Although the topic of this of this piece is academic, I want to share an anecdote we all can relate to.
Now, it is not uncommon to use unrelated, but similarly sounding terms interchangeably. One term that is relevant to this backdrop is Hypothesize – to put (something) forward as a hypothesis.
Earlier this year, while in the office, I overheard a conversation between an associate and a client, whereas, the associate wanted to relate a hypothetical situation and stated “let’s hy·poth·e·cate here for a moment”. Loosely translated this means lets pledge (something) as surety for a loan. What the associate meant to say was: “let’s hy·poth·e·size here for a moment”.
On that note, let’s get to the topic at hand – Note Hypothecation.
A google search of the word Hypothecation will turn up about 388,000 results. Essentially to hypothecate is to pledge, whereas a third party pledges property (real or personal) as security or collateral for a debt, with or without delivery of title or possession of the collateral. Simply stated, hypothecation refers to the pledging of assets as collateral for a loan. In plain English – It’s a loan secured by a loan.
In the note world, hypothecation refers to the ‘borrowing of money’ by pledging a note and trust deed as the collateral for the loan.
For example: We recently closed a note hypothecation where the Investor/borrower, Mr. Z., was seeking funds to acquire an investment property at a discounted price if bought for all cash. As Mr. Z. had just completed renovations on a current flip that had yet to sell, his funds were limited. However, Mr. Z. had sold several prior flips and carried back the notes. As such he had three performing seller carry back notes and deeds of trust to pledge as security for a new hypothecation loan. In this case Mr. Z. leveraged his notes and used the borrowed funds to pay cash for another property he intends to flip.
As a matter of practice, Hanover MC writes note hypothecation loans where (a) the borrowed funds will be used strictly for business purposes (no personal use of funds) and (b) the note & DOT being pledged is secured against non–owner occupied property.
If you are note holder considering leveraging your note(s), you should understand the general structure of loan agreements in a note hypothecation.
Generally a note hypothecation loan agreement is comprised of five documents:
- Pledge Agreement
- Secured Promissory Note
- Collateral Note Assignment
- Collateral Assignment of Deed of Trust
- Offset Statement & Estoppel Certificate
A Pledge Agreement is a contract (security agreement) that governs the relationship between the parties (PLEDGOR & PLEDGEE) in a secured transaction. It provides a lender a security interest in a specified asset or property that is pledged as collateral – the PROMISSORY NOTE AND DEED OF TRUST, and contains covenants that outline provisions for the advancement of funds (expenses or costs such as unpaid insurance premiums, property taxes or foreclosure fees), the collection of funds – servicing rights (collection of scheduled payments of the pledged mortgage loan), a repayment schedule, and default & foreclosure rights and duties.
Secured Promissory Note is used when the lender requires collateral for the loan, such as a pledge of the PROMISSORY NOTE AND DEED OF TRUST. It provides the lender a security interest in a specified asset or property that is pledged as collateral.
Collateral Note Assignment is the transfer of ownership rights of an asset from a borrower to a lender, in exchange for the granting of the loan. A security agreement mitigates the default risk the lender faces. In the event that the borrower defaults, the pledged collateral can be seized and sold. A secured party may perfect a security interest by taking possession of the collateral. We custody the original installments notes until repayment.
Collateral Assignment of Deed of Trust provides the collateral assignee of a mortgage or deed of trust an assignment to evidence the transfer of the entire beneficial interest to the named assignee as collateral security; and (b) that no full or partial reconveyance or modification or subordination of the insured mortgage or deed of trust appears of record.
Offset Statement & Estoppel Certificate is a signed statement obtained to verify or substantiate the terms of the promissory note and DOT.
The key takeaway from the loan agreements in a note hypothecation is the ownership of the asset remains with the borrower with first right being that of the lender till the time the loan is repaid. In case of default the lender may sell off the asset to recover the loan.
Although note holders hypothecate for a verity of reasons, they primarily do so to leverage the value of their notes and the income they produce to borrow money and invest in other investment opportunities.
The information here is not intended as, and should not be relied upon as, legal advice.