Real Estate Finance Notes 9/3/04

More on Schrader v. Benton

Wraparound mortgages were very popular back in the day! The seller got a great return on their investment, and the buyer got a good deal too. Only the bank got screwed. Amfac didn’t like the deal! If they could get the money back, they could relend it at current rates. They could lend it to the Schraders or someone else entirely. They would like to get rid of old, low interest rate loans. They exercise their “due on sale” clause, which is included in virtually every mortgage contract prepared by a commercial lender. These clauses may not be present in mortgages made by individuals, or you may be able to bargain around them. The “due on sale” clause is required to make a loan saleable to FHA, Freddie Mac and Fannie Mae.

The court said that the buyers could either pay all cash or could assume the existing loan on terms acceptable to Amfac and then pay the sellers the $12,700. This is all the same to the lenders. The court says that the buyers could assume the mortgage, pay $7,000 cash, and give the seller a second mortgage for $5,700 due in two years. The court of appeals doesn’t like this! They say that the trial court abused their discretion in offering this option to the Schraders. The problem here was that the parties bargained without considering the “due on sale” clause. The only way to negotiate an arrangement like this is to bring the lender in to the negotiations.

With a wraparound mortgage, the buyer gives the seller a note and mortgage for the entire amount of the indebtedness. The buyer makes payments on that loan at whatever rate they agreed upon. The seller would take a portion of those payments and pay them to the original lender. The seller is in a position to assure that the payments are made on time. But if you do a second mortgage and the buyer doesn’t pay, the seller has no way of knowing until he gets a notice that the mortgage is in default.

Historical development of the mortgage

The original mortgage started as a fee simple subject to a condition subsequent. The mortgagor has a right of entry and the mortgagee has a fee simple that can be defeated by the mortgagor paying off on time. That means that if the mortgagor is late, at all, and time is of the essence, then the condition can never occur. The mortgagee becomes the owner of a fee simple absolute and the mortgagor has nothing. There is a great potential for an inequitable result here! If the mortgage is small with respect to the value of the real estate, the mortgagee gets a windfall. If the debt has been paid down, the mortgagee also gets a windfall. The mortgagor gets screwed!

Equity of redemption

The courts of equity come in and develop the concept of the equity of redemption (more specifically, the equity of tardy redemption). The mortgagor can come in late and pay the mortgage, even though the law courts wouldn’t have allowed it. The courts of equity say: “You’re late, but so what?” You originally had to provide a good reason, but later you didn’t really need to. But that creates another set of problems. The mortgagees say that if you’re late but have the right to pay off the mortgage, how late can you be? How do you terminate the equity? The doctrine that the courts come up with is a process for foreclosing the equity of redemption. Everybody talks about foreclosing the mortgage, but it’s not really the mortgage that’s being foreclosed. What’s being foreclosed is the further exercise of the equity of redemption, that is, your right to pay off the mortgage. The result is that the court sets an “outside date”, which is essentially the date of sale. The court orders that the sheriff seize and sell the property at public auction. That is the date beyond which the mortgagor cannot exercise the equity of redemption. The courts in Ohio, by custom, don’t approve auction sales of real property until three days after the auction.

When we looked at the mortgage as a fee simple subject to a condition subsequent, it was very much like strict foreclosure, meaning that the mortgagee is not required to sell the property. The mortgagee, upon declaring a default and foreclosing the equity of redemption, simply becomes the owner of the property. But the problem with that is that the mortgagee may get a windfall because whatever equity the mortgagor has in the property is lost and held in its entirety by the mortgagee.

Almost every state in the United States, in almost every circumstance, prohibits strict foreclosure (except maybe Vermont). Instead, foreclosure by sale is required, the benefit of which is two-fold: (1) you generate cash under circumstances controlled by the law so that there is some assurance of reasonableness of the manner in which the sale is conducted. (2) The cash is distributed to the parties to whom it’s due. The mortgagee only gets the amount of the debt outstanding, and if there is any surplus it will go to junior mortgagees, and then to the mortgagor in the value of the mortgagor’s equity. But how often is there any surplus? There is no surplus in a majority of cases. If the proceeds from the sale of the property don’t satisfy the debt in full, the debtor will be personally liable for the balance.

There is a so-called rule against “clogging”. Mortgagees would sometimes demand that mortgagors waive the equity of redemption. This was found to be against public policy and would not be upheld. The assumption is that the mortgagor and mortgagee have unequal bargaining power and that the law will be entirely circumvented if we allow these waivers to take place. The circumstances under which the courts find an attempted waiver can be surprising. Courts look very closely at mortgage deals to look for anything that looks like a waiver of the equity of redemption.

Before default and acceleration, you have the legal right of redemption: you may have the right to pre-pay, you may have to wait until a specified date, but the law lets you eventually take the property free of the encumbrance and hold it in fee simple absolute. After default but before foreclosure, there is the equitable right of redemption, which is what we’ve just been talking about. After foreclosure, you have a statutory right of redemption in some states (mainly Midwestern farm states not including Ohio). This developed during the Depression with the idea that people were losing their property, and if people could just wait a little while, values would bounce back up (but this was overoptimistic – it took until the 1950’s for the prices to reach pre-Depression level). The idea was that the person foreclosed upon had time to raise the money to get the property back from the purchaser at the auction.

Any time you create a right in the mortgagor, you create a risk in the mortgagee. The mortgagee will try to protect itself from that risk by raising interest rates or changing some other term of the mortgage. There’s no free lunch here! The person who buys the property at the foreclosure sale in a state with statutory redemption will probably get it at a discount because they’re taking subject to statutory restrictions. That increases the personal liability for the person who suffers the foreclosure. The farm lobby is powerful! The farm states all get two senators.

An acceleration clause says that in the event of a default, the whole amount of indebtedness becomes due. You must have an acceleration clause in the note for this to be allowed. It would be very risky to foreclosure prior to acceleration: you would only get the payments in default, not the entire balance.

Mortgage foreclosures

A mortgage is a right to get paid out of the proceeds of that sale in preference and priority over everybody with a subordinate right. That means that if you have a mortgage on certain real property, you get paid before the unsecured creditors of the mortgagor. You get paid before the other people that may own an interest in the property that is junior in time to yours. The property gets sold at foreclosure. What is the state of title of the purchaser? The purchaser at foreclosure gets the title as it existed immediately before the original mortgage was entered into. That’s important! This is part of the definition of a mortgage. In the overwhelming majority of cases, the original mortgage ceases to exist; the purchaser at foreclosure takes free of the first mortgage. When we get to the problem of omitted junior lien holders, we’ll find that the mortgage will be considered to still be in existence for certain purposes. What if a second mortgagee forecloses? Who owns what? The purchaser at foreclosure gets the title as it was just before the mortgage was entered into, namely, they take the property encumbered by the first mortgage. [See hypo in slides]

Junior mortgages are more risky because you get paid second. What’s a less obvious reason? The second mortgagee can’t control the timing of the foreclosure, and that may be important. If you’re in a situation where your judgment as the lender is that if you wait you can sell the property for more money later than now, and if you’re in control of the foreclosure process, then you can decide to wait. But if you’re the second mortgagee, you can’t control the timing. The first mortgagee is in control. If you have a sale by the first mortgagee, the purchaser will pay no more than fair market value. But if you have a sale by the second mortgagee, you buy for fair market value minus the value of the first mortgage. When the second mortgage forecloses, the first mortgagee receives none of the proceeds of the sale, but the mortgage is still in effect. The first mortgagee can foreclose later.

Deeds of trust

This is a not a mortgage substitute. There are some states where these are common, such as California, and others where they’re never used, like Ohio. The reason for this device is not to get around the equitable right of redemption. It’s designed so that the lender can purchase at the lender’s own foreclosure sale. In some states, mortgagees couldn’t bid at their own sale, meaning that they couldn’t control the property anymore. So this device was created to allow the person who would be the mortgagee to purchase at the lender’s own foreclosure sale. This also gives the lender the option whether to go through judicial foreclosure or to exercise the power of sale, which happens by statute and without much intervention by the courts. Three people are involved: the grantor is the same as the mortgagor. The trustee is the new person in this transaction, but the trustee’s sole job is to get the deed to the property and then to reconvey it to the grantor when the deed of trust is paid off. The “trust form” is borrowed for the purposes of getting around restrictions in certain dates.

Mortgage substitutes

These are designed to avoid the equity of redemption. One is the covenant not to coney or encumber the property. The bank asks the mortgagor to promise not to convey the property to anyone else or use it for collateral in any other transaction. It’s not a very powerful device, but it at least keeps some property there that will be available to satisfy the bank’s personal judgment. The second thing you can do is just lie. Instead of a mortgage, the borrower conveys the property to the lender without reference to a loan, but with a secret agreement that it is a mortgage. This doesn’t work either, but the idea is that in the event of a default, you don’t have to go through foreclosure or sale or anything else. These kinds of deeds are actually quite easy to set aside if you can prove this arrangement. Finally, you have the installment or land sale contract. This looks like a purchase agreement, but in substance it’s a mortgage. Law treats the last two as mortgages. The first one is not treated by a mortgage. You have a cause of action for breach of contract, but you don’t have the priority that a mortgage would have given.

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