© JR DeLisle, Ph. D.
Lecture 3: Residential Mortgage Life Cycles
by
James R. DeLisle, Ph.D.
January 12, 2010
Real Estate Finance
Lecture Overview
© JR DeLisle, Ph. D.
• Mortgage Life Cycles
– Mortgage Process
– Mortgage Risk Management
– Legal Concepts in Mortgages
• Life Cycle Management
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Planning
Origination
Operation
Disposition
Real Estate Finance
Current Crisis
© JR DeLisle, Ph. D.
Real Estate Finance
Individual Mortgage Life Cycle
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© JR DeLisle, Ph. D.
Planning/Application
Acquisition
Operation
Disposition
Disposition
Acquisition
Planning/
Application
Operation
Real Estate Finance
© JR DeLisle, Ph. D.
Components of a Mortgage
Priority of
Claim
Nature of
Real Estate
Pledged
Components
of a M ortgage
Security
Device
M ethod of
Repayment
Nature:
Recourse or
Non-recourse
Real Estate Finance
Key Elements of Mortgage Transactions
© JR DeLisle, Ph. D.
• Parties of Interest
– Formal Names
– Roles
• Consideration
– Economic transfers
– Real estate as underlying collateral
• Contractual obligations
– Terms & Payments
– Conditions
• Termination provisions
– Repayment or Prepayment
– Assumption
Real Estate Finance
Mortgage Collateral: Property, Interests and Estates
• Property Rights
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Possession
Use
Quiet enjoyment (legal term)
Disposal
© JR DeLisle, Ph. D.
Property
Rights
Property
Rights &
Estates
• Interests
Interests in
Real Estate
Estates
– Possessory
– Non-possessory (easement, mortgage)
• Estates
– Freehold: fee simple, life, future life (reversion, remainder)
– Non-Freehold: estate for years, estate from year-year (period)
Real Estate Finance
Elements of a Mortgage Note
© JR DeLisle, Ph. D.
• Economics
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Loan Amount
Contract Interest Rate
Payment Rate or pattern
Timing
Term
Amortization Period
• Provisions
– Early termination: prepayment provisions
– Penalties for late payment
– Definition of default
Real Estate Finance
Mortgage Risks: Planning/Application Stage
© JR DeLisle, Ph. D.
Disposition
Acquisition
Planning/
Application
Operation
• Sourcing Deals
– Marketing Channels: type of applications
– Origination System: correspondents, delegation of authority
• Processing Deals
– Application Process: standard forms
– Preliminary Commitment: interest rate lock
Real Estate Finance
Strategic Market Analysis
© JR DeLisle, Ph. D.
• Role
– Important to conduct or secure market research reports
– Goal: verify and confirm rents and vacancy rates
– Explore factors influencing future rental demand as well as new supply
– Test reasonable assumptions behind the proforma
• Sources
– Analysis info provided by data vendors
– Actual market forecasts
– Use in conjunction with local broker reports
• Relevant market info may include:
– Demographic and Economic Base Trends
– Rental and vacancy rates, absorption, new supply coming online
– Transportation trends and analysis
Real Estate Finance
© JR DeLisle, Ph. D.
Consumer Protection in Mortgages
• Real Estate Settlement and Procedures Act (RESPA)
– Premise: information supports choice
– Emphasis on consumer information
• Nature & Timing: Advance disclosure of settlement
• Uniform settlement statement
• Other Protections
– Title insurance
– Prohibition of kickbacks and referral fees
– Escrow deposits
• Truth in Lending Act
– Effective cost of mortgage credit (since 1968)
– Commercial real estate transactions excluded
– APR is the most important required disclosure
Real Estate Finance
© JR DeLisle, Ph. D.
Mortgage Risks: Acquisition Stage
Acquisition
Disposition
Planning/
Application
Operation
• Evaluative Process
– Underwriting: borrower will and ability
– Due Diligence: collateral integrity, quality and quantity
• Existence of value
– Appraisal: value of underlying asset
– Collateral Commitment: clear title, deed
• Claim on value
– Priority of Claim; no intervening liens, recording
– Title Assurance/Insurance
Real Estate Finance
Due Diligence
© JR DeLisle, Ph. D.
• Overview
– Purpose of DD is to discover in detail any problems that exist
on the property which may affect future returns and liabilities
– Requires a careful analysis
• entire process of reviewing an investment opportunity
• contracting to purchase and pre-closing details
– Occurs when a tentative purchase contract has been drawn up
and buyer has time to affect possible modifications/ adjustments
• Categories:
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Market Due Diligence
Property Due Diligence
People Due Diligence
Contractual Due Diligence
Real Estate Finance
© JR DeLisle, Ph. D.
Underwriting Risks to Lender
• Borrower
– Will to pay
– Ability to pay
Borrower
Underwriting
Property
• Real Estate
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Existence of assets
Future value of assets
Continuity of rights to use
Marketability: liquidity
Real Estate Finance
People Due Diligence
© JR DeLisle, Ph. D.
• Role
– People can mess up whether or not contracts are binding
– Determine if everything else seems to be as represented
• Ability to Pay
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Who is really signing all contracts?
Income and net worth as primary source
Competing liabilities
Are personal guarantees worth anything?
• Will to Pay
– What is the track record of owners and parties involved?
– Are known risks enforceable or backed?
– Are there escrow accounts and trustworthy people involved?
Real Estate Finance
FICO Scores and Mortgage Rates
$300,000 Mortgage
http://www.myfico.com/
© JR DeLisle, Ph. D.
$800,000 Mortgage
Real Estate Finance
Property Due Diligence
© JR DeLisle, Ph. D.
• Records
– Title search and abstract verifying ownership, authority to
transfer
– Ability to secure title insurance
– Property tax records, mortgage liens, mechanics liens if any
• Quality
– The accurate “as built” survey of the building
– Operating: mechanicals including equipment
• Compliance
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Environmental studies
American with Disabilities Compliance
Zoning and building code conformity, easements
Property management review
Real Estate Finance
© JR DeLisle, Ph. D.
Existence of Collateral
• Security Device
– Deed: Warranty, special, quitclaim, trust
– Specify rights and warranties
• Interests
– Specification of possessory, non-possessory
– Clarify rights/collateral
• Estates
– Freehold or less-than-freehold
– Signify type of estate
• Title Opinion/Insurance
Transfer of
Title
Recording
Title Abstact
Title
Assurance
Title
Insurance
– Opinion: Attorney statement based on good faith/best practice
– Insurance: Against defects, unknown liens
Real Estate Finance
Collateral Elements
© JR DeLisle, Ph. D.
• Content of Collateral
– Personal Property
• Specification of items included
• Match expectations at closing
– Approvals
• Usage permits, liquor licenses
• Ensure continued operation/value
• Access to Collateral
– Priority of Initial Claim
• Subordination clause
• Avoid intervening liens
– Future Advances: treated as initial payment priority
Real Estate Finance
© JR DeLisle, Ph. D.
Contractual Due Diligence
• Several contracts of importance
– Sales/Purchase
– Leases
– Options
• Dimensions
– Costs
– Time
– Dispute resolution
• Key questions will include:
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What are the deadlines for each step prior to closing?
Who is responsible for each unresolved issue?
Who will take charge of resolving disputes?
How will time delays affect the price and terms?
Real Estate Finance
© JR DeLisle, Ph. D.
Mortgage Risks: Operation Stage
Disposition
Acquisition
Planning/
Application
Operation
• Management of Financial Obligations
– Loan Processing: collection, posting, record-keeping
– Loan Servicing: disperse payments of taxes, insurance
• Protection of Asset Value
– Periodic Inspection: property maintained, covenants honored
– Restrict Encumbrances: preclude/manage total debt, liens
Real Estate Finance
© JR DeLisle, Ph. D.
Operating Covenants
• Financial Performance
– Promise to pay
• What: Specification of payments, dates, penalties
• Strategy: Clarify expectations on cash flows
– Escrow clause
• What: Borrower periodic payments for insurance and property tax
• Strategy: Decrease financial risk; budget
• Covenants to avoid removal of Asset/Collateral Value
– Covenant Against Removal
• What: Personal Property
• Strategy: Ensure property value not gutted
– Covenant Against Partial Sale
• What: Restricts sale of portion of real property
• Strategy: Protect against reduction in collateral value
Real Estate Finance
Operational Risk Management: Asset Protection
© JR DeLisle, Ph. D.
Protection of Asset
Requires borrower to maintain property to
certain standard of care
Ensure maintenance to preserve
Good repair clause
collateral
Borrower Occupancy
Ensure "will" to pay; avoid investor
Clause
Requires borrower to use as primary residence flipping
Hazard Insurance
Insure propery value vs fire, storm, flood, etc. Ensure value protected from trajedy
Right to Inspect
Lender's right to enter, with notice
Ensure compliance with covenants
Prevents borrower from breaking up property
and selling in parcels
Protect Lender from dilution of asset
Sale in One Parcel
Real Estate Finance
© JR DeLisle, Ph. D.
Mortgage Risks: Disposition Stage
Disposition
Acquisition
Planning/
Application
Operation
• Timing and Life Cycle Returns
– Duration: actual term vs. contract term
– Prepayment Penalties: yield maintenance
• Termination
– Transfer
• Loan assumption: timing, risk, borrower substitution
• Repayment
– Foreclosure: monitor, manage and pursue/protect claims
Real Estate Finance
© JR DeLisle, Ph. D.
Transfer/Termination
Assumption
Voluntary
"Subject to"
Transfer
Transfer
Involuntary
Real Estate Finance
© JR DeLisle, Ph. D.
Risk Management at Disposition: Voluntary
Voluntary Transfer of Asset/Collateral
Voluntary Transfer
Prepayment Clause
Prepayment
Due on Sale Clause
Release Clause
Partial Releases
Borrower right to pay off
Specifies required payment to retire debt
Requires borrower to repay loan upon
property sale
Specifies conditions for freeing property from
loan security
Specifies requirements for freeing portions of
property from security
Mobility
Yield Maintenance
Terminate
Clean title
Allow orderly sale & 1st Lien for buyer
Voluntary Transfer of Mortgage
Mortgage Transfer
Assignment Clause
Estoppel Covenant
Assumption Clause
Specifies right of lender to sell, transfer,
securitize
Borrower certifies debt to provide certainty
for secondary market
Specifies right of borrower to transfer
mortgage to new buyer
Portability or Secondary Market
Risk Mgmt by Transfer; Liquidity
Borrower liquidity & Pricing
Real Estate Finance
Involuntary Mortgage Transfer
© JR DeLisle, Ph. D.
• Trigger
– Delinquency
– Default: economic or covenant
• Event Response
– Acceleration: due in full in case of breach; avoid sue for each
payment
– Foreclosure Process
– Lender in Possession: take over and collect rent prior to
foreclosure
Real Estate Finance
Loss Mitigation
© JR DeLisle, Ph. D.
• Loan modification
– Lowering the interest rate, reducing the principal balance, increase term
– ‘Fixing' adjustable interest rates,
– Forgiveness of payment defaults & Fees
• Forbearance
– Forgive portion of debt
– Permanent or temporary
• Short sale
– Lender reduces the principal balance of a homeowner's mortgage in order to
permit sale for the actual market value of the home.
– Applies to upside down borrowers
• Short refinance
– Lender reduces the principal to permit refinance with a new lender.
– Reduction in principal is designed to meet the Loan-to-value guidelines
Real Estate Finance
Foreclosure Process
© JR DeLisle, Ph. D.
• Delinquent and default events
– Notice of late, register letter
– Make decision to foreclose
– Petition Court
• Judicial Proceeding
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Judicial foreclosure sale
Taxes: priority claim that mortgagee may pay to release
Other secured claims in priority order
Deficiency Judgment
• Redemption Period
– equitable period: prior to sale
– statutory period: set by states,
Real Estate Finance
Managing Involuntary Transfer
© JR DeLisle, Ph. D.
Propensity to Default
Severity of Loss
Senior liens
Covenant to Avoid
Priority Liens
Mortgage Insurance
Avoid liens with priority over mortgage
Restirction against creation of liens with priority
over mortgage
Private mortgage insurance, FHA or VA
Joint & Several Liability Identifies parties and specifies obligations
Exculpatory clause
Makes loan non-recourse against borrower
Triggers entire outstanding balance due based on
Acceleration Clause
certain conditions
Allows lender to step in, take over and collect
Lender in Possession
rents
Prevent involuntary subordination
Protect access to collateral value
Reduce severity of loss
Recover loss beyond collateral
Protect Borrower
Access to capital without
additional litigation
Preclude borrower from skewing
funds
Post-Foreclosure
Post-foreclosure
Deficiency
Equitable Period of
Redemption
Statutory Period of
Redemption
Judicial Foreclosure
Sale
Creates possible claim against other assets
Recover loss gap after liquidation
Borrower's right to reinstate by common law
Allow borrower to common law cure
Protect borrower from unreasonable
action
Specifies process and disposition of
proceeds
Borrower's right to reinstate by statute
Lender's right to sieze and sale
Real Estate Finance
© JR DeLisle, Ph. D.
Alternatives to Formal Foreclosure
• Restructure
– Recast: change terms, permanent or temporarily
– Extension of term to reduce payments
– Grant forbearance; outright foregiveness
• Transfer mortgage
– To new party
– Voluntary conveyance to lender
Restructure
Alternatives
to
Foreclosure
Transfer
Friendly
Foreclosure
• deed in lieu reduce first mortgagee claims
• Junior claims: not released, only in foreclosure
• Collaborative Approaches
– “Friendly foreclosure,” quitclaim and hold harmless
– Prepackaged bankruptcy: agree with all creditors on asset
turnover for releases
Real Estate Finance
Chapter 7/11 Bankruptcies
© JR DeLisle, Ph. D.
• Liquidation (Chapter 7)
– Objective: give debtors a fresh start
– Process: voluntary by debtor or involuntary by creditors
– Trustee: appointed by court to oversee liquidation, allocate
proceeds
– Mortgage: generally takes priority if sufficient proceeds
• Reorganization or Rehabilitation (Chapter 11)
– Objective: preserve assets while allowing debtor to restructure
or reorganize
– Strategy: restructure or reduce debt to make debtor solvent
– Process: debtor petitions court, develops plan, seeks 2/3 creditor
approval
– Cramdown: if creditors not agree, court can force settlement
Real Estate Finance
Alternative Mortgages
© JR DeLisle, Ph. D.
Real Estate Finance
Lecture Review
© JR DeLisle, Ph. D.
• Risk Management
– Definition of Risk
– Risk Management Process
• Mortgages
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Mortgage Process
Mortgage Risk Management
Mortgage Concepts
Mortgage Transfer, Foreclosure & Bankruptcy
Real Estate Finance