Many portfolio lenders like banks and credit unions can potentially avoid the credit losses on home short sales by linking short sale approval to a requirement that the borrower defease the remaining mortgage payments on their below-market rate mortgage.
In a short sale, a homeowner sells their home for less than the remaining balance on their mortgage with an agreement from the mortgage lender to accept less than the remaining mortgage balance and wave the lender’s legal right to foreclose on the property. Portfolio lenders like banks and credit unions typically retire the remaining mortgage balance by charging-off any short-sale loss against loan loss reserves.
According to Realtor.com, there were nearly 30,000 short sales in 2025. The annual pace of short sales through 2026Q1 was up 16 percent over the same period in 2025. Recent data reported by Zillow shows more than 1,600 short-sale listing in Florida alone, an increase of over 80 percent since 2025.
Lenders prefer short sales to foreclosures. A Federal Reserve study finds that, “homes selling as short sales transact at 9.2% to 10.5% higher prices on average than those that sell after foreclosure.” Moreover, compared to foreclosures, the study finds that short sales have a smaller negative impact on nearby home values. Realtor.com reports that homes listed as lender-approved short sales typically sell faster and at a smaller discount from a property’s automated valuation model estimate compared to homes listed as foreclosure auctions or as bank-owned real estate.
Making short sale approval contingent on mortgage defeasance can benefit both the borrower and lender if the value of a borrower’s mortgage can be defeased using the proceeds of a short-sale transaction. At current interest rates, defeasance may allow portfolio lenders to eliminate credit losses on many potential short-sale transactions.
In a defeasance transaction, the US government securities required to generate the cashflow needed to make timely payments of interest and principal on the debt being retired are posted as collateral with a licensed trust or escrow agent. The trust or escrow agent uses the Treasury collateral to make the required loan payments. Generally accepted accounting principles recognize financial defeasance as a legal means of debt repayment [FASB 76, APB Opinion No. 26].
A hypothetical example illustrates how the use of mortgage defeasance could allow a lender to approve a short sale with defeasance and avoid generating any accounting loss. In fact, as our example shows, it is possible to turn some short sales into transactions that are advantageous for both borrower and lender.
A household has a home purchased the 5-years ago by borrowing $500,000 using a fixed-rate mortgage with an interest rate of 3-percent. Their monthly principal and interest payments are $2,108, and after making 60 payments, their remaining mortgage balance is $444,532. Unfortunately, personal circumstances require that the homeowner sell their home, but the current market of the property is only $400,000.
If a lender approves a $400,000 short sale and uses the standard mortgage contract “due-on-sale terms”, the loan balance of $444,532 must be repaid at closing. The short sale will require the lender to book a loss of $44,532. If instead, the lender approves a $400,000 sale linked with a requirement that the borrower defease the remaining mortgage payments at closing, the lender can avoid booking any loss.
To make the math simple, assume that Treasury securities yield 5 percent for all maturities. At 5 percent, it is possible to purchase Treasury strip securities that produce exactly the cashflows needed to make the remaining 300 monthly mortgage payments on time and in full for $360,598.
Suppose the home sells for $400,000. If the short sale approval was contingent on defeasance, at closing, the borrower uses the sale proceeds to purchase the aforementioned Treasury securities for $360,598 and pledges them to a qualified trust or escrow agent to defease all remaining mortgage payments in full and on time.
Before transactions costs, defeasance unlocks $39,402 in value. While a lender can attempt to capture some or all of this amount as a “defeasance service charge” at closing, more realistically, a substantial portion of the defeasance proceeds will be needed to cover transactions costs and induce the borrower/home seller to agree to the transaction. Under current conventions, only borrowers can defease a loan.
Negotiation will determine how the borrower and lender split the defeasance proceeds. A defeasance-contingent short sale benefits the lender by avoiding the loss otherwise incurred on a straight short sale transaction, or perhaps an even larger loss on a subsequent foreclosure. The home seller benefits by reducing the loss on the sale of the property and removing the obligation to pay the full due-on-sale loan balance.
The following graph shows the (theoretical) maximum percentage discount of a borrower’s remaining mortgage balance that a lender could approve in a defeasance contingent short-sale transaction and avoid loan loss it would incur in a straight short sale transaction. The example is based on cost of retiring the remaining 360 monthly mortgage payments on the 30-year 3-percent fixed rate mortgage, gross of any transactions costs. The maximum mortgage balance shortfall that can be covered by defeasance is expressed as a percentage of the remaining mortgage balance. The calculations assume the Treasury yield curve is flat for every rate level.
For a portfolio lender, a defeased mortgage remains valued at amortized cost, exactly as before. The institution recognizes principal and interest payments over time as they are paid by the defeasance trust, exactly as if the homeowner continued making payments. In this example, defeasance avoids any credit or accounting loss. Because a defeased mortgage is collateralized by risk-free government securities instead of real estate, banks and credit unions will be eligible for reduced regulatory capital treatment [12 CFR §217.37(b)(3)(iii)(B)].
Residential mortgage defeasance is not just a theoretical idea, but as we discuss elsewhere, it is a real option for some existing homeowners with below market rate mortgages. Not only banks and credit unions, but borrowers and communities across the nation stand to benefit if lenders embrace this approach for making sales with defeasance a less costly alternative to short sales or foreclosure.
