Real Estate Finance: Contracts and Illusory Agreements

1. Real Estate Finance Fall 2018Don Weidner • Nine sets of slides for the Fall 2018. • Are available on my web page under “Course Materials.” • Are also posted on Canvas under “Modules” or “Course Library”. • May be amended slightly. • Course Syllabus. • Is posted on my web page under Course Materials and on Canvas under “Syllabus”. • Assignments. • We shall proceed directly though the Syllabus • The slides will take us directly through content indicated in the Syllabus. They include additional material not in the Text or in the Supplement. Donald J. Weidner

2. Background on Contracts and Conditions Contract of Sale Seller Buyer Lender Listing Closing Seller Broker Buyer Agreement “Interim Contract” Consummation (“Closing”) of the Contract of Sale is subject to certain conditions, which must be satisfied within a particular period of time, usually involving: a) title; b) physical condition; and c) financing. Donald J. Weidner

3. Contract Conditions • Text says conditions “are essentially substitutes for information.” • About legal title, physical condition, availability of financing • However, conditions may also be inserted by the buyer to postpone making a commitment. • Conditions range from the extremely general to the extremely specific. • Conditions may leave so much open that a contract arguably fails to satisfy the requirement of a writing under the Statute of Frauds. • Even if the Statute of Frauds is satisfied, the contract may be too indefinite to support an award of specific performance. Donald J. Weidner

4. Illusory Contracts • “Since conditions will characteristically be phrased in general terms, and their fulfillment left to the exclusive control of one of the parties, there is the added question of illusoriness or mutuality of obligation.” • That party has, in effect, an option • “Generally, the problem is small, for the concept of good faith goes far toward preventing reneging parties from using a financing, title or other condition as an excuse for nonperformance.” Donald J. Weidner

5. Illusory Contracts (cont’d) • On the “excuse” issue, the text says: “In such cases the court will examine the motive of the party relying on the condition.” • If a written contract gives me a right, must I show that I am pure of heart before I may enforce it? • Not everyone thinks so. Courts are split on their role in applying the “good faith” requirement (or rubric). • “Good faith” can serve either as (1) a gap filler or as (2) a mandatory rule • We shall discuss this topic further Donald J. Weidner

6. Homler v. Malas(Text p. 92) • Seller sought to specifically enforce a Buyer’s promise to purchase a single-family residence. • Contract, on a standard form, had a “subject to financing” clause that conditioned Buyer’s performance • on Buyer’s “obtaining a loan” (“ability to obtain” had been deleted). • For 80% of the purchase price. • Repayable monthly over a term of no less than 30 years. • However, there was no mention of: • Interest rate (left blank). • The amount of monthly payment (left blank). • Amortization terms. • Should this contract be specifically enforced against the Buyer? Donald J. Weidner

7. Homler v. Malas (cont’d) • Buyer said the contract “is too vague and indefinite” to be specifically enforced because the “terms of the financing contingency are not sufficiently identified.” • Amount and length were specified • Other Georgia courts had said that a failure to specify a buyer’s interest rate “causes a failure of a condition precedent to the enforceability of the contract.” • Seller said that there is no need to specify the interest rate in a contract that anticipates third-party financing. • Can you see what the argument might be? • Especially in this case, with a single family residence? Donald J. Weidner

8. Homler v. Malas (cont’d) • Court said: it is not as if the contract had specified interest at the “current prevailing rate.” • However, the contract assumed a search for third-party financing. • Why not use the concept of good faith as a gap filler? • That is, the concept of good faith would fill the interest rate gap by implying into the contract that interest would be “at the current prevailing rate” • Stated differently, the default rule (the rule that would apply unless the parties specified a different rule) would be that the unspecified interest rate is the “current prevailing rate” Donald J. Weidner

9. Homler v. Malas (cont’d) • How would you decide this case? • Court concluded the contract was too “vague and indefinite” to be enforced against the Buyer and ordered the Buyer’s deposit to be refunded. • Why did the court refuse to use the concept of good faith to fill the interest rate gap? • Everyone agrees the buyer is under a duty to proceed in good faith. The split is on what that means. • What was the buyer attempting to do with the strikeout? • Did the contract merely give Option to Buyer? • Was the seller, therefore, trying to use GFFD to strike down the express language the seller had agreed to? • Could Buyer have enforced the contract against Seller? • Seller might have argued the old doctrine that there was no “mutuality of obligation” Donald J. Weidner

10. Definitions of Good Faith • Every contracting party is under a duty or obligation of “good faith” • The question is what that duty requires • UCC general definition of GF: “honesty in fact in the conduct or transaction concerned.” • Honesty to Webster: “uprightness; integrity, trustworthiness” also “freedom from deceit or fraud.” • UCC definition of GF for a merchant: “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.” • AKA “GFFD” • Many statutes use the term “good faith” without defining it. • Some scholars say good faith is an “excluder category”--one defined by what is deemed to be outside it rather than by what is in it. Donald J. Weidner

11. Liuzza v. Panzer(Text p. 94) • Contract to sell and to buy for $37,500. • Buyer’s obligation was conditioned “upon the ability of the [Buyer] to borrow $30,000.00 on the property at an interest rate not to exceed 9%.” • Buyer applied to an S & L for a $30,000 loan and was rejected because the appraisal was too low. • S & L appraisal was $32,150. • Buyer may have said “oooops!” • S & L would only lend 80% of the appraised value, or $25,720, which is less than the $30,000 loan condition mentioned in the contract. • Can the Buyer walk away from the deal at this point? • That is, before refusing to close, what more, if anything, must Buyer do to avoid breaching the Buyer’s implied obligation to act in good faith? Donald J. Weidner

12. Kovarik v. Vesely(Text p. 95) • Contract provided for Buyers’ obligation to buy for $11,000. Buyers were to pay • $4,000 down, with the • balance to be financed through a “$7,000 purchase-money mortgage from the Fort Atkinson S & L.” • Fort Atkinson S & L rejected the Buyers. • Seller offered to provide $7,000 financing on the same terms that Buyers requested from Fort Atkinson. • Buyers refused the offer of Seller financing • Seller sued to specifically enforce the contract. • Did the court correctly conclude that good faith required the Buyer to accept the Seller’s offer of seller financing? Donald J. Weidner

13. Kovarik v. Vesely (cont’d) • Court rejected the Buyer’s argument that the incomplete financing clause failed to satisfy the Statute of Frauds requirement of a writing. • The financing clause referred to “$7,000 purchase-money mortgage from the Fort Atkinson S & L.”. • How is this clause incomplete? • The court’s reasoning: “the loan application . . . is a separate writing which is to be construed together with the original contract of the parties, and together they constitute a sufficient memorandum to satisfy [the Statute of Frauds].” • Is there one transaction or two? Donald J. Weidner

14. Kovarik v. Vesely (cont’d) • To fill any gaps, consider the standard practice among savings and loan associations with respect to this particular type of loan. • That is, business practice and the rule of reasonableness would fill in the gaps • However, that does not mean that the buyer should be forced to accept purchase money financing from the seller. Donald J. Weidner

15. Kovarik v. Vesely (cont’d) • The majority apparently held that the obligation of good faith prevents the buyer from relying on the letter of the contract, which seems to say that the buyer’s obligation is contingent on the buyer’s ability to obtain a loan from the specified lender. • Even if good faith is a mandatory rule that could be applied to trump the language of the contract in this case, the question is what the mandatory rule requires. • A buyer could reasonably want: • A third-party lender to provide a “reality check” on value; and • A standard institutional approach in the administration of the loan • especially in the event of default. Donald J. Weidner

16. Variables that Determine Debt Service “Debt Service” is the amount of payment required per unit of time (usually monthly or annually) to service a debt. The 4 variables that determine debt service are: • Amount of loan • Usually determined by • Applying a loan/value ratio to • An appraisal of value • Length of loan • Rate of interest • Amortization terms—the terms under which principal is repaid Donald J. Weidner

17. Loan to Value Ratio • May be set in statute, regulation or internal portfolio or other policies. • Examples of statutory language used to mandate maximum loan to value ratios: • appraised value • estimated value • reasonable normal value • estimated replacement cost • actual cost • These terms are subject to a range of interpretations Donald J. Weidner

18. Loan to Value Ratio (cont’d) • Many lenders believe that the loan/value ratio is merely an obstacle that fails to serve the stated purpose of protecting the institution. • They believe that there is greater protection in exacting credit standards, increased site scarcity, inflation or other factors • Or, they are simply very eager to do a deal. • They might also be planning to sell the loan immediately and thus avoid any risk attendant to it—they have no “skin in the game” • Therefore, they often ignore the ratio • OR, increase the appraisal • (more on appraisals in slide Set #2) Donald J. Weidner

19. Length (“Term”) of Loan • The longer the length, or term, of the loan, the lower the Debt Service • Consider, for example, an $18,000 home improvement loan. If the interest rate is 6%, the monthly Debt Service is • $199.98 if the term is 10 years • $116.10 if the term is 25 years • $ 99.18 if the term is 40 years • The benefit of lower debt service has a cost: the longer the term, the more interest the borrower pays. Donald J. Weidner

20. Rate of Interest • The greater the rate of interest, the greater the Debt Service. • For example, consider a 25-year $100,000 home improvement loan. Monthly Debt Service at • 4% interest is $ 528 (interest rate in 2017) • 6% interest is $ 644 • 8% interest is $ 770 • 10% interest is $ 908 • 17% interest is $ 1,436 (interest rate in 1980) Donald J. Weidner

21. Points • “Point” is one percent of the face amount of a contract debt. • Points can be characterized differently, ex., as interest, as compensation for services, etc. • Basic examples of ways points can work: • Lender can charge a borrower a one “point” origination fee. • Purchaser of a note can charge “points.” Ex., Buyer executes note to Seller for $40,000 (interest, length, amortization terms also specified). • Lender purchases note from Seller charging 6 points [$40,000 X 6% = $2,400]). • That is, Lender pays only $37,600 for the $40,000 note [$40,000 minus the $2,400]. • Buyer still pays “interest” on full $40,000 face amount of the note (thus getting Lender more than 6% on its purchase price) Donald J. Weidner

22. Principal Interest SELF AMORTIZING LOANS Loans that are fully repaid, at the end of the debt service schedule, without the requirement of a payment larger than those that have gone before. First type: Constant Payment DEBT SERVICE COMPONENTS DEBT SERVICE IN DOLLARS . . . PASSAGE OF TIME Donald J. Weidner

23. Principal Interest SELF AMORTIZING Second Type: Constant Amortization DEBT SERVICE COMPONENTS DEBT SERVICE IN DOLLARS . . . PASSAGE OF TIME Donald J. Weidner

24. Principal Interest NON SELF AMORTIZING DEBT SERVICE COMPONENTS DEBT SERVICE IN DOLLARS BALLOON . . . PASSAGE OF TIME Donald J. Weidner

25. Goebel v. First Federal (1978)(Text p. 368) The note to the S & L provided: • Interest shall be paid monthly. • Initial interest rate was 6% per annum. • The initial interest rate may be changed from time to time at the S & L’s option. • There will be no interest rate change during first 3 years. • Borrower will get 4 months written notice before any interest rate change. • Borrower has 4 months from receipt of notice of a change to prepay without penalty. Donald J. Weidner

26. Goebel(cont’d) • Nine years later, Lender declared that the interest rate was being increased and that Borrower had the option to • Pay increased monthly Debt Service, or • Increase the length of the loan. • [No mention was made of amortization terms/balloons]. • Court said it construes ambiguous language in the note against the drafter, especially when • the drafter has much greater bargaining power, and • the drafter supplied its “standard form.” Donald J. Weidner

27. Goebel(cont’d) • As to whether the lender could increase monthly Debt Service, court said expressio unius controlled: The note contained provisions to increase Debt Service in some situations but did not expressly mention increasing debt service to reflect an increase in interest rate. • Note stated that monthly Debt Service could be increased to accommodate future advances; and • Note stated that Lender had a right to payment for taxes, insurance and repairs “on demand” • Lower court said this included the right to increase monthly Debt Service. • Yet the note “fails to make similar provisions” for an increase in interest rate • Therefore, the promisor could not be required to pay more monthly debt service to satisfy an increase in interest rate. Donald J. Weidner

28. Goebel(cont’d) • As to whether the lender could increase the term (the length of the loan), the court focused on note provision that all Principal and Interest “shall be paid in full within 25 years.” • Lender argued this clause was intended for its benefit and that it, therefore, could set it aside. • The court appears to have begged the conclusion when it said that this clause was for the Borrower’s benefit. • And, therefore, Borrower could not be forced to continue to pay debt service for a longer term • Enforcing the parties’ intent? Donald J. Weidner

29. Goebel(cont’d) • How else could you implement the interest increase provisions (if you can’t increase either the amount of the monthly payments or the term of those payments)? • The court said it was not nullifying the provisions increasing the interest rate because an interest increase would still be collectible: • To offset any prior interest rate declines • In the event of a prepayment of the mortgage • “Due on sale” clause was enforceable • How does this fit with what the court said about a balloon (“this method was not used”)? Donald J. Weidner

30. Note to Goebel v. First Federal • No argument was made that an interest increase was unconscionable or otherwise illegal. • See also Constitution Bank (Text p. 378): “If the lender may arbitrarily adjust the interest rate without any standard whatever, with regard to this borrower alone, then the note is too indefinite as to interest. If however the power to vary the interest rate is limited by the marketplace andrequires periodic determination, in good faith and in the ordinary course of business, of the price to be charged to all of the bank’s customers similarly situated, then the note is not too indefinite.” • Recall, “good faith” can be a “gap filler” to salvage an otherwise indefinite contract, particularly by importing the general business practice. • Recall, too, that the borrower in Goebel had the option to prepay without penalty upon an interest rate increase. • Indicating that market forces would limit the lender from exacting an increase. Donald J. Weidner

31. Pre-”Great” Depression Residential Financing • Amount. At least theoretically, loan/value ratios were very low, typically 50-60% of appraised value. • Lenders stretched their appraisals. • Borrowers took out second, third (“junior”) mortgage loans. • Length. Seldom for more than 10 to 15 years. In 1925, the average length for mortgages issued • by life insurance companies was 6 years; • by S &Ls was 11 years. • Rate of Interest: Junior mortgages were at higher rates of interest than first mortgages. • Amortization Terms: Balloons were common. In the “Great Depression,” 1 million American families lost their homes to foreclosure between 1930-1935 However, many more lost their homes in the years following 2006. Donald J. Weidner

32. Post-”Great” Depression Mortgage Insurance Transformed Mortgage Terms • Amount. Government undertook to insure loans with much higher Loan/Value Ratios (consumers were unable to pay big down payments coming out of the depression) • Length. To decrease the debt service on the larger loan amounts, the government insured longer loans. Terms increased up to 40 yrs. for certain projects. • Rate of Interest. The government would not insure loans above a certain interest rate. “Points” became important. • Amortization Terms. Government would only insure consumer loans that were fully self-amortizing. The fundamental Lesson of Great Depression seemed to be: never require a consumer to pay Debt Service that escalates over time. --We subsequently forgot, even spurned that lesson. Donald J. Weidner

33. The American Dream of Home Ownership Americans Living in their Own Homes (text 352) • 1940 41% • 1950 53% • 1960 62% • 1981 65% • 2006 69%* • 2017 64% *By 2008, many suggest that federal housing officials trying to raise the homeownership rate as high as possible helped cause the “subprime” crisis by encouraging loans to high-risk borrowers. Many also faulted Chairman Alan Greenspan’s Federal Reserve Bank for keeping interest rates too low for too long. Later at the helm of the Fed from 2006-14, Ben Bernanke said that it was not the Fed’s fault. From 2002-2005, he had been on the Federal Reserve Bank’s Board of Governors. Donald J. Weidner

34. “NEW” TYPES OF CONSUMER MORTGAGES (After the “Great Depression” and Before the Crash) (Text p. 374) • Adjustable Rate Mortgage (ARM) (a.k.a. “Variable Rate Mortgage” or VRM) • Graduated Payment Mortgage (GPM) • And its variant the Growing Equity Mortgage (GEM) • Renegotiable Rate Mortgage (RRM) • Shared Appreciation Mortgage (SAM) • Price Level Adjusted Mortgage (PLAM) • Reverse Annuity Mortgage (RAM) Donald J. Weidner

35. 1) ADJUSTABLE RATE MORTGAGE • Interest rate rises and falls according to some predetermined standard (reflecting market rates). • Often used in commercial transactions. • Currently, “LIBOR” (London Interbank Offer Rate) is being phased out, certainly as a mandatory standard. • A borrower must pay for an interest rate increase in one of the following three ways: --1. Debt service payments will increase; or --2. The length of the loan will increase; or --3. The amortization terms will change (a balloon will be created or increased) Donald J. Weidner

36. Adjustable Rate Mortgages (cont’d) Mechanisms to protect consumers: • Limit the frequency of interest rate increases • Limit the magnitude of each interest rate increase • Limit the total amount of interest rate increases • Require downward adjustments if the standard declines. • Offer borrowers the right to prepay without penalty upon an interest rate increase. • Note: a borrower may not be able to refinance, even if rates have dropped (ex., if creditworthiness or value of the property have declined) Donald J. Weidner

37. Adjustable Rate Mortgages (cont’d) • Mechanisms to protect Consumers (cont’d) Rules may require the disclosure of “balloons.” Balloon disclosure rules may define a balloon more narrowly than simply as a note that requires any payment at the end of the debt service schedule larger than the payments that came before • Ex., Florida statute defines it as any payment more than twice the size of a preceding payment. Donald J. Weidner

38. 2) GRADUATED PAYMENT MORTGAGE • Monthly payments are from the outset scheduled to gradually rise (independent of any fluctuations in rates), while the interest rate and the term of the loan may stay the same. • Initial concept (back in the Nixon administration): Help the young family that reasonably expects its income to grow substantially over the years following the loan closing. • Initial, low payments are not sufficient to amortize the debt or even to pay all the interest, but subsequent larger debt service payments make up for it. Donald J. Weidner

39. GRADUATED PAYMENT MORTGAGE (cont’d) • The Growing Equity Mortgage (p. 375) is another form of mortgage that involves increasing debt service. • Text discusses it as a “long term, self-amortizing mortgage under which the borrower’s monthly payments increase each year by a predetermined amount, typically 4%.” • Apparently, it never goes negative as to interest or principal. • That is, equity “grows” throughout the life of the loan • Note: a borrower can tailor his or her own growing equity provisions with prepayment privileges. Donald J. Weidner

40. 3) RENEGOTIABLE RATE MORTGAGE (a.k.a. “Rollover Mortgage”) • Series of renewable short-term notes, secured by a long-term mortgage with principal fully amortized over the longer term. • Patterned after pre-depression instruments, says the text. • As initially approved for consumer transactions, the interest rate could be adjusted up or down every 3 to 5 years and could rise or fall as much as 5 percentage points over the entire 30-year life of the mortgage. Donald J. Weidner

41. 4) SHARED APPRECIATION MORTGAGE (p. 375) • Lender agrees to lend, for example, at a flat rate that is below the current market rate, perhaps well below the current market rate, in return for borrower’s agreement that: • If the home is sold before the end of x years, the lender will receive a percentage of the increase in value; • If the home is not sold within x years, an appraisal will establish the value at that time and the borrower will pay a lump sum “contingent interest” equal to the lender’s share of the appreciation. BUT::::if the borrower requests, the lender must refinance an amount equal to the unpaid loan balance plus the contingent interest. Donald J. Weidner

42. 5) PRICE LEVEL ADJUSTED MORTGAGE • It is the loan principal, NOT the interest rate, that varies over the term of the mortgage. • The principal is adjusted up or down according to a prescribed inflation index. Donald J. Weidner

43. 6) Reverse Annuity Mortgage • Designed to enable seniors to draw cash out of the equity in their homes. • The typical Reverse Annuity Mortgagee makes monthly payments to the borrower over the borrower’s lifetime or over a predetermined period. • With each monthly payment to the borrower, the debt increases. • Typically, the debt is to be repaid at the earlier of death of the borrower, or x years from the loan origination, money to come from sale of the property or the borrower’s estate. Donald J. Weidner

44. New Mortgages (cont’d) • The Garn-St. Germain Depository Act of 1982 “preempts state regulations of nontraditional mortgages that are more stringent than counterpart federal regulations.” Text p. 377. • The Act also gave the states limited time to reinstate their programs and very few did. • Similarly, Congress, preempted “any state statute or constitutional provision that limited interest rates on first lien, residential mortgage loans.” Id. • Other real estate loans are not covered. Donald J. Weidner

45. Growth of Securitization of Mortgage Debt (See p. 352-355) • In 1934, Congress created the Federal Housing Administration (FHA) to induce thrift institutions to originate long-term loans with relatively low down payments by insuring those lenders against the risk of default. • In 1938, the Federal National Mortgage Association (Fannie Mae) was created to buy and to sell federally insured mortgages. • (“For most of its early history, it operated like a national S & L, gathering funds by issuing its own debt, and buying mortgages that were held in portfolio.”) • In 1968, the Government National Mortgage Association (Ginnie Mae) was created as a second, secondary market agency to take over the low-income housing programspreviously run by Fannie Mae. It was responsible for promoting the MBS. • According to their 2015 web site, they do not “buy or sell loans or issue mortgage-backed securities (MBS).” Rather, they “guarantee investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans,” mainly loans insured by the FHA or VA. It also says that “Ginnie Mae securities are the only MBS to carry the full faith and credit guaranty of the United States government . . . .” Donald J. Weidner

46. Growth of Securitization in Mortgage Debt (cont’d) • In 1968, Fannie Mae “was moved off the federal budget and set up as a private GSE, which in the 1970s switched its focus toward conventional loans.” • It was “given the authority to buy and sell conventional (non-federally insured) home mortgage loans.” (see p. 353) • In 1970, Congress established the third major secondary mortgage market agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), • which is also empowered to buy and to sell conventional mortgages. • “Like Fannie Mae, it is a private GSE and also is off-budget.” (Text at 353). • They compete in buying and selling mortgages. • It initiated the first MBS program for conventional loans. Donald J. Weidner

47. Growth of Securitization in Mortgage Debt (cont’d) • In short, Fannie Mae and Freddie Mac buy and sell mortgages, both federally insured and conventional, and issue Mortgage Backed Securities • Whereas Ginnie Mae itself does not buy or sell loans or issue MBS, it guarantees investors that they will receive timely payment of principal and interest on MBS backed by federally insured or guaranteed loans Donald J. Weidner

48. Growth of Securitization of Mortgage Debt (cont’d) • “In the 1970s, the secondary market agencies became critical in promoting the growth of securitization.” • “Issuers of mortgage-backed securities pool hundreds of loans together, obtain credit enhancement, usually in the form of guarantees, from a secondary market agency, and sell their interests in a pool of mortgages to investors.” 1. “The first generation of mortgage-backed securities were pass-through certificates that entitled the holders to a proportionate share of interest and principal as these amounts were paid by mortgagors.” 2. Issuers of mortgage-backed securities “subsequently divided the flow of mortgage interest and principal from the pool to create debt instruments of varying maturities and levels of risk.” • These different slices are known as “tranches” Donald J. Weidner

49. Growth of Securitization of Real Estate Debt (2002 Eggert article at 355-61) • The history of mortgaged-backed bonds stretches back to the 19th century. • Private title and mortgage insurance companies sold certificates secured by mortgage pools in the 1920s. • The modern use of securitization began with the 1970 issuance of the first publicly traded mortgaged backed security by GNMA, a GSE, which securitized mortgages backed by various government entities. Donald J. Weidner

50. Growth of Securitization of Real Estate Debt (2002 Eggert article at 355-61)(cont’d) • Various definitions of securitization. • His: “the method of aggregating a large number of illiquid assets, such as notes secured by deeds of trust, in one large pool, then selling securities that are backed by those assets.” • Think, selling interests in a package of receivables. • Through securitization, the source of mortgage funding has shifted from depositary institutions to the capital markets. • broker sells to lender, lender sells to bundler, bundler transfers to seller, seller transfers to SPE (trust), which issues the securities the seller sells. Donald J. Weidner