INVESTING IN JUNIOR NOTES? THIS CASE MAY INTEREST YOU

There are many types of investors. There are several varieties of investments that are presented by some as ways to make profits. One of these investments is the purchasing of promissory notes secured by deeds of trust on real estate. Usually the note purchaser acquires the note at a discount from the face amount of the note, thereby “locking in” a profit should the note be held to maturity or later resold. The benefits of such notes as investments are stated to be that they provide regular income over an extended period and are secured by real estate, making them a relatively secure investment. At least that is what the people who recommend note purchasing as an investment suggest. It is interesting that the promissory note and the deed of trust are actually separate claims on the property of the borrower, and this can become important. We are all also aware that in today’s economy, sometimes borrowers default on their notes that are secured by real estate, and it is then up to the holders of the notes to seek to recover their investments.

Of the types of notes available for purchase, there are senior notes and junior notes. Senior notes are those that are secured by deeds of trust that are in first position on the title. In the event of a default by the borrowers, holders of senior notes have the best chance of recovering the full amount owing on the note. Junior notes are every other kind than senior notes. Because their holders have a relatively higher risk of not recovering the full amount due in the event of a default, usually junior notes carry a higher interest rate and when purchased in the secondary market, a higher discount to the face amount of the loan, than do senior notes.

Normally, in the event of a default on a note secured by a deed of trust in Washington, the holder of the note begins a foreclosure of the deed of trust. This can be judicial, by filing a lawsuit, or nonjudicial, by giving notice of a trustee’s sale and then conducting such a trustee’s sale. Ordinarily if a borrower defaults on a junior note, there is no reason why the holder of that note should not use the nonjudicial foreclosure procedure available under Washington laws. However in the recent economic climate even a home that is not “underwater” may not be attractive to buyers in a trustee’s sale foreclosing a junior note because such buyers must take subject to the senior deed of trust. A recent case in Washington shows the importance of the separate nature of the note and deed of trust.

In this case, a home worth some $310,000 was secured by a first deed of trust for a loan of $200,000 and a second deed of trust to a different lender for a loan of $80,000. The homeowners defaulted on the junior note and the holder of that note began foreclosure and then discontinued foreclosure. The holder of the junior note filed a lawsuit against the borrowers on the promissory note and obtained a default judgment against them for the amount owing on the note. The holder of the second note then tried garnishment but was unable to recover any funds through that method.

The homeowners then defaulted on the senior note and the holder of that note foreclosed by holding a trustee’s sale which produced surplus proceeds of some $110,000 which were deposited in the court. The homeowners and the holder of the junior note both claimed the surplus proceeds. The court decided that the holder of the junior note had a first priority claim on the surplus proceeds of the trustee’s sale of the senior note and that the homeowner’s homestead exemption did not apply to those proceeds. The court ruled that even though the foreclosure of the senior note holder’s deed of trust wiped out the junior deed of trust’s lien on the property, that lien attached with first priority to the surplus proceeds of the trustee’s sale and the fact that the junior note holder had obtained a judgment against the borrower based on the borrower’s default on the note did not preclude the junior note holder from asserting that first priority. Sometimes it is helpful to have both a belt and suspenders when seeking payment on a loan secured by real estate.

The foregoing is not intended as legal advice and is instead only for education.

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