REAL ESTATE 410 Mortgage Documentation and Foreclosure

1. REAL ESTATE 410 Mortgage Documentationand Foreclosure Spring 2017

2. Topics • Promissory note and mortgage • Key clauses • Prepayment • Factors affecting defaults • Foreclosure process • Alternatives to foreclosure

3. What’s a Mortgage Loan? • A mortgage loan is a debt that involves real estate as collateral security. • It is a contractual agreement between the mortgagor (borrower giving the lender a mortgage on the property as security) and the mortgagee (lender receiving the mortgage). • A mortgage loan includes two separate legal documents: • A promissory note (pronote) • A mortgage

4. Promissory Note • Written loan agreement containing the contract terms between the borrower and the lender. • It contains the specific financial and legal terms of the loan. • Legally, the pronoteprovides evidence of the debtbetween borrower and lender. • Without the pronote, the lender cannot technically foreclose on the property • A mortgage cannot be enforced unless the mortgagor owes a debt to the mortgagee

5. Mortgage • A temporary, conditional pledge of property to a creditor as security for repayment of a debt or performance of an obligation. • A written legal instrument (required by the Statute of Frauds) that ties the property to the loan as collateral security for the debt. • Elements essential to the existence of a mortgage: • Consideration • A pledge of property as security for that obligation

6. Mortgage vs. Pronote • The pronote creates the obligation to repay the loan in accordance with its terms. It admits the debt and generally makes the borrower personally liable for the obligation. • The mortgage ties the real estate being financed to the loan used to pay for the real estate. • In case of default the mortgagee (the lender) may elect to disregard the mortgage and sue on the note alone! • When is this likely to happen?

7. Pronote Clauses • Loan terms (amount, interest rate, repayment, etc.) • Escrow for property taxes and insurance • Late payment provisions • Events of default • Acceleration clause • Prepayment provisions • Due on sale clause • Assumption clause • Lender-in-possession clause • Preservation and maintenance (bad-boy clause) • Additional guarantees • E. g., recourse, credit enhancements, etc.

8. Common Clauses • Acceleration/Remedies Clause • This clause allows the mortgagee toaccelerate repayment of the debt in the case of a default. • Without this clause, a mortgagee can only sue a delinquent mortgagor for payments then in default. • But borrower may be given rights to reinstate the original terms after the mortgagee has caused an acceleration. • Lender-in-Possession Clause • Upon acceleration of the debt, the mortgagee may enter the property and collect rents until the mortgage is foreclosed. • Rents collected must be applied first to the costs of managing and operating the property, and then to the mortgage debt

9. Common Clauses • Due-on-Sale Clause • Allows the lender to accelerate the debt when the property is sold or transferred to someone else. • Prepayment Clause • The lender is not required to accept advance payments unless there is a prepayment clause. • It may include a prepayment penalty that the lender, at his option, may choose to charge. • Most conforming residential mortgages allow prepayments without penalty since it one of the conditions required by Fannie and Freddie (GSEs) to purchase the loan. • On the other hand, commercial mortgages rarely do.

10. Prepayment as an Option • Prepayment clause gives the borrower the option to pay down the mortgage at any time. • Questions • Why would lenders penalize borrowers for prepaying their mortgages? • When are borrowers likely to pay down their mortgages? • When are Lenders most likely not to enforce a prepayment penalty provision then? • What impact would a prepayment option have on the pricing of a mortgage? • Is the practice of not including prepayment penalties for conforming conventional mortgages optimal?

11. Common Clauses • Assumption of Mortgage • The mortgagor transfer his rights to another person; grantee become then liable. • It shifts the responsibility for the payment of the debt from the grantor to the grantee. • However, the mortgagee (lender) may still hold the original mortgagor liable, unless the original borrower obtains a Release of Grantor from Assumed Debt. • Acquiring Title “Subject to” a Mortgage • Similar to mortgage assumption, but grantee not personally liable for the debt. • Grantor still personally liable and may be held liable for any deficiency judgment.

12. Common Clauses • Funds for taxes and insurance clause • Charges and liens • Preservation and maintenance of the property Clause • After-acquired property and fixtures • Subordination clause • Recourse clause • Power-of-sale clause • Required in some states (e. g., Wisconsin) for non-judicial foreclosures Many of these clauses shift risk from the borrower to the lender (or vice versa) and are therefore priced in the mortgage!

13. Mortgage Default • What is delinquency? • Failure to meet an installment of the interest and principal payments • What is default? • Prolonged delinquency • Default can also result from breach of terms and conditions of the loan contract (technical default) • E. g., failure to pay taxes or insurance premiums, failure to repair or maintain the property, etc. • But technical default seldom leads to foreclosure right away • Lender notification to borrower required!

14. Average Monthly Default Rates Seriously delinquent mortgages: • Dec-95 0.88% • Jun-96 0.93% • Dec-96 0.96% • Jun-97 0.98% • Dec-97 0.96% • Jun-98 0.90% • Dec-98 0.87% • June-99 0.74% • August 2009 9.24%

15. Default Probability

16. Factors Affecting Default • Drop in property values causing loan to be under water (negative equity) • Strategic default • Build-up in loan balance (negative amortization) • Increase in mortgage payment • Drop in income • Other default “trigger events” • E.g., divorce, sickness, loss of job, etc. • Non-recourse vs. recourse loan • Neighborhood factors (negative externality) • Government intervention (moral hazard)

17. Exogenous vs. Endogenous Factors • Exogenous means reasons not directly related to the structure of the loan • Negative income shocks (unemployment) • Negative house price shocks (negative equity) • Divorce • Illness • Endogenous means cause of default related to the structure of the loans • Interest rate structure • Mortgage cost • Loan size (LTV, DTI) • Amortization structure • Recourse vs. non recourse • The two main causes of default are negative income and house price shocks

18. How common is Strategic Default? FED Working Paper No. 2010-35 (by NEIL BHUTTA, JANE DOKKO, and HUI SHAN “A central question in the literature on mortgage default is at what point underwater homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to 62 percent of their home's value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the "double-trigger" theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.”

19. Life-Changing Events and Defaults 54%if the borrower has an unexpected drop in income 26%if the borrower gets divorced from his/her spouse 6%for each additional household member after the first two

20. Reasons for Delinquency Source: Freddie Mac; data cover period 2001-2006

21. Default on Prime Mortgages Fixed vs. variable mortgage delinquencies Source: Garfinkel and Sa-Aadu (2009)

22. Default on Subprime Mortgages Fixed vs. variable rate delinquencies Source: Sherlund (FEDS, 2008-63)

23. Loss Severity & Recovery Rate • This is key consideration for a lender or an investor in mortgages or mortgage-backed securities. • Recovery rate: Fraction of the balance the lender expects to recover if default takes place. • Loss severity rate: Ratio of expected losses if default takes place to outstanding balance Loss Severity rate = 1- Recovery Rate • Loss severity varies with the market cycle. • Why is this the case?

24. Default Is Costly! • Foreclosed residential properties sell at a 25% discount on average relative to similar properties that have not foreclosed. • Loss severity rates can exceed 50%, and typically range from 30 to 40% on commercial loans, mostly due to • Transaction costs • Payment delays • Low foreclosure proceeds

25. Foreclosure Process • Delinquency • Foreclosure suit filed (in state court) • Notice of default • Complaint • Court hearing • Court decision • Period of equity redemption • Foreclosure sale • Period of statutory redemption • 6 months to one year after foreclosure sale (not in all states)

26. Foreclosure Sale • Judicial foreclosure states • A mortgagee (lender) must obtain a state court order and the borrower be given opportunities to contest the foreclosure in the court • Lengthy and costly for the lender • Non-judicial (power of sale) foreclosure states • No court action required for the sale of property by the mortgagee • The borrower still has the right to challenge the foreclosure in a court, but he/she needs to obtain a (temporary) injunction from the court in order to stall the foreclosure process. • Some states allow both (e.g., WI), but judicial foreclosure is usually the default if not included in loan contract.

27. Foreclosure Sale • In non-judicial foreclosurestates, foreclosures typically take about 4 months, while the typical foreclosure in judicial foreclosurestates can take 8 months or more even more. • Effect of foreclosure law on mortgage rates? • Deficiency Judgment • Right for the lender to go after the borrower’s other assets for any shortfall • Effect of deficiency judgment on mortgage rates?

28. Alternatives to Foreclosure • In practice, most mortgagees are not anxious to take property from mortgagors because the foreclosure process is quite expensive • Alternatives to foreclosure: • Restructuring/recasting the loan (commonly referred to as mortgage modification or renegotiation) • Transfer of the mortgage to a new owner • Voluntary conveyance of the title to the mortgagee (deed in lieu of sale) • Friendly foreclosure • Prepackage bankruptcy • Short sale

29. Mortgage Renegotiation The purpose of mortgage restructuring is to make the mortgage affordable again to the borrower. This may be achieved by • Lowering interest rates • Extending the maturity date • Reducing the principal • A combination of all these • Advantages: • Less costly to the lenders, mortgage more affordable to borrower • Disadvantages: • Moral hazard, re-default risk, default cure rate?

30. Role of Securitization in Renegotiation “Role of Securitization in Mortgage Renegotiatioin” by Agarwal, Amromin, Ben-David, Chomsisengphet, Evanoff (JFE 2011) • This study employs data that directly observe lender renegotiation actions and cover more than 60% of the U.S. mortgage market • Frictions introduced by securitization create a significant challenge to effective renegotiation of residential loans • Bank-held loans are 26–36% more likely to be renegotiated than comparable securitized mortgages • Modifications of bank-held loans are more efficient: conditional on a modification, bank-held loans have 9% lower post-modification default rates

31. Alternatives to Foreclosure • Transfer of the mortgage to a new owner • By assumption of the mortgage or transfer of title “subject to” the existing mortgage • Advantages and disadvantages • Voluntary conveyance of the title to the mortgagee • Deed in lieu of foreclosure • Quiet, quick and cheap • But other liens remain

32. Alternatives to Foreclosure • Friendly foreclosure • Borrower waives any rights • Takes more time than voluntary conveyance • Is shorter and less expensive than normal foreclosure • Prepackage bankruptcy • Borrower turns the property to the lender (and any other lienholder) in exchange for a discharge of liabilities • Lender may be worst off if borrower files for normal bankruptcy

33. Short Sale in Lieu of Foreclosure • Short sale is a sale of real estate in which the sale proceeds fall short of the balance owed on the loan. • Typically, the owner negotiates the sale of property with someone and approaches the bank for approval • Gives borrower more time to move out of her home and damage her credit rating less than a foreclosure. • Quicker and less costly for the bank • This agreement, however, does not necessarily release the borrower from the obligation to pay the remaining balance of the loan, known as the deficiency. State laws are critical. Further, while lenders sometimes forgive the remaining loan balance, other lien-holders likely will not.

34. Short Sale in Lieu of Foreclosure • The borrower’s credit often will restore within 18 months or so, and depending upon other credit information, she can obtain another mortgage 1–3 years after a short sale. • Banks are careful and somehow reluctant about short sales. • Concerns about fraud are one of the reasons: Sometimes well-off homeowners portray their finances as dire and try to cut their losses on a property (get rid of an underwater mortgage). • In other instances, distressed homeowners try to make a short sale to a relative, who would then sell it back to them (a practice that is illegal). • Because of such concerns, banks require homeowners to be delinquent and apply for a modification first, even if chances of approval are slim. • The aversion to short sales also leads banks to take many months to process applications, and some lenders set unrealistically high sales prices, which discourage borrowers to apply for a short sale.

35. Fixed Rate Mortgages Next: