4000 - Advisory Opinions
Regulation O: Wrap-Around Mortgage Transactions
February 15, 1980
Pamela E. F. LeCren, Attorney
The following is in response to your request that this office assess the practice of granting "wrap-around" mortgages within the context of Federal Reserve Regulation O (12 C.F.R. Part 215). The question was initially posed to you by ***.
A "wrap-around" transaction typically takes the following form. A borrower who has an outstanding mortgage wishes to refinance the mortgaged property without disturbing the existing loan which may be at an interest rate much lower than currently available. The borrower obtains a mortgage from a second institution (the "wrap-around" lender) in an amount that equals the sum of the outstanding mortgage at the first institution and the new money sought with interest calculated on the total figure at an interest rate below current market rates. The borrower does not receive funds equal to the full wrap-around mortgage, but rather the difference between the full mortgage and the outstanding debt to the first institution. The "wrap-around" lender collects payments from the borrower based on the full mortgage, passes through to the initial lender an amount equal to the debt service on the first loan and retains the remainder. In this manner the initial mortgage is repaid according to its outstanding terms and the "wrap-around" lender obtains a return on the new funds extended that is higher than the stated interest rate of the wrap-around mortgage.
Before turning to the question of how to assess this practice under Regulation O, it should be noted that the practice itself is one that should be carefully reviewed outside of any Regulation O context. Since the wrap-around mortgage is essentially a second mortgage, and therefore an inferior lien, it may be a questionable investment for the bank to engage in and one that has little advantage if any for the bank. If there is any advantage gained from extending a wrap-around mortgage, it may well be unlawful. There is a real danger that the practice may be used as a mechanism to obtain a higher return than permitted under state usury laws.
Assuming in any particular instance that the practice does not result in a usury violation and that the investment in the second mortgage is not otherwise questionable,1 the extension of a wrap-around mortgage to an insider of the lending institution may or may not present problems under Regulation O. Initially, let us state that only the new money extended by the wrap-around lender would be counted against the insider's loan ceiling under Regulation O. We would also look to the actual return on the new money in order to judge whether or not the extension was preferential and not the interest rate as stated in the terms of the note itself. (If we looked to the stated terms, the transaction would be preferential in all cases as the interest rate is below current interest rates.) If the actual return is not the same or substantially the same as the bank obtains on a second mortgage2 extended to persons not associated with the bank who are equally as credit worthy, then the transaction would be preferential and constitute a violation of section 215.4(a) of Regulation O. Even if the return is the same or substantially the same, the transaction may be preferential if the bank has not extended, and does not anticipate extending, wrap-around mortgages to persons not associated with the bank.3 We are unable to determine whether or not the particular wrap-around mortgage *** is contemplating is preferential under Regulation O as we do not have sufficient facts at this time.
1 According to *** inquiry, the bank's accounting records would show a participation to the initial lender in the amount of the outstanding balance on that loan when no such participation actually occurred. This may or may not be proper accounting procedure. Go back to Text
2 If the wrap-around mortgage is accorded first lien status under state law or by the state banking authorities, then the interest rate would be compared to interest rates obtained on first mortgages. Go back to Text
3 It is our understanding that structuring the second mortgage in the form of a wrap-around loan is advantageous to the borrower in that the monthly debt service on the wrap-around loan is less than the debt service that would otherwise be paid if two schedules were being independently serviced. Go back to Text