Keywords

JEL Classifications

Introduction

Mortgages underlie a great deal of property ownership in the USA, both commercial and residential – more than 69% of US owner-occupied housing units are subject to a mortgage (US Census Bureau, 2010 Census). These critical tools aid in the smooth operation of the housing market, and residential mortgages allow borrowers to live in homes that they otherwise could not afford to own. But for such an instrumental component of the economy, mortgages are widely – and wildly – misunderstood. We explain the complex legal and economic structure of a modern mortgage, including its applications to foreclosures and public policy. Our goal is to provide a conceptual overview, not comprehensive coverage of all aspects of mortgage law; this article is not written to provide legal advice.

To understand mortgage law, it is useful to go back to its historic origins in medieval England. The original common-law mortgage was a repurchase agreement in which the borrower sold the property to the lender and promised to buy it back by repaying the loan, plus interest, on an agreed date known as law day. If the borrower failed to appear on law day, the repurchase agreement was void and the lender received clean title to the property – title unencumbered by the borrower’s right to repurchase. English courts of equity viewed this contract as unfair because the value of the property could exceed the balance of the loan, in which case failing to appear on law day would lead to an excessive transfer of wealth from borrower to lender. To remedy this, courts in 16th century England gave the borrower the right to repurchase, or redeem, the property, even if he or she had failed to appear. The borrower could exercise this repurchase right by paying off the loan, including interest and any associated costs. The courts understood that there needed to be some limit on this right of equitable redemption, as it became known, because otherwise lenders could never obtain clean title and, under such circumstances, no property could ever serve as good collateral for a loan. To solve this issue, courts allowed lenders to petition to foreclose the borrower’s right of equitable redemption. This basic legal concept is the principle behind foreclosure to this day.

As we explain in section “Legal Frameworks: Title Theory and Lien Theory” below, in 30 US jurisdictions a mortgage contract is still a repurchase agreement as it was in medieval England. But even where it is not, the repurchase metaphor goes a long way towards explaining some counterintuitive concepts about mortgage law. For example, in common usage a mortgage transaction involves the lender giving a mortgage to the borrower; however, in the eyes of the law, the borrower is actually granting the mortgage to the lender. The logic is that the mortgage transaction, as in medieval England, is the grant of the property from the borrower to the lender.

In a sense, a mortgage contract establishes a form of shared ownership of a residential property, in which each party can extinguish the other’s ownership rights under certain conditions. For the borrower, the equitable right of redemption provides the power to claim the property by paying some agreed amount of money. In the event that the borrower fails to repay the loan as promised, the lender gets the right to extinguish the borrower’s ownership interest by following the appropriate foreclosure procedure.

In this article, we first discuss the mortgage contract, including the two principal legal regimes behind the transfer of ownership rights, as well as the standards for recording mortgage documents with the relevant authorities. We then discuss foreclosure proceedings, including how they are affected by the different legal regimes, why such formal procedures are necessary, and some repercussions and complications that can emerge.

The Mortgage Contract

A mortgage is an exchange of a collection of rights between a borrower and a lender. Although in common usage a mortgage refers to a loan secured by real estate, legally the loan is called a ‘note’ and is secured by a separate instrument called a ‘mortgage’. The note is a debt contract which specifies the amount lent and the schedule for repayment – including the interest rate, amortisation schedule, prepayment penalty and any other relevant information such as the index used for adjustable-rate mortgages. With the mortgage, the borrower conveys to the lender an interest in the property in order to secure the debt evidenced by the note.

The contract works simply. If the borrower makes the scheduled payments according to the note, the lender can exercise essentially no property rights. The lender cannot sell the property, or even set foot on it, without the permission of the borrower. By repaying the loan, the borrower satisfies the note and redeems the mortgage, extinguishing the lender’s security interest in the property. If the borrower violates the terms of the note, or defaults, the lender can exercise the right in the mortgage to foreclose the borrower’s equity of redemption and extinguish the borrower’s interest in the property. What constitutes default is specified in the note; it includes failing to make a scheduled payment, but may also include other violations of the contract, such as failing to insure the property or renting the property without permission. It is important to recognise that problems with the borrower’s finances or with the collateral property do not directly constitute default on a mortgage, and that this is different from many other types of loan. For example, the borrower is not required to maintain a certain amount of equity in the property, as would be required with a margin loan against a stock holding. We discuss default and foreclosure proceedings in more detail in section “Foreclosure Proceedings”.

Almost all mortgage contracts today are uniquely connected to both a particular property and a particular borrower. Historically, however, lenders offered both assumable and portable mortgages. An assumable mortgage is tied to the property and can be transferred to a new owner after a sale; today, a typical mortgage includes a due-on-sale clause which requires the borrower to pay off the loan when the property is sold. A portable mortgage follows a borrower from property to property, allowing the borrower to keep, for example, a low interest rate even if market rates have increased; such loans are rare.

In the remainder of this section, we discuss two topics relating to mortgage contracts. The first involves the two conceptually distinct US legal frameworks for mortgages, known as title theory and lien theory. The second is the role of the recording process for mortgage documents.

Legal Frameworks: Title Theory and Lien Theory

Although the USA inherited much of its property law from England, individual states have since developed distinct branches. The main difference across jurisdictions relates to the ownership framework. According to the first such framework, title theory, the mortgage actually conveys legal title to the property from the borrower to the lender with a mortgage deed. It is only upon satisfying the mortgage note – by paying off the debt – that the borrower becomes a legal homeowner. Meanwhile, the borrower retains equitable title to the property and, for all intents and purposes, remains the apparent and effective owner of the property. In Massachusetts, the Supreme Judicial Court described the phenomenon thusly: ‘to all the world except the [lender], a [borrower] is the owner of the mortgaged lands’. Dolliver v. St. Joseph Fire & Marine Ins. Co. 128 Mass. 315, 316 (1880).

Over time, because the lender could not exercise any property rights despite having legal title to the property, some jurists argued that ‘the [lender] could no longer be said to have legal title… and the interest of the [lender] was only a security interest which was called a lien’ (Osborne 1951, p. 311). Statutes were enacted in a minority of states, the earliest of which was South Carolina in 1791, officially effecting this change and establishing the alternate theory of conveyance, lien theory, which allows the borrower to maintain legal title to the property. In a lien-theory state, property rights are conveyed by a mortgage lien. In contrast to a deed, a lien does not transfer title to the property. Instead, a lien grants the right to recover debt through the sale of the property if the borrower defaults on the note, although this usually requires a lawsuit.

Thus title theory, which is used in 30 US jurisdictions, including Arizona, California and Nevada, is the most directly analogous to the medieval legal regime in which the mortgage was an explicit repurchase agreement. However, lien theory, used in the other 21 jurisdictions, including Florida, Illinois and New York, can also be construed in roughly the same terms.

So under either framework the borrower retains effective ownership of the property until one of two possible events occurs. The first is that the borrower satisfies the note by paying off the debt, at which point either, under title theory, legal title reverts to the borrower or, under lien theory, the lien is extinguished. The other possibility is that the borrower defaults, usually by failing to make a periodic payment. A borrower in default maintains the right to repay the debt in full – including late payments, fees and other expenses – and thereby satisfy the note. Under title theory, a defaulted borrower satisfying the note does not automatically regain legal title unless the lender reconveys it, but a court can compel this reconveyance; under lien theory, satisfying the note automatically extinguishes the lien, and insodoing the borrower immediately has free and clear ownership of the property (Osborne 1951, pp. 836–7).

As long as the borrower maintains the equity of redemption – the ability to satisfy the note and regain title to the property – the lender’s ownership is in question. In order to remove this cloud from the title, a lender must foreclose on the borrower’s equity of redemption. By doing so, the borrower loses his or her right to redeem the mortgage and regain clear title; this process of extinguishing the borrower’s equity of redemption is the foreclosure. In a title-theory state, foreclosure is usually carried out through a foreclosure auction (see section “Foreclosure Types: Strict Foreclosure and Foreclosure by Sale”). In a lien-theory state, because the lender does not yet possess legal title to the property, the lender usually must go to court to effect the foreclosure. Thus, in most lien-theory states, foreclosure is carried out through a judicial process (see section “Foreclosure Methods: Judicial Foreclosure and Power-of-Sale Foreclosure”).

Borrowers in all states can redeem the mortgage debt before foreclosure. About half the states also have a statutory right of redemption explicitly permitting borrowers or their successors a limited time – generally six months to two years – to redeem the mortgage after a foreclosure, usually for the price of the foreclosure sale (Nelson and Whitman 1985, p. 616). This action nullifies the foreclosure sale, but it is hardly ever used in practice (Nelson and Whitman 1985, p. 622).

Mortgage Records: Document Recording, Registration, and Priority

As a general rule, all mortgages in the USA are publicly recorded at a town or county registry, while records of the note are kept privately by the borrower and the lender.

Public records generally contain most transfers of interests in a property from one party to another. However, they typically do not contain the title to the property because there is usually no physical document showing title. To establish that a particular person has title to a property, one must show that anyone with a previous interest in the property has relinquished it – in other words, all previous owners have deeded the property to someone else, forming a chain of ownership, and all previous mortgages have been discharged. This system of recording transfers and inspecting the historical record to establish a chain of title is the de facto standard throughout the country.

However, in some jurisdictions there is title registration for property more analogous to title registration for vehicles, which usually involves physical documents. Such a method ‘registers and determines title to land so as to amount to practically a government patent to each purchaser’, but these systems have not been fully utilised even where they have been formally adopted (Osborne 1951, p. 496). In Massachusetts, for example, one of the states which permits land registration, only about 20% of land is registered.

The role of the public records differs across states. In some states, only recorded documents have legal standing. In other states, a deed is valid even if it is never recorded. In the latter states, however, a recorded deed almost always takes precedence over an unrecorded deed, so failure to record is rare. To understand the issue, consider an example. Suppose Alex sells a house to Bailey and Bailey does not record the sale deed. In some jurisdictions, this transaction is perfectly valid and Bailey has title to the property. Now suppose Alex also sells the house to Casey and Casey’s deed is recorded. Then both Bailey and Casey think they own the house, but in some states, the courts would hold that Casey, as the first to record the purchase, is the legal owner of the property. In other words, recording provides protection to the buyer, even if the contract is valid without being recorded. (Of course, Bailey could then sue Alex for damages, but Bailey has no power over Casey’s valid ownership. However, if Casey had knowledge of Bailey’s deed before buying the house from Alex, Casey’s deed would be considered invalid in some, but not all, states. These details are governed by state recording statutes, which are known generally as one of ‘race’, ‘notice’ or ‘race-notice’. See Hunt et al. (2011) for a brief discussion.)

Documents eligible for recording include purchase deeds between homeowners, mortgage deeds and liens between borrowers and lenders, and more controversially, assignments which transfer ownership of mortgages between lenders. Unlike deeds involving homeowners and borrowers, which are almost always recorded, assignments between lenders frequently go unrecorded. To make matters even more confusing, in the 1990s the mortgage industry set up the Mortgage Electronic Registration System (MERS). MERS was created for many reasons. One was because an increase in securitisation meant that assignments were more common and consequently their frequency was more burdensome. Another was that most registries still required paper copies. But a third important reason was that, during the savings and loan crisis of the 1980s and 1990s, bank failures resulted in serious title problems as mortgages changed hands, often several times and without clear documentation.

To use MERS, the lender assigns MERS as the mortgage owner of record in the registry. MERS, in turn, keeps track of any underlying assignments of ownership from one lender to another. If and when the controlling lender needs a recorded interest in the property, MERS goes to the registry and records an assignment of the mortgage to that lender. MERS has worked smoothly since its inception in 1995, but during the foreclosure crisis that started in 2007, some people raised questions about its legality, in particular with respect to foreclosures. In general, appellate courts have found in favor of MERS, but it remains controversial and litigation continues.

Most US jurisdictions respect the doctrine that ‘the mortgage follows the note’, meaning that any time a mortgage note is sold from one party to another, ownership of the mortgage goes along with it automatically, without requiring a separate assignment. The two notable exceptions are Massachusetts and Minnesota. Reliance on this doctrine may simplify foreclosure, because the foreclosing party need only demonstrate possession of the note in order to have the right to foreclose that is provided by the mortgage. However, this simplification has recently been called into question, particularly regarding its interplay with MERS assignments.

Foreclosure Proceedings

The fundamental principles of foreclosure date back centuries, but the actual procedures have evolved considerably over time. To understand the logic of the foreclosure proceeding, it is important to understand the motivations of the two key parties. For the lender, the primary goal is to ensure that there is no risk that the original borrower can recover the property, which allows a new buyer of the property to get clean title. For the courts, the overarching concern is to prevent a lender from injuring a borrower by taking more than the lender is owed. Under current foreclosure law, the court is not generally concerned with whether the original loan was suitable for the borrower or whether the lender made efforts to prevent foreclosure, because the court’s narrow focus is on whether borrower and lender upheld their respective ends of the mortgage contract. In particular, neither the mortgage contract nor current legal principles oblige the lender to modify the loan or work with the borrower to prevent foreclosure.

Foreclosure Types: Strict Foreclosure and Foreclosure by Sale

Before the 19th century, foreclosures were what are now called ‘strict’, meaning that the lender took possession of the property and it was disposed of at the lender’s discretion. However, US courts found that this was unsatisfactory for largely the same reason the English courts of equity distrusted the original medieval mortgage – the value of the property could exceed the amount owed and in that case ‘there is injustice to the [borrower]’ (Osborne 1951, p. 904). The solution to this issue became known in the USA as ‘foreclosure by sale’, whereby foreclosure is effected by a public auction of the property and the borrower receives any proceeds in excess of the amount owed (Osborne 1951, p. 908). It is important to emphasise that the auction does not take place after the foreclosure; the auction itself is the legal foreclosure. In other words, the equitable right of redemption vanishes the moment the auctioneer sells the property.

Most often, the auction is something of a formality where the lender is the high bidder and the property ends up in the ‘real-estate owned’, or REO, portfolio of the lender. At the auction, the lender usually starts the bidding, often with an offer much higher than the actual market value of the property. This at first appears puzzling, but recall that the goal of the lender in the foreclosure process is to ensure that title to the property is clean. Since a borrower could contest the foreclosure if the lender does not get the best possible price at auction, a low winning bid could potentially cloud title to the property. By setting the opening bid sufficiently high – often only slightly less than the borrower owes, which is generally more than the property is worth – the lender can forestall any challenge to the foreclosure.

Foreclosure Methods: Judicial Foreclosure and Power-of-Sale Foreclosure

Two types of foreclosure by sale emerged in US law. The first is foreclosure by judicial sale, in which the lender petitions the court and the court orders a foreclosure auction. Judicial sale is available in every jurisdiction. The alternative approach is that, when the mortgage is originated, the borrower gives the lender the right to carry out a foreclosure auction in the event of default, a right known as the ‘power of sale’ (Osborne 1951, p. 992). Although rare in the early 19th century, power-of-sale foreclosure became more common in the USA over time (Osborne 1951, p. 993).

Power-of-sale foreclosure is available in a majority of states. In general, states in the south and west of the country offer power of sale and states in the north and east are judicial; whether power-of-sale or judicial foreclosure is the preferred method aligns almost exactly with whether the state follows title or lien theory, respectively. Of the states with the most severe foreclosure problems in the current crisis, Arizona, California and Nevada all allow power-of-sale foreclosure, while Florida only allows judicial foreclosure. Other notable judicial states include Illinois, New York and New Jersey. For fuller discussion of judicial and power-of-sale foreclosure, see Gerardi et al. (2011) and National Consumer Law Center (2010).

Some have suggested that the judicial procedure, by giving the borrower an opportunity to appear in court, is friendlier to the borrower. Meanwhile, power of sale is generally viewed as lender-friendly because lenders face no official supervision by the courts. But the truth is more nuanced. Under power of sale, the desire for clean title leads to implicit supervision. Specifically, most buyers of residential real estate need title insurance – lenders usually require it before funding a loan – and title insurers will not insure a foreclosed property if there is any chance that a previous owner could contest the title and that the courts could declare the foreclosure invalid. So, in a sense, title insurers act as third-party enforcers in place of the courts in power-of-sale states.

In judicial states the courts provide explicit supervision, but that supervision provides surprisingly little, if any, additional protection to borrowers. To get the court to order a foreclosure in a judicial state, a representative of the lender must attest that three key conditions are met: the borrower took out a mortgage, pledged the property as collateral, and defaulted on the mortgage. This attestation usually comes in the form of an affidavit certifying that the representative has reviewed the borrower’s loan file. Since effectively all borrowers facing foreclosure meet these conditions, the borrower has little to contest in court and borrowers rarely succeed in blocking foreclosure; borrowers contesting judicial foreclosures usually yield only delays. During the recent foreclosure crisis, some lenders’ representatives signed affidavits without complete knowledge of the loan files, a practice often referred to as ‘robosigning’. Because of these affidavits, borrowers were able to raise questions about the validity of the attestations despite the fact that the foreclosure files met the three key conditions.

The data suggest that judicial foreclosure is borrower-friendly and lenderunfriendly only in the sense that it extends the foreclosure timeline. Gerardi et al. (2011) show that fewer than half of initiated foreclosures are completed within three years in 14 of the 18 judicial states, whereas the same is true in only seven of the 33 power-of-sale jurisdictions. Nor do borrowers benefit from judicial foreclosure in other ways – they are not more likely to cure a serious delinquency in judicial states than they are in power-of-sale states, and they are not more likely to receive a mortgage modification.

Legal scholars have long argued that the power-of-sale procedure can replicate the protections of the judicial process at much lower cost. Nelson and Whitman (1985, p. 536), for example, write that

The underlying theory of power of sale foreclosure is simple. It is that by complying with the above type statutory requirements the [lender] accomplishes the same purposes achieved by judicial foreclosure without the substantial additional burdens that the latter type of foreclosure entails. Those purposes are to terminate all interests junior to the mortgage being foreclosed and to provide the sale purchaser with a title identical to that of the [borrower] as of the time the mortgage being foreclosed was executed.

Mortgage Deficiency: Deficiency Judgments, Lender Recourse, and Second Liens

The concern of the courts, as we have discussed, has historically been that a foreclosure would injure a borrower who owned a property worth more than the loan balance. That is, of course, ironic because a borrower with a property worth more than the loan balance is virtually never foreclosed upon; the borrower can simply sell the property and pay off the debt. Rather, the overwhelming majority of foreclosures involve the opposite scenario: borrowers with negative equity. In this situation, when the borrower owes more on the loan than the value of the property, the amount recovered from the auction will not cover all the money the borrower owes. In the language of the mortgage contract, the security for the mortgage will not cover the debt specified in the note. This gap is called a deficiency, but it is not automatically a debt owed by the borrower, since the note has been extinguished. (The balance of a deficiency may become a debt due the lender as part of a strict foreclosure proceeding, although these are relatively rare (Nelson and Whitman 1985, p. 595).) Historically, lenders in the USA could sue the borrower and get a deficiency judgment, which converts the deficiency into an unsecured debt. This process of pursuing a mortgage deficiency is called recourse and is common throughout the world. During the Great Depression, however, US lenders abused deficiency judgments by underbidding at auction in order to inflate deficiencies; consequently, some states enacted anti-deficiency statutes. The anti-deficiency laws often have confusing subtleties: in California, for example, deficiency judgments can only be pursued for judicial foreclosures of refinance mortgages, and even then the deficiency is limited and the borrower is provided a right of redemption. According to Ghent and Kudlyak (2011), only 11 states have legal systems that are effectively non-recourse. Statutorily, most mortgages in the USA are recourse loans.

It is true, however, that lenders generally do not pursue deficiency judgments on first mortgages and, as mentioned earlier, set an opening bid that is close to the amount owed on the loan in order to ensure a small deficiency, even if the REO sale price (i.e. the price the lender receives when reselling the property to a third party) leads to a large loss. The main reason lenders do not pursue deficiency judgments is that borrowers who lose their homes typically have few or no other assets. US bankruptcy also law allows borrowers to discharge deficiency judgments. Moreover, a deficiency judgment may cause the court to question the fairness of the foreclosure, in particular the auction and bidding process, regardless of the circumstances. Thus, lenders often forgo pursuit of a deficiency judgment because of the inclination of mortgage law towards borrower protection; in this way, most first mortgages are effectively non-recourse in practice.

In contrast to lenders of first mortgages, lenders of second mortgages have only a limited amount to gain from foreclosure, because the collateral for the second mortgage is not the property itself but the borrower’s equitable right of redemption. In other words, if the second lender forecloses, the buyer at auction acquires the property with the first mortgage still in force. Such foreclosures on second mortgages are rare; much more common is foreclosure of a first mortgage on a property which also has a second mortgage. In that case, the second lender is entitled to recover its debt from the proceeds of the foreclosure sale, but only after the first lender’s debt has been satisfied. If the auction price is insufficient to cover the amount owed on the second mortgage, as is usually the case, the second lender can pursue a deficiency judgment against the borrower; deficiency judgments for second mortgages are much more common than deficiency judgments for first mortgages.

Avoiding Foreclosure: Deeds-in-Lieu and Short Sales

Given the time, expense and complexity of foreclosure, many in the current crisis have asked if there are alternatives. Alternatives such as mortgage modifications that allow the borrower to retain ownership do not generally involve real property law and are beyond the scope of this article. However, there are two procedures designed to generate the same outcome as a foreclosure at a lower cost.

A deed in lieu of foreclosure, or simply a deed-in-lieu, is when the borrower deeds the property to the lender in exchange for forgiveness of most or all of the mortgage debt. A short sale is when the borrower sells the property for less than the outstanding balance of the loan and the lender agrees to discharge the mortgage despite the deficiency. Both procedures benefit the lender, saving time and expense, and the borrower, who gets a cleaner exit from an unfortunate situation and a less damaged credit history than would result from foreclosure. Further, lenders agreeing to deeds-in-lieu or short sales generally choose to forgo the possibility of a deficiency judgment; choosing to forgo the deficiency also helps to preclude accusations of exploiting the borrower. The downside of a deed-in-lieu or short sale from the borrower’s perspective is that he or she cannot live rent-free while waiting for a foreclosure auction – a wait that can often take months or years.

Deeds-in-lieu and short sales each face a serious obstacle: they avoid a true foreclosure. At first, it may be surprising that this is an obstacle at all, particularly in light of concerns about foreclosures and their impact during the recent financial crisis. The courts, however, have historically viewed the foreclosure process, and the foreclosure auction in particular, as a central protection for the borrower. Without an auction, there is no way to know for sure whether the borrower surrendered a property worth more than the mortgage debt. The courts might then question whether the lender coerced or misled the borrower into giving up the right to a full foreclosure and thereby circumvented, or clogged, the borrower’s equity of redemption. It is for this reason that ‘the deed in lieu of foreclosure can create substantial problems for the [lender] and is often, from its perspective, a dangerous device’ – the same holds true for a short sale (Nelson and Whitman 1985, p. 474). This is even more true when the borrower has a second mortgage, because deeds-in-lieu and short sales negotiated with a first lender do not extinguish subordinate mortgages; in those cases, ‘the only prudent alternative for the [first lender] is to foreclose’ (Nelson and Whitman 1985, p. 476).

See Also