7 / JUNIOR REAL ESTATE FINANCE

 

Chapter Purpose

It is particularly appropriate for a California finance text to have a separate chapter on junior finance. The prices on properties in many areas of the state are higher than the allocations allowed by the underwriting guidelines of the conventional, FHA and DVA markets. As a result, owners and buyers often have to arrange for junior finance in order to complete their transactions.

This chapter examines the anatomy of a junior loan, its special clauses and the markets created for originations and sales of these relatively risky encumbrances.

 

Suggestions to the Instructor

Invite an investor who buys and sells junior securities to discuss the concepts of discounting and the entire primary and secondary markets for junior liens. Depending on where in California you are and in what activities your students are engaged, this may prove to be the most important lesson of the semester.

 

Learning Objectives

Upon completion of this chapter, the student should be able to:

  1. Differentiate between a senior loan and a junior loan;
  2. Identify the participants in the junior loan market;
  3. Define the risks inherent in establishing a junior loan;
  4. Describe the clauses which may be included in a junior loan contract to protect the lender;
  5. Understand that a junior loan finances the owners' equity in the property, raising payments and decreasing much of the safety cushion;
  6. Describe the anatomy of a junior real estate sales contract;
  7. Explain the increasing use of the home equity loan as an alternative to borrowing on personal property or credit cards;
  8. Define discounts and identify the participants in the secondary market for junior finance.

 

Presentation Outline

I. Anatomy of a Second Mortgage/Deed of Trust

A. Second deed of trust is in junior position to an existing senior loan

1. In the event of a foreclosure, proceeds from auction sale disbursed to senior lender first and then to junior lender, if any available

2. Junior loan holder in risk position

B. Protective clauses

1. Grant to the junior lien holder the right to pay taxes and insurance premiums in the event of a loan default

a. Protects vesting of a priority tax lien

b. Protects major loss in event of fire

2. Grant junior lien holder the right to make payments on senior loan in the event of a default

a. Protects problem of abandonment

b. Possibly avoids filing of foreclosure

3. Prohibit borrower from refinancing to the detriment of junior lien holder

4. Secure lifting clause which inhibits borrower from lessening junior lien holder's position

5. Establish cross-defaulting clause which automatically triggers a default in the junior lien if there is a default on the senior lien

C. Reducing risk of junior loan

1. Insist on some front-end equity

2. Secure mortgage insurance on junior loans which meet underwriting standards

3. Arrange interest rates and terms which borrower can afford

II. Anatomy of a Second Real Property Sales Contract

A. Real property sales contract (land contract)

1. Title remains in name of vendor

a. Until loan is repaid

b. Until terms of contract are met

2. Vendee secures equitable title

a. Inhibits other financing

b. Arrangement protects vendor

B. Use as junior financing tool

1. Can be a senior lien in the absence of any other liens

2. Is a wraparound loan when other loans exist

C. Collections

1. Made to an escrow collection service

2. Escrow distributes funds to appropriate parties

3. Escrow holds deed for future delivery

a. Avoids problem if vendor dies

b. Protects chain of title

4. Escrow provides accurate record of transaction

D. Home equity loans

1. Offered by banks, thrifts and credit unions

2. Increasingly popular

a. Interest is tax deductible, unlike interest on consumer debt which is not

b. Proceeds can be used to purchase personal property

3. Attractive interest rates

a. Many lower than market

b. Be aware of rates which can be adjusted dramatically

III. Secondary Market for Junior Financing Instruments

A. Private companies

1. Buy and sell junior loans

2. Purchase price at a discount to increase yields

a. Discount depends on terms of loan

b. Contract interest rate vs. required rate

c. Discounted over number of years until repayment

3. Advertise in local papers

4. Largely unregulated in California

B. Land contract second market

1. Capitalized at developer's bank when pledged as collateral for new loan

2. Factored at developer's bank when sold with recourse

C. Federal National Mortgage Association (FNMA)

1. Second mortgage participation program

2. Buys and sells junior loans from approved lenders

a. Must be experienced junior financiers

b. maintain a net worth of $250,000

c. maintain a reserve fund

d. agree to service loans sold to FNMA

e. loans on one- to four-family homes only and must include a due

on-sale clause