In some cases, rather than going through with the default/foreclosure/bankruptcy/real-estate owned (REO) process, the lender may choose to simply sell a problem loan. This sale is known as a note sale. Note sales fall into three categories: Performing Loans, Sub-Performing Loans, and Non-Performing Loans.
Foreclosure is an excellent way to cleanse the asset, as it eliminates all of the claims and liens, and it is a great tool for transferring assets. In this lesson, we will explore note sales and the foreclosure process in greater detail.
If you’re thinking of buying notes, there are several issues that you should consider first. The first is the reps and warranties. Typically, the selling lender does not provide reps and warranties to the buyer unless the note is valid. The second issue is the assignment of the note. The buyer inherits the existing note as-is, so all of the terms are pre-set. The buyer must be comfortable with the structure, terms, remedies, default rate, recourse, and other terms.
The third issue is prior promises. Borrowers might claim that the prior lender made certain verbal promises and agreements, and they may expect the new buyer to “live up” to these terms as well. The fourth issue is financing the note. Typically, the buyers must finance the purchase of the note, either from the selling lender or from a third party. The fifth issue is the default provisions. If the loan is in default, the new note buyer will seek to enact the default rate and fees. The existing note holder sets these terms. Finally, we have the existing documents. The new note buyer inherits and must accept all existing documentation – good or bad!
The foreclosure process is driven by state law, typically by the state in which the asset is physically located (although lenders or borrowers sometimes seek other venues). The options to which state rules apply can be determined by the following information:
- Choice of law in the documents
- Location of the lender’s headquarters
- Location of the borrower’s headquarters
- Location of the property
Foreclosures can take two legal forms. The first is the judicial form. In a judicial state, the foreclosure process can resemble a trial. There is a hearing date and a judge, and the two sides have their day in court to discuss the proceedings. This is not a good process for the lender, as it is costly and time-consuming. Judicial state foreclosures can take as long as one year. The second form is non-judicial. In a non-judicial state, foreclosures are fast and simple. The notice of foreclosure is filed, and these notices are typically advertised in the local papers. On the set date (typically 30 to 60 days from the filing date), an auction for the property occurs at the county courthouse.
However, the process does not end there! Regardless of the foreclosure form, there is a redemption period. The length of this period varies by state, but lasts somewhere between 30 and 90 days. During the redemption period, the borrower who is foreclosed upon has the right to buy the property back for the amount that the property is bid for at auction. If there are no other bids, the first-trust lender bids for – or buys – the property at foreclosure.
When dealing with foreclosures and note sales, pay special attention to trade and tax liens. In many states these liens have super priority, and the holder of these liens can seek foreclosure and wipe out the first-trust loan. Paying these loans in full should be part of all distressed asset pro formas.