[GHM-0007](http://www.hud.gov/offices/adm/hudclips/lops/GHM-0007LOPS.doc)

[GHM-0014](http://www.hud.gov/offices/adm/hudclips/lops/GHM-0014LOPS.doc)

Deduction of Funds in GNMA-Related Escrow

Legal Opinion: GHM-0004

Index: 3.400

Subject: Deduction of Funds in GNMA-Related Escrow

October 17, 1991

William S. Tennant, Esq.

David A. Barsky, Esq.

Krooth and Altman

2101 L Street, N.W.

Washington, D.C. 20037-1584

Re: The Ritz Plaza

Project No. 012-35620

New York, New York

Gentlemen:

This responds to your letters dated April 10, 1991, June 25,

1991, July 19, 1991 and September 10, 1991, concerning the issue

of whether the Department is entitled to surcharge the insurance

claim filed by Reinlein Lieser McGee (\"RLM\") with respect to the

letters of credit drawn down by RLM which funded a GNMA-related

escrow.

The Ritz Plaza (the \"Project\") was financed by a Section

221(d)(4) mortgage dated July 19, 1988, in the amount of

\$84,292,700. At initial endorsement RLM collected from Jason and

Julia Carter (the \"Sponsors\") letters of credit (\"Letters of

Credit\") in the total amount of 1.75% of the face amount of the

Mortgage. The Letters of Credit were provided in order to

fulfill the following condition of RLM\'s financing commitment to

the mortgagor, S-C Associates, L.P. (the \"Mortgagor\"):

\"GNMA Certificate of Deposit. GNMA requires a

Certificate of Deposit in the amount of 1-3/4% of the

FHA Loan amount, to be maintained for a period

extending three years subsequent to the date of

issuance of the GNMA Project Loan Certificate. The

Mortgagor shall provide a deposit in this sum at

Initial Closing, in a form satisfactory to Lender and

to be held in Lender\'s name during construction. At

Final Endorsement, said deposit will be converted to a

Certificate of Deposit in GNMA\'s name for the three-

year period subsequent to the issuance of the Project

Loan Certificate. Interest on the Certificate will be

paid to the Mortgagor, provided no default has occurred

in payments pursuant to the FHA Loan.\"

Prior to final endorsement the Mortgage went into default. RLM

has drawn down the Letters of Credit. FHA has paid the final

settlement on the insurance claim, but has reserved its

determination as to whether a deduction should be made with

respect to the Letters of Credit. Accordingly, the insurance

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benefits paid were reduced by the amount of the Letters of Credit

pending such determination.

At the outset it is important to make clear that Letters of

Credit do not themselves constitute an escrow required by GNMA.

Paragraph 16-5(b) of the GNMA I Mortgage Backed Securities Guide

(the \"GNMA Guide\") provides that a certificate of deposit in the

amount of 1.75 percent of the face amount of the pooled mortgage

must be provided to GNMA at the time that Project Loan Securities

(\"PLCs\") are issued; the certificate of deposit is intended to

provide collateral for the lender-issuer\'s liabilities to GNMA

for losses occurring during the three-year Indemnity Period

following the issuance of the PLCs. The requirement that Letters

of Credit be placed with RLM at initial endorsement to ensure

that funds would be available to meet the GNMA requirement when

the PLCs were issued was RLM\'s requirement, not GNMA\'s. (GNMA\'s

4% collateral requirement with respect to the issuance of

construction loan securities was met through RLM\'s advance of

mortgage proceeds in an amount exceeding the total principal

amount of the securities by at least 4%, in accordance with

Paragraph 17-5(b)(2) of the GNMA Guide.) Therefore, the instant

case is distinguishable from any precedents or authority

indicating that HUD would not deduct the amount of a \"GNMA

Indemnification Escrow\" in calculating insurance benefits.

In your letters you analogize the status of RLM as lender-

issuer with that of a bond trustee. You allude to a

June 10, 1980, letter from John P. Kennedy to Kenneth G. Lore, in

which Mr. Kennedy stated that funds collected by a trustee of a

Section 103 tax-exempt construction financing issuance would not

be deducted from insurance benefits. You state in your letters

that the Letters of Credit were likewise for the benefit of

securities holders, and you point out that the proceeds from the

Letters of Credit were used to pay the securities holders in full

once RLM obtained the partial settlement from HUD. We find that

the situation described in the June 10, 1980 letter is

distinguishable from the present case. Unlike bond holders, the

GNMA securities holders are fully protected by the GNMA full

faith and credit guarantee. It was RLM, and not the securities

holders, that needed the assurance and protection of the Letters

of Credit. Moreover, even if HUD were to accept the analogy

between a bond trustee and a GNMA lender-issuer, the fact remains

that the Letters of Credit were held by RLM in anticipation of

its potential responsibilities under the PLC program, and not to

fulfill any then-existing responsibilities as a lender-issuer.

You also cite in your letters a March 20, 1986, letter from

Eliot C. Horowitz to Gerald D. Levine, Esq., which concluded that

certain security devices required by GNMA would not result in a

surcharge in insurance benefits. The letter\'s holding was based

in part on the fact that GNMA is the sole party authorized to

draw on the letter of credit (or certificate of deposit) and that

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the security devices are delivered to GNMA and not held by the

mortgagee. Once again, the situations addressed in that letter

are clearly distinguishable from the instant matter. The Letters

of Credit were not held by GNMA, and GNMA was not designated as a

party entitled to draw on them.

We would like to point out that in a later letter we

distinguished the security devices discussed in our

March 20, 1986 letter from security devices held by the lender-

issuer. The December 1, 1988 letter (copy enclosed) to Mr.

Levine from Eliot C. Horowitz discussed cases in which the

lender-issuer obtains a letter of credit from the mortgagor, and

then has a separate letter of credit, with itself as the account

party, issued to GNMA. If a mortgage default occurs and the

lender-issuer obtains insurance benefits and pays the securities

holders in full, GNMA will return the letter of credit which it

holds to the lender-issuer. The lender-issuer, on the other

hand, will draw down on the letter of credit that it obtained

from the mortgagor. We stated that in this situation HUD was

entitled to make a deduction in the amount of the mortgagor\'s

letter of credit drawn down by the lender-issuer, since the

purpose of that letter of credit was to protect the lender-

issuer, not GNMA.

Our December 1, 1988 letter cited New York State Teachers\'

Retirement System v. HUD, 290 F. Supp. 346 (N.D.N.Y. 1968), in

which the mortgagee collected from the mortgagor funds in the

amount of one percent of the mortgage, under an agreement

providing that in the event of default and assignment of the

mortgage to FHA, the mortgagee would be entitled to retain the

deposit. The court held that HUD was entitled to deduct the

amount of the deposit from the insurance claim. See also State

Street Bank & Trust Co. v. United States, 657 F.2d 1199 (Ct. Cl.

1981). Likewise, in the instant case it appears that RLM drew

down on the Letters of Credit to compensate itself for losses not

reimbursed through the insurance claims process.

In your letters you stress that the Letters of Credit were

drawn on the account of the Sponsors and not the Mortgagor, and

you cite previous letters from this Office which draw a

distinction between funds provided by sponsors and those provided

by the mortgagor. In his June 10, 1980 letter John Kennedy noted

that the funds in question were deposited by the sponsor and not

the mortgagor. He concluded that no deduction was warranted,

because the funds were held not by the mortgagee but by the

trustee, and would not be held for the account of the mortgagor,

but \"for the benefit of the holders of the notes.\" Thus, the

distinction drawn by Mr. Kennedy was whether the funds were

intended to benefit the mortgagor or the securities holders. As

we explained above, in the present case we regard the Letters of

Credit as providing assurance and protection to RLM, and not the

securities holders.

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Finally, in our March 20, 1986 letter, we again noted that

the security devices in question were drawn on the account of an

affiliate or general partner of the mortgagor, and not the

mortgagor itself, and thus were not \"for the account of the

mortgagor.\" However, unlike the security devices examined in

that letter, which existed for the protection of GNMA, the

Letters of Credit constitute the equivalent of \"cash held by the

mortgagee or its agents or to which it is entitled\....\"

24 CFR 207.258(b)(5)(ii). Clearly, the Letters of Credit were

held by RLM, and since RLM has drawn down the Letters of Credit

to help cover its losses, it appears that the Letters of Credit

were funds to which RLM was entitled.

For the reasons stated above we have concluded that HUD is

entitled to impose a surcharge in the amount of the Letters of

Credit. We are so instructing our Office of Mortgage Insurance

Accounting and Servicing, and thus no supplemental insurance

benefits claim will be paid to RLM.

Very sincerely yours,

John J. Daly

Associate General Counsel

Insured Housing and Finance

Enclosure