfolio to changes in the market we have provided the Dollar Value of 1 basis point (DV01) for the portfolio on our Defeasance Calculator.

The expected change in the cost of the portfolio can be calculated by multiplying the DV01 by the change in rates. An increase in rates will decrease the cost of the portfolio and vice versa.

Close Answer

Once you make the decision to defease, your next step will be to submit a letter to your Servicer stating your intent to defease your loan. They will likely send you an information packet on defeasance and request up front payment of their processing fee. The Servicer will not start the process of defeasing your loan until they have received this fee.

To expedite the process, Chatham can prepare a draft of the notification letter and provide you with the wiring instructions and deposit information for your Servicer.

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Some loans are made against a portfolio of properties rather than a single asset. On occasion, borrowers may want to defease a single property from the portfolio rather than the whole loan. This may be possible, depending on the wording contained in the loan documents. However, a "Release Factor" or other multiplier may be applied to the amount of the loan that you intend to defease. It is not uncommon to see Release Factors of 125%. For example, if your loan originally allocated $10,000,000 to a property, you may have to defease $12,500,000 of the total principal of the loan to release that property.

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Your loan documents will normally contain restrictions on when you are able to defease your loan. These may, for example, specify that you can defease no earlier than 2 years after the securitization of the loan or 3 years after the origination date of the loan.

While the second figure is somewhat arbitrary (we also regularly see 4 years), the 2 year restriction following securitization is a legal requirement for REMIC Trusts.

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Defeasance vs. Yield Maintenance

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1. You may be partially hedged against fluctuations in interest rates if you are entering into a new fixed rate financing.

   Since the defeasance collateral consists of bonds that are either Treasuries, or priced over Treasuries, the cost of the defeasance collateral moves with an inverse relationship to interest rates. As interest rates increase, the price of each bond (and hence the overall portfolio) will decrease and vice versa.

   Please note that if you enter into a rate lock on your new financing and you are defeasing your old loan, you may be exposed to falling interest rates - rather than rising interest rates. Please see the grid below for a high level summary of the possible situations.

   		Unlocked	Locked
   Rates Up	Price of Treasuries	Down	Down
   	Cost of new financing	Up	No change
   	Net effect	Partially hedged	Good for defeasor
   Rates Down	Price of Treasuries	Up	Up
   	Cost of new financing	Down	No change
   	Net effect	Partially hedged	Bad for defeasor

   This is important to understand so that you do not over hedge with a rate lock agreement. Chatham Financial can help you to negotiate your rate lock (which is a derivative product) to ensure that you get the best terms and conditions.

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The best way to minimize your future costs is to negotiate for the most favorable terms for your new financing. The link below will take you to an article that highlights some of the most important terms.

Close Answer

Defeasance is most easily avoided by changing the structure of the loan to floating or by borrowing from non-CMBS lenders, but that may not be practical if fixed rate CMBS lenders offer the best loan terms.

Chatham Financial has executed over $1.3 trillion of interest rate hedges on behalf of our clients. Chatham provides execution, documentation and accounting support and has a well defined approach to advising our clients on the best possible combination of financing and interest rate hedging. Our goal is to make the process as transparent as possible. We acknowledge that there is no single, ideal type of financing for all of our clients and are careful to consider all of the options available.

To summarize some of the possibilities available to our clients:

Lender Type	Interest Rate	Interest Rate Hedge	Factors Affecting Decision
CMBS Bank Life Insurance Company Finance Company	Fixed Floating	Interest Rate Swap Interest Rate Cap (or other option products) None	Avoidance of prepayment penalties Credit Exposure to interest rate risk Cost Term of loan

Common combinations of these alternatives include:

1. Entering into a floating rate financing and managing interest rate risk by purchasing an interest rate swap.

   Points to consider:

   • A floating rate loan gives the borrower greater flexibility in terms of refinancing or selling their property. Prepaying a floating rate loan typically carries no penalty. At worst case, terminating a swap will always be less costly--by a considerable margin--than defeasing a loan or prepaying a fixed rate loan. A swap may have a positive or negative value.

   • The borrower has greater flexibility in managing their interest rate exposure. The loan can be completely swapped (replicating a fixed rate loan) or partially swapped (if the borrower desires some interest rate exposure).

   • An interest rate swap has no up front cost, but does require credit.

   While structurally it is easy to execute a swapped-floating strategy, it may be difficult depending on the credit situation. If the loan is housed within a Single Purpose Entity (SPE), then the only possible swap counterparty is the lender. If the lender does not provide swaps, this structure will be difficult unless the owner of the SPE is willing and able to provide enough credit for a swap.

   This approach would require a hedge strategy at the term sheet stage of a loan, which is why we encourage our clients to consult with us at the early stages of the loan process!

2. Entering into a floating rate financing and managing interest rate risk with an interest rate cap.

   Points to consider:

   • As with the interest rate swap, this allows the borrower to enter into a floating rate loan, which typically carries no prepayment penalty and allows for greater flexibility in refinancing or selling the property.

   • Purchasing an interest rate cap does incur an up front cost. However, once purchased, the buyer is protected from interest rates above the strike rate for the life of the cap. Also, once purchased, an interest rate cap is always an asset - it can never be a liability (a swap may have a positive or negative value.)

3. Entering into a fixed rate financing.

   In some cases, fixed rate financing is the best choice for our clients. This may be because the client requires a longer term loan than is typically available through floating rate financing or plans to hold the property for a longer period of time (with no plans to refinance or sell).

   By entering into a fixed rate loan, a borrower typically gives up flexibility. Besides the prepayment friendly language which we encourage, Chatham Financial has also been involved in structuring optional prepayment windows and other strategies which create greater flexibility for the borrower.

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