Scary Things Can Happen When You Make a Loan Against a Commercial Loan
My mentor - the man who taught me commercial real estate finance years ago - is the wise, old veteran, Bill Owens, of Owens Financial Group. "So, Bill," I asked today, "please tell me some horror stories about hypothecation loans."
You will recall from my earlier blog article that a hypothecation loan is a loan secured by a mortgage loan. The easiest way to understand what we're talking about here is to imagine a cranky old investor who owns a 36-unit apartment building free and clear. The cranky old investor sells his apartment building for $1 million, and he carries back an $800,000 first mortgage at 7% interest for seven years. It's a good deal for the investor because he couldn't earn 7% on his $800,000 in sales proceeds if he deposited the cash in the bank.
Now let's scroll forward three years. The 72-year-old old investor meets 37-year-old Blondie the Bimbo in a bar. Blondie wants a new car, a diamond necklace, and a vacation to the Bahamas. The investor needs cash. So he trots down to Blackburne and Brown and pledges his $800,000 first mortgage receivable to us as collateral for a $600,000 loan. Blackburne & Brown is comfortable with the loan because if the old man doesn't make his payments, we'll simply execute (think of it as a fast foreclosure) on his $800,000 note and mortgage. Our $600,000 investment would then be secured by a $1 million dollar apartment building.
Blackburne and Brown made several hypothecation loans last year, and we are hungry to make more. But I was nervous. I didn't know the pitfalls of hypothecations, so I asked Bill Owens, "Bill, please tell me some horror stories about hypothecation loans."
"Okay, George, try this one. A guy owns an $80,000 first mortgage note against a $100,000 house. You make a $60,000 hypothecation loan against it, evidenced by a promissory note and hypothecation (pledge) agreement against the mortgage. Then the borrower goes bankrupt, and the bankruptcy court rules that because you only had a collateral assignment of the mortgage, rather than a mortgage against the actual real estate, you are an unsecured creditor. Such a ruling, in real life, means that you will be probably completely wiped out by the bankruptcy!"
"So what should I have done, Bill?" I asked.
"You should have a taken an absolute assignment of the mortgage. Now you can still give the borrower a buy-back agreement that says he can buy back the mortgage if he makes all of his loan payments, but it is critical to take an absolute assignment of the mortgage, as opposed to a collateral assignment."
"Please tell me another horror story, Bill."
"Okay, suppose you execute (foreclose) on a $60,000 note and mortgage, secured by a $100,000 house. Then you notify the underlying borrower - the owner of the house - to start making monthly payments to you. He replies that he doesn't owe any payments for another year because he prepaid them to the original mortgage holder, in return for a discount."
"So what should I have done, Bill?"
"You should have gotten a combination Waiver of Offset and Beneficiary Statement, signed by both the mortgage holder and the underlying borrower. (A Waiver of Offset is a statement by the underlying borrower that he doesn't have any claims against the mortgage holder - such as prepaid payments.) These would act as an estoppel against any claim by the underlying borrower that he owes less than what the mortgage holder claims."
I, George, also remember that whenever you make a hypothecation loan that you should take possession of the original note and be sure to record your absolute assignment of the mortgage note.
I spoke again with Bill and he confirmed that I make a hypothecation loan that I should notify the underlying borrower that the mortgage holder has assigned the note to me and inform him that he should make all future payments directly to me.