Security Instrument

A security instrument serves as a shield for the lenders, providing them the legal claim right on the borrower's asset or property when the latter defaults on the loan. Thereby, the lender can take the respective property under control and liquidate it for the loss recovery. For instance, a home buyer takes a home loan from the bank by mortgaging the legal title papers of that property with the bank. Then, if the buyer doesn't pay the loan installments to the bank, the latter can put the home for auction and recover their dues.

Now, a simple home loan agreement has a promissory note and a mortgage document. In a promissory note, the borrower promises to pay a certain principal loan amount and the interest rate chargeable up to a maturity date in regular installments as specified by the repayment schedule. At the same time, a mortgage specifies the loan amount, legal description of the real estate, foreclosure and repossession rights, and covenants. However, both these documents are incomplete without a security instrument that specifies the consequences of the non-repayment. Such a contract forms a lien on the property and secures the promissory note. Moreover, it is to be duly signed by both the borrower and the lender.

The satisfaction of the security instrument is the final document released to affirm that the borrower has fully paid the deed of trust or mortgage. The document is filed as part of the real property records at the local county where the real estate is registered.

A security instrument can be of the following different kinds based on the type of purchase agreement:

1. Mortgage: Mortgages are a common form of legal contract in real estate loans. The lender keeps the borrower's property as collateral until the final repayment of the loan as per the decided terms and conditions. If the borrower denies or defaults on payment, the lender has the legal right to claim the dues from the liquidation of the property and foreclose the loan.
2. Deed of Trust: Next comes the deed of trust, where a third party, the trustee, retains and holds the property or asset kept as collateral until the borrower repays the overall loan to the lender. Moreover, it can be foreclosed through both judicial and non-judicial processes.
3. Installment Land Contract: In an installment land contract, the land buyer pays the seller in installments. The latter finances the real estate and possesses its legal title until the former makes the full payment.

Security instruments are commonly used in most of the loans where the borrowers have low creditworthiness or where a large amount is at stake. Let us take the following examples:

Example #1 

Suppose CBA Ltd. takes a business loan from ZYX Bank worth $0.4 million against their factory in Amsterdam. The company has to pay a monthly installment of $51,00 for 10 years. However, after 3 years, the company went into losses and couldn't repay the loan. In this case, the mortgage security instrument came into effect, and the ZYX Bank seized the company's factory to recover their amount by selling the property. Thus, the bank took whatever was due from the sales proceeds of the factory and foreclosed the loan after handing over the remaining sales proceeds to CBA Ltd.

Example #2

The commercial real estate (CRE) market is facing more difficulties, with increased loan defaults and a high number of office vacancies. As the delinquency rates on office building loans have surged over the period, nearly $2 billion has been lost. Moreover, property prices in the sector have also declined for the first time since 2011. The regional banks, which are highly exposed to CRE loans, are more vulnerable to potential fraud and inaccurate property valuations.

Meanwhile, credit rating agencies like Moody's and Standard & Poor's (S&P) are being criticized for assigning overly favorable AAA ratings to commercial mortgage-backed securities (CMBS) despite the surging risks. Marc Joffe, a former director at Moody's, has complained to the SEC, accusing S&P of not adhering to Dodd-Frank regulations by failing to apply consistent rating standards. Joffe points out that the state bonds, which haven't defaulted in almost 100 years, are rated lower than the CMBS, backed by risky commercial properties. Such discrepancy increases the borrowing costs for states and poses significant risks to investors in CMBS.

Joffe further emphasized the failures of CMBS tied to single properties, which have seen significant downgrades and defaults after the Covid pandemic. Despite these risks, CMBS issuance remains high, raising concerns about the reliability of ratings and the broader implications for financial markets. This situation mirrors some of the issues that led to the 2008 financial crisis, where overly optimistic ratings misled investors and caused market instability.

Security instruments have various advantages for lenders but also have a few benefits for borrowers. Let us discuss these in detail below:

• l  Secures Lenders: It protects creditors and lenders from capital loss and default risks since they have collateral to retrieve their losses in case of non-repayment by the borrowers.
• l  Lower Interest Rate: Borrowings secured by a security instrument charge a lower interest rate to the borrowers.
• l  Lender Get Legal Claim: It allows the lender to have a legal right on the borrower's property if they fail to make the payment.
• l  Recovers Investment: If the borrower doesn't pay, the lenders can recoup their invested capital by selling or liquidating the asset.
• l  Negatively Motivates Borrowers To Repay: The risk of losing the collateral encourages the borrowers to make timely repayments to the lenders.

Although a security instrument protects the lenders from the potential default on the borrower's side, there are still several uncertainties and limitations, as discussed below:

• l  Borrower's Property At Stake: Such a contract secures the lender but increases the borrower's risk of losing their property.
• l  Market Risk: The market value of the assets or property changes over the period, increasing the lender's risk exposure to a potential decline in the value of the mortgage.
• l  Property Valuation: Another issue is the fair valuation of the collateralized asset or property and the chances of dispute upon the vague terms and conditions.
• l  Interest Rate Risk: If the interest rate increases, the borrower may have to arrange finances to meet the higher borrowing cost, fearing the risk of losing their collateral.
• l  Liquidity Risk: If the borrower is unable to make the payment and decides to sell the asset to repay the loan, they may face difficulty selling it at a fair price.
• l  Ethical Concerns: These contracts increase ethical considerations, such as sufficient time provided to the borrower to make up for the default payment, legal action taken by the lender for property seizure, or terms of foreclosure.