This section is from the book "Practical Real Estate Methods For Broker, Operator & Owner", by Thirty Experts. Also available from Amazon: Practical Real Estate Methods for Broker, Operator, Owner.
It often happens that the lender desires to hypothecate his security, that is, borrow money on the mortgage which he holds, and is unable to assign the mortgage for the full amount that it secures. If he is able to borrow 90 per cent of the face of the mortgage he secures the remaining 10 per cent by taking a participating interest in the mortgage. Sometimes mortgages from the inception are made in this way, one party holding the first interest, and another the secondary or junior interest, subordinated to the prior interest.
Participating in mortgages is of recent date, and originated with the title companies. When they found that they had on hand large numbers of mortgages which they were carrying and unable to dispose of separately to various clients, they went to investors, and, offering as collateral, for example, a million dollars' worth of these mortgages, borrowed perhaps $800,000 to $900,000 upon them. As security for these loans, they assigned the mortgages absolutely, with an agreement from the lender that when the entire principal was collected and the lender had received the amount due him with interest, he would account to the title company for the balance. This form of agreement has gradually become a standard one, and is now known as a participation agreement. This hypothecation of mortgages as collateral is perfectly legal and proper, and gives opportunity to the large life insurance companies, savings banks, etc., to invest their funds in first-class mortgages with first-class security. This form of investment then took another phase. The title companies and individuals, finding a ready market for first interests in mortgages, began taking mortgages at 5% interest and hypothecating them for from 80% to 90% of their face value at 4 1/2%, the return on their subordinate interest being, of course, very large, as they made one-half per cent per annum on the whole amount.
A further development was the forming of companies to take these secondary interests. They would accept first mortgage loans, provided they could hypothecate with some individual or institution the first interest at one-half per cent lower interest rate, which gives them a large return on their secondary interest, which is, in effect, a second mortgage.
There has been much criticism against this new development in the mortgage business, due to the fact of the obvious deception that might be or has been practiced upon innocent third parties, who, having no knowledge of the first and secondary interests in the supposedly first mortgage, purchase property, thinking that they have on it a bona fide first mortgage, whereas at the end of three or five years they find a secondary interest must be paid off.
The objection to this method of arranging mortgages can be readily overcome by simply recording the participation agreement. If this is done every purchaser, when he searches his title, will find this agreement of record, and will know exactly the status of the mortgage on the property he is buying. Although there is no law to compel this, it should be insisted on by the first interests to prevent misrepresentation. An affidavit from the holder of the mortgage, stating that he held the entire interest, or how it was actually held, would cover the same point.