How troublesome are those “troubled assets?”

When the value of a bank’s assets is insufficient reserve to assure that it can meet its obligations, regulators step in and take over. Among the reasons for a drop in asset values may be an increased default rate in the bank’s loan portfolio, or a decline in the market value properties securing its loans or a diminished rating for bonds supported by a pool of loans (e.g., “sub-prime” mortgages.)

Whatever the reason for a bank’s failure, when a bank fails the regulator or successor bank frequently sells off large loan portfolios at substantial discount. This presents a great opportunity, as long as the risks are understood. Those risks can be summarized in one word: uncertainty.

Loans categorized as “troubled assets” are not necessarily worthless. Rather, it is often because their worth is uncertain. A bank’s assets include the promises made by its borrowers to pay back their loans. When large numbers of borrowers default, or when there is a significant decline in the aggregate value of the real estate securing the bank’s loan portfolio, the bank may fail or be shut down by the FDIC. In the process of sorting out the failed bank’s assets, large bundles of the bank’s loans are sold to investors, at prices that are heavily discounted because their value is unknown. The large bundles are then broken up into smaller bundles and sold to other investors. Some loans are kept by the investors and some are sold, and the process may be repeated. With each subsequent sale, an investor may offer to sell one loan or a group of loans.

A given loan may or may not be in default, but more important, the property securing it is likely (but not always) “under water,” i.e., worth less than the outstanding loan balance. To avoid buying a “pig in a poke” the purchaser of mortgages is confronted with two categories of uncertainty: economic and legal.

The prudent investor must first evaluate the economic potential of the property based on his or her plans for the property (foreclosure, loan modification, rental, immediate or long term sale, personal use, etc), as well as the asking price for the lender’s paper, outstanding loan balance, availability and cost of financing, the condition of the property, the cost of needed repairs, presence and posture of any occupants, present, intermediate and long term value, etc.

The legal challenge is to make sure the investor is buying what he or she intends to buy. In other words, who owns the land and who owns the paper? If the investor is purchasing a debt obligation, this means answering two questions: First, does the seller own the mortgage and note and have the right to sell it, and second, is mortgage a valid security interest?

These used to be routine questions, easily answered by any experienced real estate attorney. Unfortunately, recent practices in the lending and financial world have resulted in widespread corruption of recording systems intended to keep track of real property interests. Notes and the mortgages securing them were often traded separately and with scant attention to proper documentation or recording of the transactions. This requires extensive investigation and detective work to bring ownership of the note and mortgage into the same party and to repair the frequent deficiencies in the documentation.

The best approach is inspect the property as best you can (depending on accessibility), request whatever documents the seller is willing to provide, do a preliminary online title search (which is necessarily inconclusive) and then make an offer contingent on verification of the chain of title to both the mortgage and the note (as well as further physical inspection).

Once the offer is accepted, then a full title examination should be ordered. Careful review of a foreclosure commitment must be done to be sure that all the title company’s requirements are met. This often involves re-execution of some of the documents in the chain of title. Finally, to assure that you obtain good title, you must assure strict compliance with the notice and procedural steps required by your state’s foreclosure laws.

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