Timothy Raty of Mortgage Cadence: USDA and the GSEs’ New Uniform Security Instruments
Timothy Raty is a Legal Research Analyst with Mortgage Cadence, based in Idaho Falls, Idaho. He previously held compliance positions with Docutech and Mortgage Builder Software.
Earlier this year, both Fannie Mae and Freddie Mac published new versions of their uniform security instruments and announced that lenders must use them for loans sold to these GSEs, starting January 1, 2023 (see FNMA Ann. SEL-2021-06 and FHLMC Bulletin 2021-25).
It is typical in the mortgage industry to use these SIs for loans guaranteed by the U.S. Department of Agriculture through Rural Development, mainly because RD’s security instrument requirements are largely lacking in specifics, as the following requirement illustrates:
“Rural Development will only guarantee loans that are adequately secured. A loan will be considered adequately secured only when all of the following requirements are met:
- Recorded security document. The lender obtains at closing, a mortgage on all required ownership and leasehold interest in the security property and ensures that the loan is properly closed. . . .” (7 C.F.R. § 3555.204)
Thus, lenders may find it preferable to use SIs which have been vetted for compliance with state laws by the legal departments of two major GSEs, rather than spending the time and resources “reinventing the wheel” by creating original instruments.
However, while RD’s requirements lack details specific to the content of the security instruments used, they do have plenty of other requirements regarding the servicing of a loan which may not be completely compatible with the covenants within the SIs.
The following summarizes the types of conflicts, additional requirements and near conflicts that may exist:
Under Section 3(c) of the SIs, the lender covenants that escrow funds “will be held in an institution whose deposits are insured by a U.S. federal agency, instrumentality, or entity (including Lender, if Lender is an institution whose deposits are so insured) or in any Federal Home Loan Bank.”
USDA’s regulations are slightly more restrictive:
“Lenders with the capacity to escrow funds must establish escrow accounts for all guaranteed loans for the payment of taxes and insurance. Escrow accounts must be administered in accordance with the Real Estate Settlement and Procedures Act of 1974, and insured by the FDIC or the NCUA.” (7 C.F.R. § 3555.252[b]; see also RD HB-1-3555 ch. 17.2)
Property Insurance Proceeds
Under Section 5(d) of the SIs, when the subject property has been damaged to the point that the lender considers a restoration or repair to be infeasible, then property insurance proceeds are to be applied to the sums secured by the security instrument, with any excess paid to the borrower.
Nevertheless, “such insurance proceeds will be applied in the order that Partial Payments are applied in Section 2(b).” (Ibid.) This can be read to suggest that the proceeds are to be applied to each outstanding periodic payment, in the order in which it became due; applied first to interest, then principal, escrow items, and any late fees. Any excess should then be applied, at the lender’s discretion, either to future periodic payments or to reduce the principal balance of the promissory note.
However, RD requires the following:
“Lenders must ensure that borrowers immediately notify them of any loss or damage to insured property securing guaranteed loans and collect the amount of the loss from the insurance company. Unless the borrower pays off the guaranteed loan using the insurance proceeds, the following requirements must be met: . . .
(ii) When insurance funds remain after payments for all repairs, replacements, and other authorized disbursements have been made, the funds must be applied in the following order: prior liens (including past-due property taxes); past-due amounts; protective advances; and released to the borrower if the lender’s debt is adequately secured.” (7 C.F.R. § 3555.252[c])
Section 11 of the SIs, as well as a few other areas of the documents, cover or reference the handling of mortgage insurance, if required by the lender. Of course, RD guarantees, but does not insure, mortgages, thus making Section 11 superfluous when used for loans guaranteed by RD.
One of the few specifications that RD does make concerning security instruments is when such instruments secure a leasehold estate (see RD HB-1-3555 ch. 16.12[B]). For such, specific text, promulgated in Ibid. Att. 16-A, must be used. Part of this text is substantially similar to that of the GSE’s prescribed text within Subsection 9(d) of their SIs, but other parts of the prescribed text provide greater details concerning the lease than what the SIs promulgate.
There are some RD requirements which, if it were not for caveats in the SIs’ language, could be in conflict.
For example, HB-1-3555 ch. 17.2 requires certain conditions to be met if disbursements of property insurance proceeds are to be made directly to the borrower. Under Subsection 5(d) of the SIs, a “Lender may make such disbursements directly to Borrower” without any conditions.
Use of the auxiliary verb “may” indicates that the lender has discretion in making such disbursements, rather than mandating that they be made indiscriminately. Thus, between such language and RD’s requirements, the lender may make such disbursements, but must do so with discretion for RD’s requirements.
Another interesting example is 7 C.F.R. § 3555.252(c)(2), which requires property insurance proceeds to be used for all repairs and replacements, without any caveats allowing the lender the discretion to apply the funds directly to the loan balance, if the subject property is a complete loss. On its face, this would be at odds with Subsections 5(d) & 5(e) of the SIs, which allow such discretion.
However, RD HB-1-3555 ch. 17.5(E) states that “[a]ll payments for insured losses must be applied to the restoration of the security or to the loan balance.” Thus, RD has permitted the lender some discretion as to when insurance proceeds are to be applied.
One final example is 7 C.F.R. § 3555.256(d), which limits the application of “due-on-sale” clauses to specific circumstances, unlike Section 19 of the SIs, which allows the loan to be accelerated more broadly under such clauses. However, the GSEs’ prescribed language states that the lender cannot exercise a “due-on-sale” clause “if such exercise is prohibited by Applicable Law”, thus forcing the servicer to conform to the applicable law of the USDA (including Ibid.).
Altogether, while using the SIs for RD-guaranteed loans has many advantages, lenders who so use them may wish to consult with their own legal counsel on whether or not any changes should be made before such use. Coupled with the fact that the Uniform Covenants of the SIs are no longer uniform in a verbatim way (a topic to explore at another time), attention to detail is critical to ensure that each SI complies with both the requirements of the GSEs, RD and state laws.
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