There are many reasons loans are bought and sold. Often times the reason has more to do with the individual situation of the seller than of the note itself, or the condition of the borrower. The most common reasons loans are sold are for liquidity, dissolution of a partnership, change of financial circumstance, deterioration of the underlying collateral, or the default of a borrower.
There are many opportunities for buyers and brokers to acquire loans at a discount to the principal balance which may result in substantially better yields than originating a new loan. Buyers and their brokers should consider several factors when purchasing a note, including the strength and payment history of the borrower, the quality of the underlying collateral securing the loan, and the strength of the guarantors, if any.
Loans can be purchased individually or in pools. Although the legal agreement differs for each, the basic process flow is the same whether you are buying or selling one or more loans. For simplicity purposes, I’ll refer to the transaction as a loan asset transaction. The term “loan sale” and “note sale” will also be used interchangeably throughout.
The basics of the purchase and sale process are relatively straight forward, but like any transaction, the devil is in the details. Following are eight steps involved in the purchase and sale of loan assets followed by a discussion of the most common pitfalls to avoid throughout the transaction.
Step 1: Confidentiality and Non-Disclosure Agreement
It is customary to execute a confidentiality and non-disclosure agreement to protect both parties. Sensitive borrower information is typically exchanged and both parties need to agree to safeguard this information.
Step 2: Make an Offer
Make an offer for the loan asset in writing. Work with an attorney who has handled loan purchase and sale agreements in the past and can walk you through the various nuances to the agreement. An entire article can be written on the ins and outs of this agreement, and is a topic for another time.
Step 3: Good Faith Deposit and Open Title
Typically a seller will provide a good faith deposit to get the process started, but this is a point to be negotiated between the parties. It is a lot of work to gather the loan files together and you want to make sure you have a serious buyer before you go through the effort. You should also prequalify the buyer and verify that the funds are in place and that this buyer isn’t going to try and “raise the funds” once they review your files.
After a deposit is received, the seller should open a title policy. Most of the time the seller can buy an ALTA assignment endorsement (10.6-06) which insures the assignment vesting and lien position to the new party. The endorsement is less expensive than a full title policy and is recommended if it is available.
Step 4: Due Diligence
Once a deposit is received, conduct thorough due diligence on the loan asset. Your level of due diligence will vary depending on the asset itself, and on the number of assets you purchase. Most purchasers will conduct an independent appraisal, re-underwrite the loan, examine the chain of title, review the original promissory note, review all correspondence with the borrower, the trustee, and any other parties to the loan.
There are a number of third party companies that specialize in performing independent due diligence on loan assets and generally charge $250 per loan depending on the type of appraisal and underwriting conducted.
Most of the time you will not be able to inspect the interior of the property, or conduct an interview with the borrower, but that can be a point of discussion between you and the loan seller at the time the offer is negotiated.
Step 5: Sign Documents
Besides the purchase and sale agreement, two additional documents must be signed in order to transfer ownership of a loan. The first is an assignment, which is a notarized document referencing the original mortgage or deed of trust and is recorded in the same county in which the real property securing the note is located.
The second document is a signed endorsement of the original promissory note. This endorsement can be handled by either typing language on the back of the note (e.g. Pay to the order of….) much in the way a check is endorsed when signed over to a third party. If there is not room on the back of the note, another way to endorse the note is by attaching an Allonge which effectively has the same language that would otherwise be placed on the back of the Note. The Allonge must be securely attached and at all times kept with the original promissory note.
Example of language that may be used in an Allonge is:
THIS ENDORSEMENT IS TO BE ATTACHED TO AND MADE PART OF THAT CERTAIN PROMISSORY NOTE dated Month, Day, Year, made by Borrower Name Here, in favor of ABC Company, the payee, in the original principal amount of $x,xxx,xxx. Such Note is hereby transferred pursuant to the following Endorsement with the same force and effect as if such Endorsement were set forth at the end of such Note:
THIS PROMISSORY NOTE is herby Endorsed and Assigned without recourse to: Acme Loan Buying Company
PAY TO THE ORDER OF: Acme Loan Buying Company
Step 6: Record the Documents
Step 7: Exchange Funds
Step 8: Notify the Borrower
Once the financial exchange is completed, follow the laws with regards to notifying the borrower of the new loan servicer, if any apply. Not every transaction results in a change of servicing, and different laws apply to residential and commercial transactions. Typically, the prior loan servicer provides a “good-bye” letter which indicates the loan servicer is no longer servicing the loan and instructions on where to send payments. Then the new loan servicer sends a “hello” letter introducing themselves and provide required contact information, and information on where to send payments.
Although the eight steps of concluding a loan purchase and sale transaction seem fairly straight forward, there are numerous pitfalls to avoid:
Representations and Warranties
In a typical loan purchase sale agreement there are representations and warranties that provide certain remedies (e.g. a credit, or loan buy back, etc.) if one party provides false information, or the loan is materially different, or the transaction is fraudulent, etc.
Be aware that the representations and warranties are only as good as the party making them. Even if you are dealing with a large institution, that institution may not exist after the transaction concludes. Even if the institution does remain in business, recovery may require expensive litigation. The key to avoiding problems is to conduct very thorough due diligence before the transaction is concluded. If you are in doubt of something material to the transaction, notify the seller to get clarification and/or terminate the transaction.
Chain of Title
The chain of title can be tricky in a loan purchase. Some notes may have been previously transferred several times in the past, and if the vesting is off just slightly from one transfer to the next, or there is a vesting gap between one assignment and the next, it may be very difficult, if not impossible, to resolve. Vesting gaps in title chains are very common and come about because parties receive assignments and then never record them. Other times, a vesting gap occurs because a party receives an assignment, transfers funds, and then discovers the assignment provided is un-recordable for a variety of reasons, or there is just an error which goes undetected.
A title policy or assignment endorsement is a good protective measure, but understand that your title policy covers you only after you incur a loss and not upon the discovery of an error. Consider this example of a potentially prolonged title recovery: Buyer purchases a 2nd lien and shortly thereafter the borrower stops making payments. The lienholder forecloses, and the trustee discovers there is a vesting gap in the assignment of title chain and the trustee will not foreclose. Meanwhile, the borrower continues to pay on the senior lien and the junior lienholder is unable to foreclose or collect on a title claim because the junior lienholder has not technically incurred a loss on the policy. Your loss will only occur when the senior lien forecloses out your position which may or many not happen depending on whether or not the borrower continues to pay the senior lien.
Most taxing authorities have information available on the internet and you can check to make sure property taxes are not delinquent prior to the purchase of the note. If the property taxes are delinquent, make note of that county’s tax auction procedures and decide if you still wish to continue with the note purchase.
If you purchase a junior lien, be sure to obtain verification that the senior lien is current. If the senior lien is not current, be sure you understand your rights to reinstate the lien in the state in which the loan is recorded. In some states junior lien holders may not reinstate senior liens and must instead pay them off, or protect their position at a trustee sale.
Verify that the senior lien does not have language in the promissory note which prohibits a second lien to be put in place. If a junior lien is prohibited, obtain the document granting permission to the borrower to obtain the junior lien.
Obtain the promissory note of the senior lien holder, if possible. Since promissory notes are not recorded documents, this is often not easily obtainable. If obtained, examine the document for adverse changes in interest rates, balloons, or other terms that may adversely affect your junior position.
In many loan sale transactions, the original promissory note cannot be located and the seller offers an Affidavit of Lost Note. Up until a few years ago an Affidavit was sufficient to continue foreclosing, but because of the increase in the number of foreclosures many judges refuse to permit a foreclosure without the original promissory note. Once you obtain the original note, keep it in a fireproof vault for safekeeping.
Many loans contain errors in the original underwriting. Depending on the type of loan, the error could be significant. For example, in a residential loan, an error of more than .125 on the APR presented in the borrower disclosures could enable the borrower to rescind the loan. Re-underwrite the loan as if you were making a new loan and examine every disclosure, the timing of the disclosures, and the details on any applicable rights of cancellations.
Independent Confirmation of Loan Terms
If permitted in the terms of your loan agreement, it is a good idea to send an Estoppel Certificate to the borrower. The loan Estoppel Certificate is a document which asks the recipient to confirm the terms of the mortgage such as the outstanding balance, interest rate and frequency and due date of payments. Independently verifying that the borrower is in agreement with the loan terms can save a lot of aggravation down the road.
In some transactions, the borrower is skeptical that the loan was transferred and may not pay the new note owner, especially in private, non-bank note sale transactions.
Anticipate potential borrower confusion and establish a procedure with the note seller in the event they receive payments shortly after the transaction concludes. In addition to the customary “good-bye” letter, you may wish to obtain a separate letter from the note seller to the note buyer confirming the transaction and ensure that the note seller will cooperate in speaking with the borrower if need be to confirm the sale transaction.
Purchasing and selling loan assets is a specialized transaction, but like everything else in business, the more you do it, the better you get at it. If you’re buying or selling notes for the first time, be sure to use experienced counsel and spend extra time on your due diligence and the fruits of your labor will pay off with higher yields and fewer unexpected surprises.