The already popular secondary market for the purchase and sale of mortgage loans is steadily growing, as more lenders realize that selling all or part of their portfolios is an effective way to clear their books of nonperforming loans and to free up capital to extend new loans.
In addition, investors enjoy the opportunities created by acquiring nonperforming loans at a discount in hopes of rehabilitating them into performing assets, as well as purchasing performing loans to provide an excellent source of monthly income.
With the ever-increasing pool of buyers and sellers in that secondary market, it is important that investors — and the originators involved in facilitating the loan process — understand how to avoid some common pitfalls that are recurring themes in purchase-and-sale transactions gone bad.
Chain of ownership
Despite the obvious need for documentation of a mortgage loan’s chain of ownership and the seemingly simple nature of sellers maintaining the necessary documents to reflect the current and prior owners of a loan, the lack of adequate documentation concerning ownership is one of the most prevalent problems in loan-sale transactions. This issue can be avoided if buyers and sellers follow a few simple rules.
First, sellers should confirm possession of the original note, assignments, allonges and title policy — including endorsements — that track ownership of the loan from the original holder of the note to seller. The ownership history should be easy to track chronologically from the inception of the loan. As soon as a loan is offered for sale, sellers should be prepared to provide copies evidencing the ownership of the loan. In addition, sellers should be prepared to provide copies of the title policy and any assignment endorsements that were issued in conjunction with all previous transfers of the loan.
Second, buyers should request copies of all documents reflecting a clean trail of ownership. If sellers are not able to provide the necessary evidence upon request, the purchase-and-sale agreement should address this deficiency and make it a condition to closing the sale transaction.
Finally, to protect both the sellers and buyers, an assignment endorsement to the original lenders’ title policy should be obtained.
Oftentimes, especially in transactions involving nonperforming loans, sellers, or one or more of the predecessors in interest, have entered into one or more agreements with borrowers modifying the terms of the loan. These could include changing the payment amount, the payment schedule, the interest rate and the maturity date.
Unfortunately, the agreements modifying the terms of the loan tend to disappear from the loan-document package over the course of multiple transfers and the passage of time, resulting in buyers purchasing a completely different loan than was bargained for. A failure to account for any and all modifications of terms also can have a negative effect on sellers, if they undervalue a loan being assigned based on an incorrect calculation of the outstanding principal balance. In addition, a loan that is believed to be nonperforming may actually be in good standing as a result of modifications to the loan terms.
The steps that should be taken by sellers and buyers to safeguard against hidden modifications and/or forbearance agreements are similar to avoiding chain-of-ownership miscues. Preparation of all relevant documents by sellers and a request and review of the documents by buyers are critical. At a minimum, buyers should insist that sellers represent and warrant the completeness of the loan file.
Many mortgage-loan transactions include a delay between the execution of the purchase-and-sale agreement and the actual closing of the transaction. Some common reasons for this gap period include allowing time for buyers to conduct due diligence, to provide buyers with more time to arrange financing or to provide more time for the clearing of closing conditions.
Although the gap period is often negotiated into the purchase-and-sale agreement, the parties often neglect to account for their respective obligations, rights and liabilities during this period. To ensure certainty in the transaction, the loan purchase-and-sale agreement should account for the terms of the gap period. Chief among them are the following.
Damage to the collateral securing the loan: Will the sale still close if the property securing the loan is damaged? If buyers are still obligated to purchase the loan, the agreement should specify whether that obligation extends to instances in which the collateral is completely destroyed versus partially damaged.
It is important for buyers to know how the security instrument being assigned accounts for partial and total losses to the collateral, including the rights provided to lenders with respect to insurance proceeds. For example, are the insurance proceeds assigned to lenders, do lenders have discretion concerning the application of those proceeds and what are the limitations, if any, on such discretion?
Borrower default: What collection actions, if any, can be taken by sellers if borrowers default during the gap period? Are sellers allowed to modify the loan and/or establish a forbearance period? Are buyers entitled to direct the manner in which the default is handled or approve any forbearance or modification? Which party is entitled to fees related to the default, including late fees, modification fees and forbearance fees? Are buyers allowed to terminate the transaction if there is a default?
Furthermore, if the foreclosure process commenced prior to execution of the purchase-and-sale agreement, who makes decisions and directs the foreclosure during the gap period? Are sellers required to obtain consent from the buyers prior to acting? Can sellers use a default reserve to make periodic payments — such as paying taxes, insurance or for some other purpose defined in the loan documents? Will such an action by sellers result in an adjustment of the purchase price?
Allocation of reserve accounts and holdbacks: If lenders or third parties are administering a reserve account or holdback of funds, then who is entitled to approve disbursements from that account? Will a disbursement or disbursements affect the purchase price?
Additional decisions: Which parties are entitled to approve leases, place insurance or execute partial releases?
Because significant events can occur, even in the briefest of gap periods, it is critical that the parties contemplate the scenarios described above and provide solutions for potential problems at the outset of the transaction in the purchase-and-sale agreement. At the very least, there should be a provision requiring the sellers to provide notice to buyers of developments during the period between the execution of the purchase-and-sale agreement and the closing of the loan deal.
Furthermore, to provide certainty for the parties and guard against avoidable litigation, the buyers’ consent, which must not be unreasonably withheld, should generally be required prior to any significant action being taken.
The complexity of loan purchase-and-sale transactions can vary greatly depending on the number of loans being sold, the nature of the loans being sold, and various other factors specific to individual lenders, buyers, borrowers, collateral types and the manners of closing.
Anybody who is interested in selling or buying mortgage loans, as well as the originators involved in assisting clients with loans that are destined for resale, should educate themselves concerning the various nuances and pitfalls that may arise in a loan-purchase transaction. Gaining a thorough knowledge of the ins and outs of a loan sale, and taking the time to properly review and document events that are key to the transaction, can save all parties substantial time and money, and ensure a profitable investment.
Dennis Baranowski is a senior associate with Geraci Law Firm. He has extensive experience in helping banks, credit unions, mortgage funds, private lenders, brokers, developers and loan servicers navigate through complex transactions, including negotiation of terms, transaction review, and drafting of documents. In addition, Baranowski also has experience in default-related legal services including foreclosure, bankruptcy, and loss mitigation, as well as lender compliance. Reach him at firstname.lastname@example.org.