In-Depth: Illusions of Mortgage Lending

The Russian law offers three main schemes for sale of real properties at auctions. Historically, the first possibility was introduced by the federal law No. 178 “On privatization of government- and municipally owned properties. The sale both of certain individual real properties and enterprises as a portfolio of assets, which are regarded as real properties by the Civil Code of the Russian Federation, is possible only at public auctions. In other words, they are supposed to be alienated through auctions or on competitive basis. The second option involves the sale of plots of land, non-residential and residential buildings by building companies or owners of such properties. Finally, the third option, perhaps the most widely used today, is governed by the federal law No. 102FZ “On mortgage lending”. But namely in this latter case banks and certain real estate agencies who stake on mortgages as a lucrative vehicle are likely to suffer most should the market situation change.

Bargaining is Appropriate

In certain circumstances the lawmaker sets rigid rules for levying penalties on the mortgaged property by a court of law and selling the property on which penalty is imposed at open tender, i.e. by auction. In such cases competitive bids are not accepted. In accordance with Article 55 Paragraph 2 of the law No 102FZ claims by mortgagee cannot be satisfied out of court in following cases:

- where the property mortgage required approval or permission of a third person or a government body (federal or municipal agencies in case of sale of state-owned or municipally-owned properties, guardians, trustees, etc.);

- where the mortgaged property is an enterprise viewed as a portfolio of assets;

- the mortgaged property is a plot of arable land;

- the mortgaged property is the property of high historical, artistic or cultural value;

- the mortgaged property is in joint ownership and a co-owner refuses to assent in written or other form as established by federal law to the out-of-court satisfaction of claims of mortgagee.

In all those cases penalties on the mortgagor may be imposed only by a court of law. As a rule, in such cases properties are sold at public auctions. If the mortgagor objects to other schemes, the penalty imposed by court is the only option left.

Bargaining Inappropriate

In certain cases the out-of-court settlement is preferable both for the mortgagor and the mortgagee as the creditor does not incur court expense and afterwards those are not shifted to the debtor. On the other hand the auction sale allows the sale of property at market prices in certain cases. The parties may agree on the auction sale also where the law on hypothecation (property mortgage) allows for out-of-court penalties.

Besides, the parties may opt for the sale by auction also where no penalty is imposed yet while the mortgagor upon securing the lender’s approval puts up the mortgaged property for sale by auction. In those cases the parties enjoy considerable advantages as they are free to determine the timing and procedure of sale, for example, they may assume a wait-and-see attitude and even refrain from sale if the market situation is unfavorable.

The introduction of sale of real estate through auctions may contribute to implementation in Russia of sale of encumbered property adopted worldwide. These days mortgage lenders and mortgagors (including prospective borrowers) regard mortgages as a restriction of sorts, which has to be lifted from the property for the mortgagee to be able to control, use or sell the property.

Around the globe the sale of mortgaged property is common on such terms where the new owner becomes the new mortgagee and enters with the mortgagor into relations already agreed upon by the parties, or the agreement between them undergoes changes and alterations or a new agreement is signed. Such a scheme is convenient as it expands the circle of potential buyers as the price of a mortgaged property is significantly lower than that of a mortgage-free property. In certain cases such sale helps save on tax payments when real properties are put on sale.

It is evident that the size of taxable income of the lender where the principal debt makes up 50% of the cost of the property will equal to only 50% of the real market value of the property. In Russia of today such arrangement is of interest to individuals who have held title to real properties for a period of less than three years.

It cannot be ruled out that in the years to come the corresponding provisions of Article 220 of the Russian Tax Code may undergo changes and Russia will adopt internationals standards of taxation of incomes from the sale of real property, whereby sellers are taxed on “income minus expense”. Should this be the case the sale of encumbered property may either reduce or bring to naught the seller’s taxable income.

In Actual Fact

Buyers will only then profit from real estate auctions when those auctions are held permanently and publicly. For the time being, auctions that are not held in accordance with the federal laws No. 102 and 178 are extremely rare.

The laws on mortgage lending in effect in Russia are not perfect. Over the past five years Russia’s real estate market was booming. When the market grows no mortgagor will suffer his property to be penalized as the market value of real property grows each month. All problems arise when real estate prices start to decline. In this case it is possible that the mortgagor is interested not in repayment of the loan but allowing the mortgagee to levy a penalty on the mortgaged property.

Let’s assume a certain property was valued at $200,000 and then prices began to drop. In other words, the borrower – the mortgagor – had paid the initial installment of $20,000 and moved into the apartment. But today he opens a paper and reads that the price of an apartment such as his has dropped to $150,000 whereas he still has to pay interest to the bank and repay his principal debt of $180,000. Under the mortgage loan agreement he is also obliged to insure his property annually and insure his own life, which he is reluctant to do. And so he says: “I won’t!”, “I do not want to!” and finally: “I can’t!”

A decline in real estate prices often coincides with the general downturn in the economy. So, let’s assume that our borrower, upon learning that his flat now costs only $150,000 very soon learns that in a month from now he will lose his high-paid job. So, he offers the bank to claim the property. What position will he assume in court and what will be the initial price he will ask for at the public auction? He will demand that the property in question be put up for sale by auction at a price no less than $200,000.

The mortgagee will try to prove in court that the real market price of the property at the moment does not exceed $150,000. Thus, the judges will face a dilemma – either to proceed from newspaper ads, market surveys or from the deed registered by the Federal Registration Service, where the price of $200,000 is indicated.

Needless to say that nobody will buy a property worth $150,000 for $200,000. Under the Civil Code of Russia the price at repeated action must be lowered by 10%; according to the law No. 102 – by 15%. It is hard to tell now what the court will proceed from.

But even if the price is lowered to $180,000 the property still won’t change hands even at the second auction. That problem is likely to arise not only for a certain bank who has issued a mortgage loan but for the entire system, which on the basis of the mortgage loan agreement has issued a security known as the mortgage-backed bond.