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GHM-0011](http://www.hud.gov/offices/adm/hudclips/lops/GHM-0011LOPS.doc)

Secondary Financing Involving State Agencies

Legal Opinion: GHM-0037

Index: 3.365

Subject: Secondary Financing Involving State Agencies

March 16, 1992

MEMORANDUM FOR: Donald A. Kaplan, Director, Office of Insured

Multifamily Housing Management, HMI

FROM: David R. Cooper, Assistant General Counsel, Multifamily

Mortgage Division, GHM

SUBJECT: Secondary Financing Involving State Agencies

This is in response to your request that we provide you with

an opinion concerning a secondary financing issue referred to

your office by Mary Ann E. G. Wilson, Manager of the Richmond

Office. The question posed by Ms. Wilson is whether or not HUD

could permit any debt service loans created by the Virginia

Housing Partnership Fund for energy conservation and

rehabilitation on FHA-insured projects to be repaid from the

project\'s operating income rather than the project\'s surplus cash

account. For the reasons set forth below, it is our opinion that

second loans given in favor of a Federal, State or local

instrumentality thereof can be repaid from the project\'s

operating account provided the mortgagee of the HUD-insured first

mortgage consents to such an arrangement.

FACTS

The Commonwealth of Virginia has created the Virginia

Housing Partnership Fund (the Fund), which is being administered

through the State Department of Housing and Community Development

(HCD). HCD is currently considering a number of requests for

funding of projects that already have FHA-insured loans. The

funds may be given in the form of grants and loans to be utilized

only for project energy conservation and rehabilitation. HCD has

recently become aware of the provision in 24 CFR Section

221.520(b) which limits repayment of public agency secondary

financing to surplus cash or residual receipts. HCD is unwilling

to provide money from the Fund without enforcement remedies in

the event of non-payment or other non-performance. HCD has asked

for an opinion as to whether or not HUD would permit any debt

service loans created by the Fund to be paid from a project\'s

operating income rather than from any available surplus cash.

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Ms. Wilson notes that the repayment terms for the loans are

very advantageous to the projects involved: interest rates on the

project mortgages would range from 2 percent to 8 percent; the

amortization periods would be 15 years (possibly 30 years); and

there would be substantial forgiveness provisions for the grant

amounts. Ms. Wilson further notes that these loan terms surpass

anything available to the project owners in the private market.

ANALYSIS

Section 221.520(b) provides as follows:

The covenant required under paragraph (a) of this section

shall not apply where a lien inferior to the lien of the

insured mortgage is given in favor of a Federal, State or

local governmental agency or instrumentality under such

circumstances as may be approved by the Commissioner,

provided the source of funds for repayment of the inferior

lien is limited to surplus cash or residual receipts.

Subsection (a) of Section 221.520 provides that:

The mortgage shall contain a covenant against the creation

by the mortgagor of liens against the property superior or

inferior to the lien of the mortgage except for such

inferior liens as may be required in connection with the

insurance of an operating loss loan or a supplementary loan.

This office has consistently interpreted Section 221.520(a)

and similar regulatory provisions found in other multifamily

mortgage insurance programs as only requiring that all HUD-

insured mortgages contain a covenant against the creation by the

mortgagor of liens inferior or superior to the HUD-insured

mortgage referred to in the subsection. It has been this

office\'s position that the aforementioned requirement does not

preclude the mortgagee and mortgagor, as parties to a HUD-insured

mortgage from agreeing to the creation of liens inferior to the

lien of the HUD mortgage. If such an inferior lien is approved

by the Department as required by the Regulatory Agreement,

repayment is typically limited to surplus cash or residual

receipts; however, the Department has on occasion permitted

repayment of such inferior liens to be from the project\'s

operating income, (i.e., income that goes into the project

operating account, as opposed to surplus cash or residual

receipts). In 1985 this Office approved secondary financing

documents submitted by the Maryland Community Development Agency

(CDA) under which the CDA would give inferior loans on

HUD-insured projects and such inferior loans would be payable out

of the project\'s operating income. In all inferior liens created

under subsection (a), this office has opined that the mortgagee

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must consent regardless of the form of repayment.

Based upon subparagraph (a), a mortgage on a HUD-insured

project must contain a covenant which precludes the mortgagor

from creating a lien inferior or superior to the HUD mortgage.

However, such covenant, pursuant to the language set forth in

Section 221.520(b), does not apply to inferior liens given by the

mortgagor in favor of a Federal, State or local agency provided

repayment of such second loan is limited to surplus cash or

residual receipts. The preamble to the rule implementing

subsection (b) (and similar sections in other multifamily

regulations) does not give any guidance on what the Department\'s

intent was in implementing these regulatory provisions. It is

our view that subsection (b) can be interpreted as meaning that

if a mortgagor of a HUD-insured project obtains a second lien

which is given in favor of a Federal, State or local agency and

repayment of such loan is limited to surplus cash or residual

receipts, the mortgagor does not have to obtain the mortgagee\'s

consent prior to obtaining such loan. Mortgagee consent is not

required in cases involving governmental entities because the

mortgage covenant precluding inferior liens has, by regulation,

been made inapplicable to this type of inferior lien.1 Loans

given by project owners in favor of Federal, State or local

agencies are given in order to obtain financing to rehabilitate

the project. It appears to have been the Department\'s intention

in including subsection (b) in Section 221.520 and similar

regulatory sections, to make it easier for project owners to

obtain this type of secondary financing without mortgagee

involvement as long as the mortgagee\'s security was not affected

and repayment of such loan would not put a strain on the project

income and possibly cause the mortgagor to default on the HUD-

insured first mortgage. Even though mortgagee consent to an

inferior loan would not be required under Section 221.520(b),

HUD\'s prior consent would be necessary pursuant to Paragraph 6(a)

of the Regulatory Agreement.

In the instant case, given that the first mortgagee\'s

consent is being obtained, we consider that the case falls within

221.520(a) rather than 221.520(b). To hold otherwise would lead

to an unfair result. If Federal, State or local agency second

lenders would only be permitted to have their second loans paid

from surplus cash or residual receipts, private second lenders

1 This opinion overrules the portion of a July 22, 1986

opinion issued by this office which held that in a second lien

transaction given in favor of a Federal, State or local

governmental agency pursuant to Section 221.520(b), \" t he

mortgagee must renounce its right in writing to declare a default

and elect to receive insurance benefits upon execution, delivery

and recordation of the second mortgage as a precondition to

approval by the Secretary.\"

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would be allowed to receive more advantageous repayment terms on

their loans under subsection (a) (since loans under that

subsection could, in some cases with HUD and mortgagee consent,

be repaid out of project income). We are not aware of any

justification for the Department treating a private second lender

differently than a Federal, State or local agency second lender.

Therefore, if a private lender is permitted to give a second loan

which is payable out of project income, assuredly a Federal,

State or local agency second lender can give a second loan with

the same payment terms. It is our view that subsection (b) was

not intended to cover the only situation where secondary

financing could be given in favor of a Federal, State or local

agency: it was only intended to permit a certain type of

secondary financing on an insured project to be available to a

mortgagor without mortgagee consent.

Since the secondary financing proposed in this case is to be

given in favor of a state agency and the first mortgagee has

given its consent, this type of secondary financing should be

treated in the same manner as inferior loans permitted pursuant

to Section 221.520(a) for private lenders. Therefore, under

these circumstances the second loan may come from the project\'s

operating account. In accordance with the above interpretation

of Section 221.520(a), this type of secondary financing is

permissible provided the prior written consent of HUD is obtained

as required by the terms of the Regulatory Agreement.

If you have any questions concerning this opinion, please

contact Millicent Potts at 708-4167.