One of the unfortunate byproducts of the sub-prime mortgage crisis has been an increase in fraudulent conduct among originators of residential mortgage loans who fund such loans using warehouse lines of credit provided by banks and other financial institutions. The premise of warehouse lending is as follows: Lender A obtains a line of credit from Bank B wherein Bank B funds loans made by Lender A to consumers secured by residential real estate. Bank B secures its line of credit to Lender A by taking an assignment of the notes and mortgages given by the consumers to Lender A. The notes and mortgages are held by Bank B until Lender A packages and sells the loans on the secondary market, at which time the advances under the line of credit made by Bank B to Lender A are repaid.

Mortgage lenders typically obtain warehouse lines of credit from more than one bank or financial institution so that they can maximize the loan dollars that they offer to consumers without having to raise significant equity. A few different schemes have surfaced in which these mortgage lenders “double fund” the residential real estate loans being made by having two or more of the lenders providing warehouse lines of credit unknowingly fund the same mortgage loan. The mortgage lender uses the proceeds from one of the lines to fund the residential real estate loan while keeping the proceeds from the other loan or loans for itself.

In one of the schemes, upon making a loan to a consumer, Lender A delivers the original promissory note to Bank B in exchange for the money to fund the loan. Lender A also obtains funding from Bank C for the same loan by assigning the mortgage instrument to Bank C and recording a copy of this assignment. In another scheme, Lender A delivers the original promissory note to Bank B and delivers a copy of the same promissory note to Bank C.

In both instances and regardless of the timeframe in which Bank B and C fund the loans or obtain their respective “collateral”, the result is the same – Bank B prevails. The Uniform Commercial Code (the “UCC”) makes it clear that UCC rules govern the perfection or non-perfection of the security interests of the warehouse lenders in the above scenario. See N.C.G.S. § 25-9-109. The UCC prescribes that the mortgage follows the note and, therefore, one cannot perfect a security interest in the mortgage instrument without also perfecting a security interest in the underlying obligation (i.e., the note). See N.C.G.S. § 25-9-109, Comment 7. To perfect a security interest in a promissory note, a lender must either: (a) file a financing statement, or (b) take possession of the promissory note. See N.C.G.S. §§ 25-9-312(a) and 25-9-313(a). Although the UCC now allows a lender to obtain a perfected security interest in promissory notes by filing a UCC Financing Statement, the best practice is to always take possession of original promissory notes so as to cut off any priority rights that certain competing purchasers and lenders with possession of the promissory notes may be entitled to. See N.C.G.S. §§ 25-9-330(d) and 25-9-331.

It is clear from the above examples that obtaining possession of original promissory notes is, in most instances, sufficient to protect a lender providing warehouse lines of credit. What happens, however, when Lender A obtains duplicate originals of the promissory note from the unsuspecting borrowing consumer and delivers “original” notes to both Bank B and Bank C? In this situation, obtaining possession of the original promissory note is not enough. The determination depends simply upon which bank obtained possession of the “original” promissory note first. The first to obtain possession would prevail. See N.C.G.S. § 25-9-322(a); See also Provident Bank v. Cmty. Home Mortg. Corp., 498 F. Supp. 2d 558 (E.D.N.Y. 2007).

The above scenarios and the law applicable thereto illustrate that a lender providing warehouse lines of credit would be well advised to, in addition to taking possession of original promissory notes, closely monitor the lending activities of its borrowers, including the funding and borrowing from warehouse lines of credit provided by other lenders.