Foreclosure 101: vesting title
The next three days get a little wonkish. Prepare for a primer on foreclosures.
Ownership is primal. The first two words children learn in any language are “no” and “mine.” People have an deep intuition of what is theirs and what is not. Emotionally, It’s Mine defines ownership; in the real world, it is not so black and white.
When people own real estate, what they really “own” is a bundle of property rights. What rights are the bundle, and how are these rights held? Today, I want to take a step back and review real estate law and outline property rights and vesting title. As I recently took the excellent Broker’s review course from Real Estate Trainers, much of the legalese comes from their study manual.
Who or what is an Owner?
The Owner of Real Property can be (1) an individual owning in his or her own name; (2) a group owning together either as Community Property, Tenants in Common, or Joint Tenants; (3) an entity such as an LLC or a Corporation, (4) or a living trust.
Many people hold unshared title in their own name, and it is not limited to singles as many married owners in California are listed as either a man or a woman owning as “sole and separate property.” This distinction is important in a Community Property state like California where it is assumed that husband and wife act as a family unit with ownership apportioned equally between the two parties. In instances of inherited wealth, prenuptial agreements, or other business dealings, spouses often buy and sell property in their own name; however, these separations are tenuous in a marriage, and in hostile divorces, sole and separate can be anything but.
Tenants in Common is the most common form of multi-party ownership other than Community Property. Each Tenant in Common can dispose of their share of ownership as they see fit including passing it to descendants upon death. This stands in contrast to Joint Tenants where the death of one tenant causes their share of ownership to pass automatically to the other. Joint Tenancy is more common as a form of spousal ownership in states without Community Property laws.
Investors and others hoping to limit liability and remain somewhat anonymous often buy and sell real estate through special entities. These entities have the legal status of individuals capable of entering into contracts including owning real estate. There are advantages and disadvantages of using entities, and anyone considering doing so should consult an attorney and a tax advisor.
Another way people hold title is through a living trust. The trust itself holds title just as an individual or entity would, the main feature of living trusts, which make them a desirable method of holding real estate, is that property can transfer upon death directly to the heirs avoiding probate.
What does an Owner Own?
An owner, to the exclusion of all others, has a bundle of rights: possess, use, sell, enter, give away, lease, encumber, dispose, exclude or, do nothing subject to governmental powers and claims of others, and the owner may dispose of the whole bundle or any one of these rights at any time. Ownership can be held in a number of ways known as Estates, of particular interest to us is the perpetual Freehold Estate; it has no termination date and no party to accept ownership after reversion as does the Less-Than-Freehold estate known as a lease.
Most homeowners possess a Freehold Estate known as a Fee Simple Estate or Fee Simple Absolute where the owner holds title without any qualifications. In my description of property rights above, I mention ownership is subject to claims of others, the most common being the mortgage encumbrance. Owners whose properties are encumbered by Trust Deed (similar to mortgage) also signed a Promissory Note with a lender stating they will pay back borrowed funds according with terms and conditions described in the Note. These owners still possess a Fee Simple Estate, but the mortgage lien is such an onerous encumbrance that an argument can be made that lenders are owners, and owners are money renters.
Trustee sale occurs because borrowers, for whatever reason, are not meeting their financial obligations. A process is set in motion when borrowers default leading often to a change in ownership either through (1) market sale, (2) short sale, (3) deed-in-lieu (legal abandonment) or (4) trustee sale.
Mortgage or Deed of Trust?
The legal system of Mortgages and Promissory Notes identifies the parties to the transaction and establishes rights and responsibilities. There are two basic systems from managing the complexities: Mortgage or Trust Deed. In California as in some other states, we have a Trust Deed system, but since it is the more complicated of the two, I will address the Mortgage system first.
The Mortgage system is simple; the borrower signs a Promissory Note and issues a Mortgage to the lender. The borrower is the Mortgagor, and the lender is the Mortgagee. The borrower still holds title, and if the lender desires to force foreclosure auction, they must petition in court as any other litigant would. I can only imagine the court system backlog in Florida where this system is in place. In reality, in the Mortgage system, all foreclosures become judicial foreclosures because they move through the judiciary, but the term Judicial Foreclosure has special meaning and entails obtaining a judgment against the borrower (a topic for tomorrow).
Courts are ill-equipped to handle several hundred thousand mortgage actions. What is ordinarily a rare occurrence courts can easily handle can become a crisis, and the Trust Deed system avoids the court backlogs.
In a Trust Deed system, a neutral third-party is involved similar to an escrow; in fact, the trust deed system functions just like an escrow lasting the term of the Promissory Note because legal title is actually held by the Trustee not by the Owner. The borrowers have a recorded interest in a property, and they possess all the rights of ownership subject to the Trust Deed encumbrance, but their interest is not unencumbered ownership, and it will not become true ownership until they pay off the Promissory Note; until the Note is paid off, legal title is held by a Trustee while Owners have Equitable Title with rights of possession and use.
The trustee is empowered to call a public auction without going to court — avoiding court being the main reason the system was developed. This gives lenders the option of forcing sale at minimal cost and minimal delay. The system is streamlined and capable of expanding and contracting to meet demand. Lately, the Trustee business has been a stellar growth industry.
A business transaction
First and foremost, the documents exchanged by borrowers and lenders are a business transaction as Henry Blodget recently informed borrowers:
“Specifically, when you borrowed money to buy your house, you engaged in a business transaction. The bank or mortgage-lender evaluated the risk of the transaction and concluded that it would was a risk worth taking. To protect its money, the lender also required that you pledge the house as collateral, and it required you to have some equity in the house as an additional cushion. In the event that you didn’t pay, the lender retained the right to seize the house, sell it, and pay itself off before you got your equity. The lender loaned you the money because it concluded that this was a smart business decision.
You, meanwhile, also made a business decision. You decided to borrow money to buy your house even though it meant risking your equity, home, and credit rating.
And now it turns out that both of you made a bad decision.
Fortunately, you don’t have to fight about what happens next. The contract between you spells everything out: If you stop paying, the lender gets the house. That’s it. Unless the contract specifically differentiates between a failure to pay based on hardship (involuntary) and a failure to pay based on a collapse in the value of the house (voluntary), there’s no difference. If the lender thought at the beginning that you had a “moral obligation to pay,” it would have specified that in the contract.
Now, compare this to a situation in which you DO have a moral obligation to pay: When you borrow money from a friend at no interest, for example, and you promise that friend that you will give him or her every penny back. THAT is a moral obligation to pay. In this case, your friend did not lend you money to make a profit. Your friend loaned you money to help you out–with no collateral or contract other than your promise to pay.”
Many people persevere in business transactions throwing bad money after bad for vanity, entitlement or misplaced moral obligation.
The big bluff
Threat of calling a foreclosure auction is supposed to be a bluff. Neither the lender nor the borrower want an auction, but similar to Texas Hold-em, each party has cards to play, and where they are in the process and the relative strengths of their bargaining positions matter.
Ordinarily, threat of forcible eviction from the family home compels borrowers to do whatever is necessary to make payments, and the carrot (keep a home) and stick (threat of foreclosure) are enough to keep the system working. However, when people don’t have equity or when it is in their best interest financially to get out of a loan, lenders find the threat of forcible eviction less compelling; in fact, the more underwater a homeowner is, the less power lenders have. What possible threat can a lender hold over a money renter who is 30% underwater?
What property right does the 30% underwater homeowner particularly value that they don’t obtain as a renter?
The right to improve a lender’s property? Good luck getting a loan for that.
The right to lease out for less than the mortgage payment? Not a great deal for the owner.