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Chapter 2: Documentation

She got a mortgage on my body now, lien on my soul.

-Robert Johnson, Traveling Riverside Blues

After the bank has underwritten and approved a loan, documents must be prepared. Real estate loans require extensive documentation, and many is the lawyer who makes a living doing little else. As a credit analyst, you're not expected to be a lawyer, but you are expected to understand, and to be able to prepare a number of different loan documents. Preparing and reading legal documents takes time and practice. My advice is to take the time to read legal documents thoroughly at the earliest opportunity. At first you will experience a number of unpleasant symptoms: befuddlement, falling asleep at your desk, mild nausea (in the case of a mortgage, severe nausea), and a strong urge to die. However, most of these symptoms decrease with time and experience. You'll still fall asleep at your desk, but the urge to die will become replaced with an urge to kill. If you cannot understand something, consult with an attorney or an officer or another analyst only after you've read the document yourself. Doing this will save you the embarrassment of standing at someone's desk and having him read the answer to you from the top of the first page of the document you had a question about. You'll also learn more, and learn it more quickly. Again, it does take time, but it also gets easier. Eventually, you'll wow your friends and colleagues with your legal astuteness.

The bank documents its loans by working from standard templates and filling in the correct names, amounts, percentages, etc. These documents have been written, edited, and rewritten by armies of attorneys working for years. You will not find a mistake in them. You might make a mistake in customizing it, or use it inappropriately, but you will not find a mistake. Preparing documents is like reading them. It takes time and practice. It also helps to be ridiculously anally retentive. Fortunately, for many of the transactions the bank makes, the bank hires lawyers to do this work.

Good legal writing is actually easy to understand. The idea is to remove any potential ambiguity from what you are writing. However painful it is to argue with a customer before making the loan, it will only be a million times worse after you lend the customer a million dollars. So, you want to be sure that any argument the borrower makes about your documents will not just be wrong, it will be obviously wrong. The reason that documents get so long is because they incorporate refutations to all the arguments that have been made in the past. This aside, for some unintelligible reason, the legal community has latched onto some particularly ill phrases that still pain me every time I read them. The thing that I hate most is "interest shall accrue on the principal balance from time to time outstanding". This, or some variant of it, appears in almost every note (I'll explain what a note is in a moment) I have ever read. It makes me cringe. "From time to time"?!? How vague and arbitrary can you get?

Since this is the most legalistic section of my text, I cannot resist putting in the following disclaimer. Everything in this section is untrue. (Or at least, there are a myriad of exceptions to everything I say. You want to be an expert? Go to law school and then practice law for 30 years.)

Legal Entities

Before I begin my discussion of particular loan documents, I want to spend a little time on discussing different legal entities. The bank lends money to many different types of borrowers: people, partnerships (limited or general), trusts, limited liability companies (LLCs), and corporations, or some combination or nesting of the above. The simplest case is making a loan to a single individual. That person signs the appropriate documents himself, as himself. In the case of a partnership, one (or more or even all) of the partners will sign the documents as partners, not as individuals. The same applies to limited liability companies, which is something of a hybrid between a corporation and a partnership. For either of those entities you have to read the documents that formed the entity to determine who has the authority to borrow and to execute documents. There is no other way to know who can execute the documents. You cannot trust the borrower to tell you who can execute the documents. Not only because the borrower might try to pull a fast one, but also because borrowers are extremely careless about understanding the entities they control, confusing who is the manager of what LLC, or if any partner can enter the partnership into a contract, or if there has to be the consent of all the partners. Authority to enter into legal contracts for a corporation rests in the board of directors. It must adopt a resolution allowing the corporation to borrow money. This resolution will generally give the president the authority to borrow for the corporation, and therefore to execute the needed documents.

A further complication is that property in Illinois is often held in a land trust. This invariably confuses people greatly. The first time I encountered it, it confused me greatly. By this arrangement, the owner of the property places it in a trust. After this happens, the trust owns the property. People have a hard time understanding that. So, I repeat, the trust owns the property. The old owner of the property becomes the beneficiary of the trust. That means that whatever benefit is derived from the property held in the trust, the "corpus", is given to the beneficiary. So, if you are the beneficiary of the trust that owns a commercial property, you get to collect the rents. The trustee of the trust, generally a bank, is the only authority that can enter into any agreements, like loans or leases, for the property. Of course the trustee should always do what the beneficiary instructs it to. The trustee generally collects a yearly fee from the beneficiary, and also an extra fee for each service it provides, for instance signing loan documents. Why would anyone put his property into a land trust? There are at least two reasons. 1. Anonymity. Who owns a particular piece of property is a matter of public record. Who is the beneficiary of a trust is not. 2. Real estate is real property, beneficial interest in a trust is personal property. It is easier to transfer ownership of personal property than real property. For this reason, land trusts are sometimes used for estate planning purposes.

Without further ado, onto the loan documents.

Notes

The single most important document is the note. The note is the only document which states that the borrower owes the bank money. If you give someone money without a note, you didn't make a loan, you made a gift. I repeat, the note is the only document which states that the borrower owes the bank money. All the other various and sundry documents refer to and depend on the note. The note will always contain the following information:

  1. Who the borrower is (the "Maker" or "Debtor" or "Borrower").
  2. How much money is being borrowed.
  3. What the interest rate on the loan is.
  4. When the loan must be repaid in full (the "Maturity Date").
  5. What payment schedule the borrower must follow during the loan, including the amortization period, if applicable.
  6. What late fees will be charged for violating the schedule set forth above.
  7. What the penalty for a default (a violation of the terms of the note) on the loan is.
  8. What prepayment penalty will be applied to unscheduled repayment(s).

Understanding number 1 above is critical. You must always know exactly who the loan is being given to, and what type of entity that someone is. The entity being given the loan is called the "Borrower" (capital B). The Borrower is the only entity that owes the bank money. When preparing a note it is critically important that the NAME of the entity be given correctly. It is also of critical importance that the correct entity sign for the Borrower. A simple case: a limited liability company called The Borrower, L.L.C., is managed by Joe Bossman. The signature block should look like this:

The Borrower, L.L.C.

By: _______________________________
Joe Bossman
Its: Manager

If instead, you prepare the note to The Burrower, L.L.C., even if Joe Bossman signs it, and admits to signing it, he'll potentially be able to argue in court that The Borrower, L.L.C. owes the bank nothing, and that the bank is welcome to attempt to collect whatever it likes from The Burrower, L.L.C., as soon as the bank finds it. Whether or not the court would agree is another matter, but you never want to take this chance. (One condition of the bank's loan documents is the waiver of the right to trial by jury. This is important. The bank will almost never make a loan without this. Judges may be crazy, unpredictable, corrupt, and immune to logic, but when dealing with a jury you have at least 12 times the chance of running into one of the above, and occasionally something worse: a populist. * Get the name right, including commas, periods, accents, eccentric printer's dingbats, Greek letters, and any other craziness.

There are a variety of different kinds of notes. The most basic is a fixed rate loan with a fixed amortization schedule. The Borrower receives the face amount of the loan on day one, and then must make fixed payments monthly until maturity when the remaining balance is due. It is standard in commercial real estate transactions to make loans for a ten year term on a thirty year amortization schedule. By comparison, this is almost unheard of in home lending, where the amortization schedule is almost always equal to the loan term. Why is commercial real estate so different? This is a large and difficult question, but it boils down to commercial properties being much more likely to fluctuate in value than homes are. A bank can be reasonably sure that that bungalow in Levittown it is lending against will remain stable in value for years to come, and will probably actually appreciate as the years go by. Commercial properties are much more prone to obsolescence, and to a corresponding reduction in value. By making the loan term ten years instead of thirty the lender introduces a mechanism that forces a confrontation with this issue. Imagine a situation where the value of the bank's collateral is eroding, but the borrower continues to suck profits out of the building without missing loan payments on the one hand, but without reinvesting any money to update or maintain the building on the other. The bank would not have much right to complain, even as the loan became more and more insecure. After sucking whatever profits he could out of the building, the borrower would throw the bank the keys and walk away. By keeping the loan term short, commercial lenders hope to avoid such a scenario. If the building is worth much less at the maturity date, the borrower will have a number of choices: try to refinance the debt at a lower amount and pay the difference out of pocket, give up the building to the lender without getting the chance to suck out the last profits, or attempt to sell the building for at least the remaining amount of the mortgage. If, on the other hand, and as is frequently the case, the building has appreciated in value, the borrower can of course attempt to refinance the debt with a larger loan, and pocket the difference.

Another important type of note is the construction note. This arrangement allows a borrower to receive the money in chunks from the lender, building up to its maximum amount. The idea is that the lender will only disburse money to pay for the construction of the building as those expenses are incurred. Construction lending has a number of wrinkles that I promise to explain, after we get through the basics.

One final important note is the line of credit, which is frequently called a revolving note. Under this arrangement, the lender allows the borrower to draw as much as he needs, and pay off as much as he is able, at times that are convenient to him. (Something like a credit card.) Obviously such loans are more work for the loan department. They are also more difficult for the bank from point of view of asset management. The bank must always have funds available for the borrower to draw upon, and so cannot have that money invested in any way that might postpone the borrower's required disbursements. Loans like this are almost always at variable rates. (The same is also true of construction loans.) One other interesting feature of revolving notes is that they often do not include a fixed maturity date. Instead, repayment is required "on demand." If the bank is going to make a loan it had better make sure that the note makes it clear that the bank has the right to demand payment whenever it damn well feels like it. It is a nightmare to imagine that a borrower could argue in court that the bank has not shown that the conditions required for demanding repayment have been met. In such a scenario, the bank could never be sure that its loan would be repaid.

Mortgages

A mortgage is the document that contains the borrower's promise to hand over the building to the bank if he cannot pay back the bank according to the terms of the note. (Really, I should say the mortgagor's promise. After all the Mortgagor could be different than the Borrower.) Sounds simple, right? Trust me, reading a mortgage is one of the most hideous things you will ever be called upon to do. Most mortgages are at least 30 pages long, chockfull of wheretofores and anywises, and some time when reading about the middle of page two your extremities will begin to numb.

As I mentioned above, you must recognize that the Borrower is not always the same entity as the Mortgagor. Generally, to avoid confusion, documents should be prepared so that they are the same entity, but that is not always possible. Only one entity can meaningfully sign a mortgage: the one that owns the property. By executing the note The Borrower, L.L.C. promises to pay back the bank the money it owes according to the terms therein. By signing the mortgage The Borrower, L.L.C. promises to give the property to the bank if it does not comply with the terms of the note. So, you had better make damn certain that The Borrower, L.L.C. does own the property.

By signing a mortgage the owner of the property creates a lien on the property in favor of the bank. But the job is not yet finished. As I mentioned above, property ownership is a matter of public record. Just as the owner of the property had better make sure that the county recorder knows that he owns the property, the bank must make sure the recorder knows about its lien. The bank therefore always records its mortgages with the Recorder of Deeds. This process is called perfecting the lien. Until a mortgage is recorded it is almost valueless. Once the lien is perfected there is an indelible mark on the title of the property. Anyone who takes a look to see who owns that piece of property will see that the bank has an interest in it. The mark can only be removed by filing a release deed executed by the bank. The perfected lien makes it impossible to transfer title to the property without the bank's consent. And of course, if the borrower does not conform with the terms laid out in the note, the lien gives the bank the right to take the property away through a legal process known as foreclosure.

The bank is generally in the business of first mortgage lending. The first means that the bank is at the head of the line of people with claims to the property. Sometimes properties have second (also called junior) or even third mortgages on them. What these ordinals indicate is the place in line that the various creditors have. Place in line is everything. It is not a case that the person who is first gets moderately better treatment. Rather, the first person has to be paid off in full before the second person gets a single penny. Then the second person must be paid off in full before the third person gets anything. In practice, if you secure a debt with a second mortgage, and the holder of the first mortgage forecloses, your mortgage will simply disappear. You have only one real recourse: you have the right to pay off the first mortgage in full, and therefore advance to the head of the line. So, if you are thinking about doing second mortgage lending, you had better be sure that is a step you'll be willing to take, or that you're prepared to make the loan unsecured if you aren't.

Sometimes the bank will make several loans to the same borrower which are collateralized by several properties. In this case, the bank may demand that the loans be cross-collateralized. Imagine that the borrower has two properties, A and B. The bank is going to make two loans, both secured by first mortgages, and additionally, the loan secured by a first mortgage on A will also be secured by a second mortgage on B, and vice versa. So, if there is a default under the loan secured by property A, the bank can foreclose the first mortgage on A and the second mortgage on B. Since the only person in front of the bank for property B is the bank itself, both loans are effectively secured by both properties.

There are a few things that can jump ahead of a first mortgage, but only a few. When something jumps ahead of a mortgage in line, it is said to "prime the mortgage." The bank goes through great pains to be certain that nothing ever primes its mortgage. The two most likely things to prime the mortgage are real estate taxes and mechanics' liens. Since non-payment of real estate taxes could do that, the bank almost always demands that in addition to making a monthly payment to the bank for principal and interest, the borrower must make a tax escrow payment. The bank collects these payments and then pays the taxes itself. In this way it can be certain that the taxes are being paid and its mortgage is secure. If the taxes are not paid, then the county can "sell the taxes". What this means is that someone else can walk into the collector's office and pay the tax bill. If after a certain period of time, the owner or the mortgagor of the property doesn't pay back the person who paid the bill, that person will be given title to the property. Mechanics' liens are liens that are filed by people who have done work on the building. If a contractor adds an extra room to a building, and is unpaid, he can record a lien against the building for an amount equal to the value his work added to the building. Again, before the bank will be able to get its mitts on the property it will have to pay off the mechanics' liens.

A last word about mortgages before I leave the topic. Why are they so long and complicated? There are at least two reasons that I can think of at the moment. The first is that in addition to allowing the bank to foreclose when there is a default under the note, they also give the bank many other rights regarding the property. For instance, almost any mortgage will give the bank the right to place insurance on a building if the borrower has not. Naturally this is important to the bank, since an uninsured property has less value as collateral than an insured one. Of course, the bank would expect to be repaid by the borrower for the cost of placing insurance on the building. So, that has to go into the mortgage too. But at this point the borrower objects that he won't sign that, since it might lead to an increase in the amount of money he owes the bank, unless the bank agrees to make a real effort to make sure that there isn't already insurance on the building. And so the mortgage must contain an exact description of the insurance that the borrower must have for the building, and the way that the borrower must inform the bank of the insurance, and the way the bank must notify the borrower before buying extra insurance, and the way the borrower can reply to the notification, and the, well you can see why a mortgage might get pretty long, especially considering insurance is just one of the issues that has to be covered. The other reason mortgages are long is simply because there is a substantial body of law surrounding mortgages and foreclosure. Allowing a corporation like a bank to wrest property from citizens is something that is rightly made difficult by the law and the courts. Mortgages increase in length simply to deal with the mass of potential pitfalls created by this body of law.

Title Insurance

Title insurance and mortgages go together for bankers like ham and eggs for breakfasters. Actually, it's really more like pancakes and syrup. You wouldn't want to have syrup (title insurance) without pancakes (mortgage). Leaving aside distracting issues like waffles and little kids who pour syrup directly into their mouths, the point is that title insurance complements a mortgage. A mortgage without a title policy is a mortgage that makes a banker nervous. Title insurance without a mortgage has nothing to do with real estate lending, which always involves a mortgage.

Title insurance is exactly what it sounds like: the title insurance company insures the bank that the title of the property actually looks as the bank thinks it does. Obviously, this is critically important. The most obvious reason is that someone might mortgage a piece of property he didn't own. If the bank sought to foreclose the mortgage and take the property, the actual owner would have a strong defense in court, namely that he didn't ever grant a mortgage to the bank. This is how you would be caught if you ever tried to bilk a bank out of a few million by claiming to own the Standard Oil Building. The loan officer would be all excited about the great loan opportunity: a first mortgage on the Standard Oil Building, and the borrower only wants a few million! Sadly, in the midst of imagining the great pats on the back forthcoming from the board of directors, the cruel title insurance company comes along, and tells him they won't insure his mortgage unless the actual owners execute it.

Naturally, if all title insurance told you was who owned the property, it wouldn't be that much use (although it would still be essential). But, it tells you so much more: like what other liens are on the property and what priority they have, if the taxes have been paid, if the improvements to the property are allowable under the zoning laws, and all manner of other good stuff.

Title insurance comes in several flavors. Two are of particular interest: owner's insurance and lender's insurance. The property buyer wants owner's insurance, obviously. It tells him that he owns the property and furthermore it tells him about any liens on the property ("defects to title"). If some bank comes along and produces a legal mortgage executed by a previous owner, and this is not mentioned as an exception to the owner's title in his insurance policy, the title insurance company has to pay off the mortgage. Or, if someone comes along and can prove he has the right to dump toxic waste on the owner's lawn due to an agreement with the previous owner, the title insurance company will have to pay the owner to compensate him for the reduction in value to his property due to all the toxic waste.

Lender's policies are a little different. They insure that the property is owned by the entity granting the mortgage and furthermore that the bank's lien is a legitimate one. (Obviously they couldn't do the second without doing the first.) If the title insurance company assures the bank that it has a legitimate first mortgage to the property, and some other mortgage is produced which has priority, the title insurance company is out of luck, not the bank.

A title policy comes in a standard printed binder with several custom sheets inserted into the middle. The binder contains all the standard garbage that is universal to all title policies. You should read it at least once. Then, of course, you should go lie down. After you have recovered, take a look at the stuff in the middle. The things in the middle can be broken down into three general categories. The first is a schedule which tells you who is insured, who owns the property, what the legal description of the property is, and all the other information you would need to figure out who and what the policy is for. The second category is the exceptions to the policy. This is a list of all the things that mess up title to the property: liens, mortgages, easements, unpaid taxes, right of neighborhood dogs to come and urinate on the property, or whatever. What the title company is saying to the property owner or mortgagor is that even though you hold title to the property, other entities have rights to the property that your ownership interest cannot prevent. So, if you want to file a claim against the title insurer because you can't rent the property what with all the dog urine, too bad, we already told you at the outset that that was an exception to your title insurance. The third category of insurance contents is policy endorsements. As you might expect, these are the opposite of the exceptions to the title policy: they are extra things the title company will insure you for. But don't get too happy, they charge you for each and every one. Though it may soften the blow for you somewhat to tell you that the bank makes the borrower pay for everything in the end. Some of the standard endorsements we might require follow.

A) Location endorsements, which can endorse such things as that the survey the borrower provided the title company and the bank is accurate, and that the property has access to the street. B) Zoning endorsements, which has at least two types, 3 and 3.1. Flavor 3 does not cover much but is cheap. Always insist on flavor 3.1 which gives the bank much more protection, but costs the borrower more. C) Variable rate endorsements, which insure that the mortgage creates a valid lien securing a variable rate note.

I want to mention two other kinds of endorsements. One is the comprehensive endorsement, which I do not understand. Everything in it seems to be a restatement of the boilerplate of the policy itself. In my opinion, either this endorsement is meaningless, or title insurance is meaningless without it. The other type of endorsement that people talk about a lot is the date-down endorsement. This is a key endorsement for any construction loan. Again, I promise to talk about this and other aspects of construction lending lots more later.

Guaranty Agreements

Those of you who are clever might have noticed something fishy going on above. You recall that the Borrower is the only entity that is required to pay any money to the Bank, and that the mortgage only entitles the Bank to take away the property. Well, you might be thinking, what if the Borrower is an entity that only owns the property and the property's value goes way down? What is to keep your human customer from giving you the keys and sticking you with the loss? Well, precisely nothing, unless that customer has the misfortune of having executed a guaranty agreement for the loan. (Guaranty is a really annoying banking word. Half the time it's spelt with a "y" and the other half with an "ee". Also half the time it is used as a noun and half the time as a verb. And no, there is no correspondence between its usage and its spelling.)

When a person executes a guarantee agreement that person guarantees that the bank will be repaid as specified in the note. If the bank is not repaid it has recourse to anything and everything that person owns, just as if the person had executed the note. Note that guarantee agreements can be executed by entities other than people. However, in general almost all guarantees are personal guarantees, in which a member of an LLC, for example, guarantees the obligations of the LLC. Loans that are made without guarantee agreements are referred to as non-recourse loans.

Ask a lawyer if a guarantee agreement is enforceable and the only thing you are guaranteed to get is an evasive answer. There is a considerable body of common law that has grown up surrounding guarantee agreements that protect guarantors. Like mortgages, the reason guarantee agreements get long is so that they can contain waivers to all the defenses guarantors have. Without these waivers a guarantee agreement is worth even less than the paper it's printed on. After all, there is a market for blank paper.

Banks rarely attempt to sue under guarantee agreements because the court battles can be so difficult to win, but they like to collect guarantees anyway. For the bank a guarantee is something that can be waved in the face of an obstreperous borrower as a threat. For this reason alone, many borrowers are reluctant to sign them.

Guarantee agreements can be the subject of some of the stickiest negotiations between the bank and its customers. Many guarantees are relaxed from the "100% irrevocable and unconditional, joint and several" guarantee the bank likes to get. Some guarantee agreements only guarantee repayment of principal, not interest or fees. Others only guarantee some percentage of the principal. Others guarantees are restricted to only certain assets of the entity signing the guarantee. For instance, an individual might be willing to pledge to repay the bank with all the assets of his business, but not dip into his personal property.

In real estate lending, guarantees are added security to the bank beyond the mortgage. For this reason, they are often the first thing to be thrown out in a competitive lending market. The Office of the Comptroller of Currency and other regulators hate to see this happen. They view it as a sign of lax underwriting standards. Whatever the lending environment happens to be it is important to remember that no guarantee makes a bad deal good, though lack of a guarantee can make a borderline deal bad. Guarantees are additional security, and only that. The primary source of repayment for the loan should always be the regular business activities of the borrower. If you are counting on your guarantor to repay your loan, it is time to rethink the whole transaction.

Other Documents

There are a number of other documents that frequently come into play in closings, but are not as important as those I discussed in detail above. Here are a few choice words about some of them.

Environmental Indemnity Agreement - This is like a guaranty agreement that only kicks in if the property loses value due to some form of environmental contamination. Borrowers are generally happy enough to sign this, since the bank always gets an environmental study of the land before it makes the loan. The required study is rather grandly referred to as a "Phase I". By giving the bank a clean Phase I the environmental inspection firm essentially guarantees that there is no contamination on the land. If it turns out that there is, the bank will have a choice of people to sue.

Authorization to Pay Proceeds - This is a one page document in which the borrower tells the bank what to do with the monies being disbursed under the loan. I'll talk about this more in the discussion of closings below.

Survey - Both the bank and the title insurance company will want a recent, professional survey of the property being mortgaged. Generally both the bank and the insurer insist on a so-called ALTA survey, which means a survey that meets certain standards regarding disclosure of easements, set back lines, and various other details.

Escrow Instructions - This is a document in which the bank explains in detail to the title company exactly what it expects the title company to do at the closing. See closings below.

Authority Documents - This is a catchall term for the various documents such as partnership agreements, certificates from the Secretary of State, corporate resolutions, or whatever else that is required to prove that the entity taking the loan exists, and the people doing the signing are actually empowered to do so.

UCC Filings - UCC filings (UCC = Uniform Commercial Code) are something like mortgages. They secure property as collateral for the bank. Like mortgages they must be filed with the appropriate governmental authority, and must be released when the loan is paid off. UCC filings are more general than mortgages, and can secure collateral like equipment, building fixtures, furniture, and even accounts receivable and other intangibles.

IRPTA Disclosure - (IRPTA=Illinois Responsible Property Transferors Act) This document states that the signer (mortgagor) does not know about any environmental problems relating to the property. The act of signing a mortgage is considered a transfer of the property, and so this has to be signed at any closing, even if the property is not being sold.

Closings

Once all the documents are prepared, there is a complicated, and in the beginning nerve wracking ceremony called a closing. Closings can be like war: long periods of boredom punctuated by moments of extreme terror. Closings are nerve wracking and terrifying because you cannot understand what is going on, but you're expected to be responsible for the millions of dollars the bank is disbursing. Everyone at the closing will understand what is going on better than you, and no one will want to answer your damn fool ignorant questions.

I won't pretend that I'm any great expert on closings, since I've only been to a few. But I will explain the basic principles that govern them. Closings take place at the title insurer's office, and are generally handled by a closing officer. Closing officers are referred to as closers. I think that has a great homey ring to it.

Before we jump in, consider what must be accomplished at the closing. Before the closing, the property is owned by the seller, who owes money to the old lender who has a recorded mortgage on the property. Some time after the closing, the buyer must own the property, the new bank must have a recorded first mortgage, and the bank and the buyer must have title insurance.

The process begins when the buyer, or his bank, orders a title commitment from the title company. The title commitment looks like the first two inserts to the title policy discussed above. It says exactly what the property is, i.e. its legal description, who currently owns it, and all the exceptions to title. Assuming the current owner has a mortgage on the building, this will appear on the title commitment. The buyer and the bank both inspect this title commitment and determine which of the exceptions they will allow to appear on the final policies, and which must disappear. Naturally the title insurance company will only agree to erase its exceptions if it has some reason to do so. Thus we get to one of the critical pieces of a closing, the pay-off letter.

Since the existing lender will not agree to release its mortgage until it is paid off in full, but the new lender is demanding that the title company promise to insure that it will have a first mortgage, the title company must be assured by the old lender that it will release its mortgage. The existing lender therefore issues a pay-off letter promising to issue a release deed for the mortgage upon the condition that its loan is paid off. A pay-off letter should always contain five things.

  1. Who the current debtor is.
  2. What the property is.
  3. What amount the lender must be paid.
  4. What date and time the lender must be paid by.
  5. A per diem (day) charge to be added to the pay-off amount if it is not received by the date and time given.

I emphasize what a pay-off letter contains, since credit analysts not only have to read them, they have to prepare them. Only with this letter in hand will the title company be willing to close the loan.

When the day of the closing arrives everyone marches off to the title company. The seller comes with his pay-off letter, and his seller's closing statement. The buyer comes with his money, deed, buyer's closing statement, and his title commitment. The bank comes with its loan documents, escrow instructions, money, and its title commitment. (Actually, people will often come with lots more than this, but I'm trying to keep this simple.)

The closer gathers all the things I've listed above, and tries to make them all fit together. Included in what the title insurer gathers together is the money. The insurance company not only wants to know what and when the seller and his bank need to be paid to release their claims on the title, it also wants to do the actual paying. Only in that way can it be assured that the payments actually took place. The money must be brought to the title company either by wire transfer or cashier's check ("collected funds"). This is protection for the title insurer against the buyer's (or bank's) check bouncing.

The list of things brought to the closing above includes a few things that I have not yet explained. We have already covered pay-off letters, money, loan documents, and title commitments. The seller's and owner's closing statements indicate from their own points of view where the money is coming from and where it should be going. The deed is the actual legal document the seller must sign to transfer ownership of the property. The escrow instructions are the bank's instructions to the title insurance company of what the bank expects the title company to do before disbursing the loan proceeds. The instructions should always include a list of all the endorsements to the title policy required by the bank.

Only after all the documents have been signed, and all the documents that have to be recorded are notarized, will the title company disburse the money to the seller or the seller's bank. The title company disburses money to the seller's bank according to the terms of the pay-off letter, and requests that the bank issue a release deed for its mortgage. The title company then gives both the buyer and the lender what is called a "marked up title commitment". This looks like the title commitment, but the closer writes in by hand all the changes that have to be made. When the title policy is issued, this is exactly how it will look, so it is critical that the bank's representative not allow any exceptions to title that the bank is not willing to allow.

The seller then walks away with a bunch of cash. The bank with all its loan documents that do not have to be recorded (including the note!) and its marked up title commitment. The buyer walks away with his marked up title commitment. The title insurer should soon receive the release deed from the previous lender. Once it is received, the insurance company heads down to the recorder's office and has the following things recorded: the release deed, the deed transferring the property, and the new mortgage. Once they have been recorded, the title company does a title search, to be sure that all the things that should have happened did. After all this, which takes about a month, the title company sends a package back to the lender with the recorded mortgage and the final title policy.

Naturally, by this time you will have completely forgotten all the myriad complexities that went into the transaction, and you'll throw the title policy into the file without noticing the half dozen errors that have mysteriously crept in. Ahh, don't worry about it. No one will ever care, unless the loan has to be foreclosed.

Return to Chapter 1: The Basics of Underwriting - Continue to Chapter 3: Problem Loans


The math above is hopelessly inadequate. Assuming that the incidence of freakishness among judges is equal to that of the incidence of freakishness among jurors, a big assumption, but this is a footnote to a parenthetical remark, then the chance of getting at least one freak in a jury of twelve is equal to 1-(1-p)^12, where p is the probability of freakishness. If we estimate the chance of being a freak is, say 3%, then the chance of getting one freak out of a jury of twelve is about 31%, not 36%. That is still enough to make Bob Glickman sweat. Return to above.