For the first 18 months, all went well. Then both Mary Flakey and the Joneses got a certified letter from the loan servicing department of Choppy Bank demanding to know why the payments were coming from Mary Flakey and not the Joneses. When the story of the sale of the property came out, Choppy Bank accelerated its loan and demanded to be paid off in full.
An acceleration clause is a provision in a mortgage that gives the lender the right to stop accepting monthly payments and to demand that the loan immediately be paid off in full. There are a number of triggers for a lender to use its acceleration clause. Waste is one of them. For example, if a borrower starts to intentionally demolish the property - the lender's security for its loan - the lender can accelerate its loan.
Now back to our story of Mary Flakey and the Joneses. Sounds like a rock group from the 1970's - Eric Burton and the Animals, Paul Revere and the Raiders, Mary Flakey and the Joneses... Ha-ha! The reason why Choppy Bank accelerated its loan was because Mary Flakey failed to assume its loan, and the bank exercised the alienation clause in its mortgage.
An alienation clause is a provision in a mortgage that says that the lender can accelerate its loan if the borrower alienates (transfer) title in any way. In our story, the bank actually had TWO grounds to exercise its alienation clause. Can you guess them? Well, first of all, the Joneses transferred title to a new buyer. That one was easy, but there's one more. The Joneses put a second mortgage on the property! Mortgaging a property constitutes a transfer of some of the ownership rights to a property. This is why commercial second mortgages are exceedingly rare these day. Almost all bank first mortgages prohibit placing additional financing (second mortgages or mezzaine loans) on the property.
When Choppy Bank demanded that its full $550,000 first mortgage be immediately paid off, Mary Flakey simply didn't have the money, nor did the elderly Joneses. The bank foreclosed, and the second mortgage owned by the Joneses was completely wiped out. Not surprisingly, Mary Flakey stopped making payments on the old second mortgage. It was a brutal blow. That $1,500 per month in income was crucial to the budget of these poor retired folks.
After Choppy Bank foreclosed, the building fell on hard times. The tenants moved out, and the building was boarded up. It sat there unoccupied for months, slowly falling apart. Then Mary Flakey borrowed some money her parents and cut a deal to buy the neglected REO from Choppy Bank for just $100,000! The term, "REO", stands for real estate owned, which is what banks must call their foreclosed properties. Under banking regulations, banks are under tremendous economic pressure to get rid of their REO's quickly - which explains why Mary was able to get such a great deal.
So Mary Flakey is sitting there feeling pretty good about the situation. She now owned a $1 million apartment building free and clear, and she had only $250,000 invested in the deal - her initial $150,000 down payment and her additional $100,000 investment to buy the REO.
But then an attorney for the Joneses came knock - knock - knocking on Heaven's door. "Ms. Flakey, you need to start making payments again to the Joneses. Under the After-Acquired Title Doctrine, the mortgage in favor of the Joneses has re-attached itself to the property, and if you don't make up the past due payments and keep them current, the Joneses will foreclose on their mortgage."
Well, that visit from the attorney certainly was a Buzz Kill for Mary Flakey. What happened? Weren't the Joneses wiped out by the foreclosure? Well, they were; but then Mary Flakey reacquired the property. The After-Acquired Title Doctrine says that if you give someone a mortgage or lien on a property that you do not own, but you later acquire it, that mortgage or lien immediately attaches to the property.
I write this blog to two teach my two sons, George and Tom, the business of commercial real estate finance. By subscribing to this blog, you get to "audit the class" for free. I try to write two training classes per week.