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Foreclosing A Wraparound Mortgage
A wraparound mortgage is a financing arrangement between buyer and seller which "wraps around"  an existing mortgage still held by the seller.  Foreclosing a wraparound mortgage can be quite problematic. For purposes of discussion, assume the following hypothetical:

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  • Seller Smith sells Bob Buyer his Up Creek Farm for $750,000. Buyer Bob (the maker), executes a wraparound note in the original principal sum of $750,000 payable to Smith (the holder).  The terms of the wraparound note expressly state that its principal balance includes or "wraps around" an underlying note with an outstanding principal balance of $500,000 executed by Smith (seller) and payable to the first lien holder, Big Bank.

The wraparound note represents a "true debt" of only $250,000 payable by Buyer Bob to Seller Smith. Buyer Bob immediately defaults on the payment of the wraparound note. What does Seller Smith do to take back possession of Up Creek Farm? 

Several issues must be considered when foreclosing a wraparound mortgage. They include: [1] the determination by the Seller (holder) of an appropriate bid amount in the event the holder desires to purchase the property back at the foreclosure sale, [2] the amount the Seller may bid as a credit against the wraparound note, and [3] the calculation of any resulting deficiency against the holder  -or- surplus in favor of the maker following the foreclosure sale.

Two approaches have emerged relative to calculating the deficiency against or surplus in favor of the maker following a foreclosure sale. Both have dramatically different consequences for the maker and holder.  In one approach, the existence of the underlying note is virtually ignored while fully recognized in the other. 

In considering these two approaches, assume the following additional hypothetical facts:

  • the maker defaults
  • foreclosure occurs
  • the value of Up Creek Farm remains at $750,000 
  • a successful foreclosure bid of $250,000 and 
  • Up Creek Farm remains encumbered by the $500,000 underlying note

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