The Fannie/Freddie Mortgage/Deed of Trust Instrument

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1 The Fannie/Freddie Mortgage/Deed of Trust Instrument Who Are Fannie and Freddie? Fannie Mae was founded by the U.S. government in 1938, in the wake of the mortgage foreclosure crisis occasioned by the Great Depression Purpose: to make home mortgage credit widely available (at time, you couldn t get a 30 year mortgage of today) In 1968, Fannie Mae was re chartered as a forprofit, publicly traded corporation Mortgage Loan Types: Fixed Rate, Level Amortizing Loan Borrower makes equal payments of P&I (principal and interest) each month over the loan term Commonly 15 or 30 years (some choose your own term options are becoming available) In the old days, a mortgage was a local transaction; banks and thrifts (S&Ls) made loans using funds on deposit Once bank/thrift made a mortgage loan, it held it in its portfolio until repaid Supply of mortgage funds was limited; only high credit borrowers could get mortgages (low rates of homeownership) Jimmy Stewart as George Bailey, It s a Wonderful Life (1945) 1

2 Fannie Mae s Role Increase the supply and availability of mortgage credit and rates of homeownership It agreed to buy mortgage loans that met certain underwriting criteria (this created a secondary market for mortgage loans) Once banks/s&ls could sell mortgage loans to Fannie, their capacity to make loans was no longer limited by the amount held on deposit! Over time, Fannie and Freddie began to facilitate the securitization of mortgage loans E.g., Fannie buys 100,000 mortgages loans which are pooled together and placed in a trust, which then securities (e.g., bonds) to private investors Through a loan servicer, Trustee of trust collects mortgage P&I payments from mortgagors Trustee uses those sums to pay bond principal and interest payments to the private investors (an obligation secured by the underlying mortgage loans) Ostensible Benefits of Securitization Should increase the flow of investment capital into the mortgage market (disintermediation) Private investor would be reluctant to buy a single loan or a small pool of loans (undiversified risk) By creating huge pools, risks (i.e., risk of mortgagor default) are spread, attracting private investment Greater supply of mortgage money leads to lower interest rates, higher homeownership rates Uniform Instruments Note: evidences borrower s obligation to repay the debt, sets forth terms of that repayment obligation (governed by Contract law and/or UCC Article 3) Mortgage/Deed of Trust: conveyance in which owner (mortgagor) grants lien to lender (mortgagee) to secure repayment of debt evidenced by the Note 2

3 Uniform Instruments Fannie/Freddie drafted the approved uniform instruments; lenders can use them Lender could modify the forms based on negotiation with borrower, BUT If Lender modifies the form, Fannie/Freddie won t buy the loan! Thus, lenders using the Fannie/Freddie forms typically won t modify the forms, to preserve their ability to sell the loan on the secondary market On the one hand, this limits borrowers from negotiating for more favorable terms (other than the interest rate, loan term) On the other hand, many of the standard terms are very borrower favorable, e.g., Prepayment right, without fee [Note 4] Right to reinstate after default [DOT 19] Can use insurance proceeds for rebuilding in event of casualty [DOT 5] Loan Charges (Usury) [Note, 5] Historically, laws in most states established a maximum interest rate (usury laws) Interest in excess of maximum rate was illegal Lender guilty of usury had to disgorge all interest This provision is a usury savings clause (if loan determined usurious, interest reduced to maximum legal amount) Occupancy [ 6 DOT] Why does the Uniform Instrument require the Borrower to occupy and use the Property as his/her principal residence? 3

4 Occupancy [ 6 DOT] Lender has different standards for underwriting an owner occupied home loan vs. a rental home Owner occupied home loan is underwritten based on borrower s income Rental home is underwritten based on net cash flow (gross rent property expenses) Which is a riskier loan? Occupancy [ 6 DOT] If I m an investor being asked to buy securities backed by home loans, I might require a larger return to invest in securities backed by loans on rental homes (if they are perceived as riskier) To attract capital at lowest rates, Fannie and Freddie must assure investors that loans are really home loans (borrower in occupancy) What if Borrower lied (and was planning to flip the house)? Failure to comply with 6 is a default; 22 would thus allow lender to accelerate the maturity of the debt and demand FULL payment of entire debt even if Borrower was otherwise current on its payments! Lying on a loan application is also punishable as crime under both federal and state laws Mortgage Insurance [DOT 10] Lender typically requires private mortgage insurance (or PMI ) for any mortgage loan with a principal amount >>> 80% of fair market value (FMV) of mortgaged land PMI allows someone to buy a home with a smaller downpayment, rather than having to wait to accrue 20% for a downpayment 4

5 The smaller the % of the price the borrower puts down, the greater the risk a foreclosure sale may produce a deficiency (i.e., sale proceeds not enough to pay off full balance of debt) Low down payment borrower has to pay for PMI to protect against this risk, so that mortgagebacked securities will get favorable risk ratings If borrower defaults, and foreclosure sale results in a deficiency, lender can recover this loss from insurer Once borrower builds up enough equity (20 23%, depending on loan type), borrower has right to cancel PMI coverage [Homeowner s Protection Act of 1998] Escrow [DOT 3] In addition to P&I payment each month, borrower must also pay 1/12th of the estimated annual cost of (a) real estate taxes + (b) casualty insurance premiums + (c) PMI premiums + (d) perhaps (but not likely) homeowners association dues Lender holds these funds in escrow Lender uses these funds to pay taxes, insurance premiums, PMI premiums, and/or homeowners association dues directly when they are due If taxes, insurance, PMI premiums not paid, Lender s lien is threatened Nonpayment of real estate taxes = tax lien in favor of taxing authority (and that tax lien has priority over all other interests, including Lender s mortgage!) Nonpayment of casualty insurance = cancelled insurance = risk of uninsured loss Nonpayment of PMI = loss of recourse to PMI insurance if borrower defaults and foreclosure sale results in deficiency Riders (DOT Def. H) For some loans, a Rider is needed b/c the basic Fannie/Freddie DOT form lacks a provision needed for that specific transaction E.g., Condo Rider includes covenants to pay all condo association fees, comply with condo rules, etc. E.g., Second Home Rider has covenants that limit ability of Borrower to rent/time share the property E.g., 1 4 Family Rider? 5

6 Exemptions: Missouri Debtor can keep certain property exempt from creditor claims (not a complete list): Up to $15,000 equity in home (homestead) Up to $3,000 equity in one car Up to $3,000 in household goods Up to $500 in jewelry ($1,500 for wedding rings) $3,000 in tools of the trade $600 wild card (any asset) Exemptions allow a debtor to retain exempt assets free of the claims of creditors generally Example: Bailey gets judgment vs. Uphoff for $4,000 If Uphoff has less than $15,000 in equity in his house, the house is exempt from Bailey s claim (i.e., Bailey can t force house to be sold at execution) If Uphoff has greater than $15,000 in equity, Bailey can force execution sale, but the first $15,000 of proceeds would be paid to Uphoff (Bailey can only be paid from any surplus proceeds, over $15,000) Exemptions and Secured Creditors Debtor can t assert homestead exemption against a secured creditor with a mortgage lien on the land E.g., if Uphoff grants Bailey a deed of trust on his home to secure his debt to Bailey, Bailey can foreclose if Uphoff defaults, w/out regard to Uphoff s exemption rights Granting security interest in an asset = waiver of exemption as to that asset [ 26, Freddie Missouri form DOT] Forfeiture [DOT 11] Suppose Debtor gets arrested and indicted for production and sale of crystal meth If Debtor used the land in production of meth, forfeiture laws may permit government to forfeit Debtor s interest in the land Forfeiture could potentially extinguish lender s interest (unless lender could establish innocent owner defense) 6

7 Forfeiture [DOT 11] Institution of an action or proceeding that poses a risk of civil/criminal forfeiture permits Lender to declare a default Default would then allow Lender to pursue its default remedy (foreclosure) Borrower could avoid the default, and reinstate the loan, by getting that action dismissed 7