FALL, 1999

The New Fannie Mae/Freddie Mac Uniform Note and Mortgage: A Brief Review

By Mark K. Rabidoux*

With interest rates at historic lows for an extended period of time, most attorneys have reviewed the notes and mortgages signed at their own closings, or have done so on behalf of clients. In most cases, those notes and mortgages were standard form documents in use (with minor state law-driven modifications) across the country. In the case of so-called conforming mortgage loans (those with initial principal amounts of $240,000 or less which are not insured or guaranteed by the Federal Housing Administration or by the Department of Veterans Affairs), the most commonly-used note and mortgage forms are those promulgated by the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Fannie Mae and Freddie Mac require the use of these standard form documents, with few permitted modifications, for all loans sold to them or securitized by them in order to promote an active secondary market in residential mortgage loans.

The Fannie Mae/Freddie Mac uniform instruments currently in use were last significantly revised in 1990. Beginning in the late 1980s and continuing in earnest through the 1990s, plaintiff class action lawyers have focused on real or imagined differences between the uniform instruments and actual lending and servicing practices among mortgage servicers and have brought an array of class action lawsuits against the mortgage banking industry. One of the most common of such lawsuits was based on mortgage servicers' escrow accounting practices. The tide of escrow litigation was, in large part, stemmed by changes made to Regulation X¹ of the Real Estate Settlement Procedures Act². Many mortgage servicers have also been subject to litigation based on alleged adjustable rate mortgage annual adjustment errors, private mortgage insurance cancellation practices, and practices concerning the placement of forced-order insurance (insurance on the house placed by the mortgage servicer when the borrower's own homeowner's insurance lapses or is canceled and is not renewed or replaced with other insurance of the borrower's choosing).

In 1996, the Mortgage Bankers Association of America, Fannie Mae and Freddie Mac began meeting to work on revising the uniform instruments. Their efforts culminated in Fannie Mae and Freddie Mac publishing new uniform instruments in April, 1999. Use of the new forms by lenders intending to securitize or sell loans to Fannie Mae or Freddie Mac is optional until July 1, 2000, when it becomes mandatory. The new forms do not contain everything on the mortgage industry's wish list, but they do go a long way toward reconciling modern mortgage servicing practices with the legal contract between borrower and lender.

Nearly every paragraph of the former documents was touched by the revision process in some way. The following are perhaps the most significant or noticeable changes to the documents from the perspective of the borrower or the borrower's lawyer:

The Mortgage

• Payment Medium: The mortgage now specifies that payments made are due in U.S. funds. It further states that if a borrower tenders a check that is returned for insufficient funds, the mortgage servicer may require that future payments be made in cash, money order, certified or cashier's check drawn on an FDIC-insured institution, or electronic funds transfer. The new mortgage gives the mortgage servicer explicit authority to hold insufficient payments in "suspense" (a side ledger account in which funds are held until their proper application can be determined) until additional funds are tendered to apply as suspense funds to the principal of the loan immediately prior to foreclosure.

• Payment Application: Under the new mortgage, the hierarchy of payment application has changed from (1) prepayment penalties, (2) escrow charges, (3) interest, (4) principal, and (5) late charges in the old mortgage form to (1) interest, (2) principal, and (3) escrow charges, with any additional amounts received applied first to late charges, second to any other amounts due under the mortgage, and third to additional principal reductions. In the case of a delinquent loan, the new mortgage says that payments received from the borrower should be applied to the delinquent principal, interest and escrow payments if enough money has been received to pay all of the delinquent payments in full. Payments may be applied to late charges only if there is an excess of funds received from the borrower over the amount of delinquent principal, interest and escrow payments due.

• Escrow Accounting: The new mortgage states that the mortgage servicer may require that the borrower pay into escrow the amount of any condominium or homeowners association dues or assessments that the servicer may require and allows the servicer to escrow and disburse them if the servicer chooses. This is important in states that have statutes granting liens for association dues superpriority over prior recorded mortgages. Michigan does not currently have such a statute.

• Homeowners Insurance: Earthquake insurance has been added as a hazard for which the mortgage servicer may require insurance. The new mortgage gives the mortgage servicer the right to specify maximum deductibles for any type of insurance maintained by the borrower. The language concerning the forced placement of hazard insurance has been modified to clarify that the mortgage servicer's forced place insurance might cost more and provide different coverages than the insurance the mortgagor preciously had in place. There is new language stating that any insurance coverage placed on the mortgaged property by the borrower, even if not explicitly required by the mortgage servicer, must still include a standard mortgagee clause naming the mortgagee. This addresses situations like the earthquake in Northridge, California, when insurance companies were routinely issuing checks jointly payable to the mortgage servicer and the borrower even though the insurance policy did not include a mortgage clause. Following consumer group protests, the insurance commissioner ordered the insurance companies to cease the practice.

• Private Mortgage Insurance: In the event that mortgage insurance coverage lapses and other coverage cannot be obtained, the new mortgage allows the mortgage servicer to require the borrower to continue making monthly premium payments and to deposit those payments into a non-refundable, non-interest bearing loss reserve account to be held by the mortgagee for the life of the loan. The mortgagee may keep the funds even after the loan is paid in full. The new mortgage states that the borrower must continue making payments for mortgage insurance (or the loss reserve) until the mortgage insurance is terminated pursuant to the written agreement between the mortgagor and mortgagee (if any) or applicable law requires termination. There is a relatively new federal statute on point³ and several states (not Michigan) have adopted statutes on private mortgage insurance.

• Charging Miscellaneous Servicing Fees: The new mortgage provides that the absence of specific authority in the mortgage for any specific fee charged by a mortgage servicer to a borrower is not to be construed as prohibiting the mortgage servicer from charging that fee. This language attempts to address litigation over the practice of charging borrowers fees such as fax fees, hazard insurance substitution fees, and other service charges by providing that just because the mortgage does not explicitly allow the fee to be charged does not mean that it cannot be charged.

• Litigation Between Mortgagor and Mortgagee: Under the new mortgage, if one party wants to sue the other over a breach of the mortgage, even if only as a member of a class rather than individually, the person allegedly in breach must be notified of the breach and be given a reasonable period of time to correct the breach. In the case of a breach caused by the borrower's failure to pay any amounts due, the notice of default and right to reinstatement provisions of the mortgage control. This provision obviously is intended to address class action litigation and make it more difficult.

• Payoffs: While the old mortgage required the mortgage servicer to release the mortgage upon payment in full and prohibited charging the borrower for preparing, executing or recording the discharge document, the new mortgage allows such a charge provided that it is paid over to a third party for services rendered and provided that state law allows charging such a fee. In a number of states, state law prohibits charging the mortgagor anything for discharging the mortgage. Michigan law requires the mortgagee to pay the cost of recording the discharge, ⁴ but is silent with respect to charging the mortgagor for preparing it.

The Note

• The new note requires that payments be in cash, check or money order. The old note was silent.
• The new note clarifies that payments are applied as of the scheduled due date (generally the first day of the month), which precludes arguments that interest is intended to be computed daily.
• The thirty-day period for curing defaults begins on the date of mailing or delivery of the lender's notice of default. The former note was not as clear.

Although lender concerns clearly prompted the revision of the uniform instruments, making them clearer and more consistent with actual lender practice will have a benefit for borrowers as well.

ENDNOTES

1. 24 CFR §3500 et seq.
2. 12 USC §2601 et seq.
3. 12 USC §4901 et seq.
4. MCLA 565.41.

* Mark K. Rabidoux is a shareholder in the Detroit firm of Jaffe, Raitt, Heuer & Weiss, P.C. He represents banks, savings institutions, mortgage bankers and brokers and other interested participants in the mortgage banking industry. He thanks Elliot A. Spoon of the firm for his contributions.

As you can see, the new mortgage impacts the servicing of mortgage loans closed on the new form. It is imperative that you to review internal processes and procedures to make certain that your practices are consistent with the new mortgage. Failure to do so increases your risk of lawsuits.

Jaffe, Raitt, Heuer & Weiss, Professional Corporation is a law firm of over 80 lawyers oriented toward the needs of businesses and business owners. The Mortgage Banking Group is an interdisciplinary group dedicated to addressing the needs of the participants in the mortgage banking industry. The Firm would be happy to explore any of the issues discussed in this Bulletin with you in greater depth. Please contact Elliot Spoon or Mark Rabidoux at (313) 961-8380 (or email us at espoon@jafferaitt.com or mrabidoux@jafferaitt.com) for more information about the Firm or the issues discussed herein.

This memorandum is intended as general discussion and should not be construed or used a legal advice or legal opinion on any specific facts or circumstances. Consult a member of the Mortgage Banking Group of the Firm with any specific questions.