1. REAL ESTATE 410 Mortgage Documentation and 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 pronote provides evidence of the debt between 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 to accelerate 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 Prepayment 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? What is default?
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 %
Jun %
Dec %
Jun %
Dec %
Jun %
Dec %
June %
August %

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 (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 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

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, )

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 foreclosure states, foreclosures typically take about 4 months, while the typical foreclosure in judicial foreclosure states 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. Next:
Fixed Rate Mortgages