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Junior Liens Who Choose to Foreclose

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By Edward Brown

Many lenders opt to only fund first mortgages because they believe that second mortgages are too risky, but is that always the case? Not always. Not all second mortgages are equal.

Many private lenders may choose to fund a junior lien where the first mortgage is relatively small in comparison to the second. For example, a $200,000 second behind a first of only $40,000 on a property worth $500,000 would be an attractive loan to fund for many lenders, especially if they can command a higher interest rate due to the fact that the loan is in second position. However, if there is a foreclosure in the future, the second will somehow have to deal with the first mortgage. This can be troublesome if the first is very large; especially if the second is relatively small in comparison to the first. Why?

In looking at a foreclosure, a lender has to strategize. In the case of the second mortgage, it is imperative that the first does not foreclose out the second as there is usually nothing left over from the foreclosure to pay the second. In California, the foreclosing party gets to “credit bid” its loan. This means that it can simply bid [at the auction/trustee sale] what it is owed. Non foreclosing parties need to come up with cashier’s checks in order to bid. This can be a potential hardship for the second mortgage if the first is the foreclosing party.

For example, if we look at a situation where the property has a value of $1,400,000, the first is $800,000 and the second is $200,000 and the first is the foreclosing party, the first would most likely credit bid its entire $800,000 [it does have the right to bid less than what it is owed, but, if the value is reasonably higher than what is owed to the first, it will normally credit bid what it is entirely owed. The times where the lender bids lower than its entire principal balance is when the lender does not want to own the property and is willing to take a loss just to get the loan off of its books, or the value of the property does not substantially exceed the balance of the first mortgage].

Any bidder at the auction/trustee sale would need to come up with $800,000 at the auction itself or more should any bid exceed $800,000 if the bidder wants to be the highest bidder. In this instance [where the first mortgage is the foreclosing party], the second is not allowed to credit bid its $200,000 balance. It would need to come up with the $800,000 to pay off the first and its $200,000 second mortgage in order to be made whole. True, the second would just get its $200,000 back because that is what it is owed, but, unfortunately, in this case, since it was not the foreclosing party, it has to come up with cash just as any other bidder. Only the foreclosing party is allowed to credit bid.

For this reason, it is important for the second to have a strategy in place. The second wants to be the foreclosing party in most instances, driving the bus, so to speak. Borrowers usually go into default for two main reasons. First, they stop making payments to the lender. Second, the lender’s loan is due, and the borrower has not refinanced or sold the property. In the case where payments have not been paid, junior lien holders have the right to “cure” the first. One can usually do that simply by making the payments to the first. Since foreclosure in California normally takes three months and 21 days, one strategy is for the second to cure the first and start its own foreclosure.

However, this may be cost prohibitive, especially if the first is large and the arrearages on the first are a few months. When the first files for foreclosure, junior lien holders are to be notified. This gives them notice, so they can have the opportunity to cure the first. The second then files its own foreclosure [either because the borrower has probably also not made payments to the second mortgage or because most loan documents state that if a borrower is in default on any mortgage associated with the property, its loan is also in default whether or not the borrower has kept the second current with payments].

One strategy for the second lien holder is to cure the first as soon as possible to allow the second to be the foreclosing party. That way, the second would be allowed to credit bid its loan, but would not eliminate the first; it would have to take the property subject to the first and have to deal with them post foreclosure. However, what happens in the case where the second pays just enough to get the first to stop its foreclosure for the time being, the second starts its own foreclosure, and then does not any more payments to the first and allow the first to start its own foreclosure?

Let’s look at an example and see how this might play out; in our previous example, the property was worth $1,400,000, the first was $800,000, and the second was $200,000. Let’s presume that the borrower stopped making payments on both the first and second mortgages. Both loans have a maturity date five years in the future. If the first files foreclosure, the second could cure the first by making only one mortgage payment to them. Now it is true that most lenders will not immediately file a notice of default after 30 days, but the point here is for the second to make the first mortgage cancel or delay [even temporarily] its foreclosure, so the second mortgage can start its own foreclosure for two main reasons; it puts the second in a situation where in the first does not foreclose out the second, and it allows the second to credit bid its loan at the time of the trustee sale.

Now it is true that, if the second does not make any more payments to the first [other than the one to get the first to stop its foreclosure], the first may start a foreclosure again, but, the first’s foreclosure will be after the second mortgage has completed its foreclosure, buying time for the second to deal with the first [or sell or refinance the property] if the second is ultimately the high bidder at auction. If another bidder outbids the second, the first would get paid, the second would get paid, and the owner [borrower who defaulted] would pocket the difference.

If there is enough equity in the property, either the property will receive a high enough bid to pay off all of the liens, or the second [the foreclosing party in our example] should be able to flip the property fairly quickly or decide to keep the property, as they would be the new owner. If they choose not sell the property, they should very quickly discuss with the first some sort of agreement to either refinance [a new loan to the second who is now the owner] or make payments for a period that will allow time for a new lender. The above information is for discussion purposes only and, as always, one is advised to discuss real estate related issues with a qualified real estate attorney prior to any legal action.

Edward Brown

Edward Brown currently hosts two radio shows, The Best of Investing and Sports Econ 101. He is also in the Investor Relations department for Pacific Private Money, a private real estate lending company. Edward has published many articles in various financial magazines as well as been an expert on CNN, in addition to appearing as an expert witness and consultant in cases involving investments and analysis of financial statements and tax returns.

Why Banks Do Not Allow Junior Liens

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By Edward Brown

Ever wonder why bank’s voluminous real estate loan documents usually include a covenant that the borrower has to accept which prohibits junior [or secondary financing]? Most of the time, these covenants don’t even have language that allows for secondary financing with lender approval. They merely state that no junior liens are allowed. In fact, the language is strong enough to imply that placing a junior lien behind the bank’s 1st mortgage constitutes a default [most likely a curable one] {curable defaults are ones that can be remedied, such as placing insurance on the property if the current insurance expires or is cancelled, as compared to incurable defaults which cannot be remedied (or, undone) such as the borrower filing a Chapter 7 bankruptcy}. Placing a junior lien behind the bank’s 1st mortgage is usually curable if the junior lien can be re-conveyed and the property is put back in the same condition [title wise, that is] as it was at the time the bank made its 1st mortgage.

One might ponder why banks are so strict about not allowing junior liens. After all, a junior lien is behind the 1st mortgage. In fact, some non-bank lenders actually prefer subordinate financing because it is as though there is additional security – another party has an interest to protect; however, traditional banks do not view it in the same way. There are a few reasons for this. First, banks have strict underwriting guidelines wherein they look at the DSCR [Debt Service Coverage Ratio]. The DSCR is a ratio that analyzes the cash flow after normal expenses compared to the monthly requirement for the loan in question [both principal and interest]. Many banks have changed their DSCR ratio requirement, since The Great Recession, from 1.1 to 1.35. This can place a tremendous burden on the borrower to have to come up with a larger down payment, in most cases, thereby requesting a lower loan request by the bank, which, in turn, produces a lower monthly loan payment. Many borrowers find that they have to come up with upwards of a 35% down payment as compared to 25% [pre Great Recession] in order to satisfy the 1.35 DSCR. Adding junior liens may place the borrower in the default provision of the DSCR if the junior lien requires monthly payments.

Another point to consider is that the bank priced its loan based upon original underwriting guidelines and being the only mortgage and that no junior financing would be added. The potential risk of negative changes in the DSCR or possibility that the borrower stripped equity away by placing a 2nd mortgage had not been considered, and the bank was not compensated accordingly. The more debt on a property, the more likely there is for a chance of foreclosure. Although the bank may be protected in its 1st position [presuming that the property has not substantially declined], when a foreclosure is triggered, there is a strong likelihood that the bank may have to alter the asset class of the property from performing to non-performing or it may be categorized as a “troubled asset” or put on the “watch list” by regulatory bodies even if the bank is not at risk for losing money. For example, if the borrower put 35% down on a $1,000,000 building and borrower $650,000 from the bank, the bank’s 65% LTV loan may be considered conservative. However, if the borrower obtained a 2nd mortgage for 15% LTV, the property now is 80% leveraged. If the borrower defaults on paying on the 2nd, he may or may not default on paying on the 1st. If the borrower defaults on both the 1st and 2nd, the bank’s loan clearly has turned non-performing. Non-performing loans can have a devastating effect on a bank, as they are required to set aside reserves, and defaults exacerbate this situation. The more reserves required to be set aside means the less money the bank has to lend out and generate income. Since banks lend out in multiples of their deposits, any money that is set aside [that cannot be lent out] has a negative multiplier effect.

The 2nd may or may not cure the 1st and start its own foreclosure. Even if the 2nd cures the 1st, the bank is still left with a possible foreclosing party [the 2nd]. When banks make loans, they are usually looking/hoping for those loans to continue until maturity. Once a loan is made, there is less work the bank has to do. They collect the interest income and hope they do not have to use other resources to babysit a loan. The cost of these resources tax the bank’s bottom line. Banks are not in the business of taking over borrower’s properties. They do not want REO’s [Real Estate Owned properties]. It is much better for them to carefully underwrite loans in the beginning and avoid problems. If the 2nd ends up with the property because nobody outbid the 2nd at the foreclosure, the bank is faced with a new borrower. The bank may have to underwrite the new borrower. In fact, if the 2nd is outbid at foreclosure, the bank is still faced with a different borrower than they originally underwrote. This new borrower may or may not qualify under the bank’s lending guidelines.

What about the scenario wherein the borrower borrows on a separate property and cross-collateralizes against the bank’s subject property? In this situation, the borrower is not attempting to strip out equity from the original property. The borrower may just be faced with the reality that he cannot obtain a loan for the target property unless he is willing to allow the new lender [on property two] to place this same loan on property one for added security.  Unfortunately, although this seems innocent enough, if the bank finds out that a junior lien was placed on the property, [original one] they still may consider their loan in default. A lender who cross-collateralizes against other properties may trigger a foreclosure on all properties they encumber in order to get the borrower to move toward a solution to satisfy their loan that is in default [under their terms…usually for non-payment of mortgage payments].

Public policy may state that a bank is not allowed to interfere with a borrower’s business and force him not to purchase/borrow on other property that the bank has no involvement. There also may be a question as to the validity of the “no junior liens allowed” as this may technically interfere with the borrower’s business, especially if the bank’s 1st mortgage is extremely low. For example, if the 1st mortgage only has a balance of 20% [either because the borrow put a substantial amount down or the 1st loan is so seasoned, that it has been amortized down to a low balance], there is very little risk of the bank not getting paid in full. Even if a 2nd is placed upon the property, one has to question how the bank is impeded should the 2nd start a foreclosure. In previous scenarios above wherein the DSCR was negatively altered due to a 2nd mortgage, a 20% LTV on the 1st should still satisfy a 1.35 DSCR in most circumstances. After the 2nd obtains the property [or a new owner should the property end up in a higher bidder’s hands], most new borrower’s would hopefully be qualified to service a low LTV. Of course, each circumstance is independent, and most banks will want to preserve their right to enforce the “no junior lien” clause.

Usually, only if the bank pulls a preliminary title report, are they aware of the junior lien. They are not usually automatically notified. The main question is whether the bank will automatically declare a default if a 2nd is placed on the property behind their 1st? When banks find out that a 2nd exists, they may either ignore it or send a letter requesting/demanding that the junior lien be removed as per the terms of the bank’s loan documents. Whether a bank decides to pursue its demand that the junior lien be removed is up to the bank; however, they want to preserve their rights by notifying the borrower that they have requested removal, and thus, have written evidence that they contacted the borrower, so the borrower cannot claim ignorance or non-notification of the break in the covenant of the bank terms. This notification protects the bank should the bank choose to start its own foreclosure due to the default.

Most borrowers who have asked permission for a junior lien to be placed behind the bank’s 1st mortgage have usually been told, “No”. That is why most borrowers figure it is better to ask for forgiveness than permission in hopes that the bank will not find out about the junior lien until the borrower either sells or refinances the property in question.

 

Edward Brown

Edward Brown currently hosts two radio shows, The Best of Investing and Sports Econ 101. He is also in the Investor Relations department for Pacific Private Money, a private real estate lending company. Edward has published many articles in various financial magazines as well as been an expert on CNN, in addition to appearing as an expert witness and consultant in cases involving investments and analysis of financial statements and tax returns.