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Legal Opinion Summary
Topic:Mortgage Lending: Does a mortgage loan secured by a first lien on rural real estate that an eligible borrower leases meet the requirements of section 1.10(a)(2) of the Farm Credit Act of 1971?
ID Number:07-01
Issue Date:06/12/2007

A Farm Credit System (FCS or System) association asked whether section 1.10(a)(2) of the Farm Credit Act of 1971, as amended (Act), authorizes it to make mortgage loans secured by a first lien on leased real estate in a rural area. Our opinion is that section 1.10(a)(2) of the Act grants System mortgage lenders authority to make long-term loans, secured by a first lien, to borrowers who lease land in rural areas if (1) such borrowers have significant legal and equitable property rights in the land under the terms of these leases, and (2) these loans are safe and sound.

The association seeks to make home loans to Native Americans who lease land from their tribe in a rural area. The association plans to make fixed-rate loans for terms of 15 or 20 years on land in tribal reservations that the borrowers lease for 50 years. These mortgages will be secured by a first lien on the borrower's interest in the property. Both the tribe and the county where the reservation is located will record the association's mortgages. Title insurance is available for these mortgages, and consumer protection laws, such as the Truth-in-Lending Act, the Real Estate Settlement Procedures Act and Home Mortgage Disclosure Act apply on reservations. The homeowner may sell the house and transfer the lease to other members of the tribe. In this particular case, the tribe effectively guarantees repayment of these loans because it deducts monthly mortgage payments from a per capita stipend that it pays each tribal member every month and remits the funds directly to the association. If the borrower defaults, the tribe has a contractual right of first refusal to pay off the mortgage and acquire the dwelling. If the tribe does not exercise its right of first refusal, the association has the legal right to sue for foreclosure in tribal courts.

Section 1.10(a)(2) of the Act states that all loans originated or participated in by a System mortgage lender shall be secured by a first lien on interests in real estate of such classes as prescribed by regulations of the Farm Credit Administration (FCA). The plain language of this provision grants the FCA discretion to determine what types of interests in real estate qualify as first-lien security for mortgages. For this reason, the FCA has authority to designate a borrower's leasehold interest in rural real estate as appropriate collateral for a first-lien mortgage from the System. The legislative history to section 1.10(a)(2) of the Act verifies that Congress intended that the FCA would authorize System mortgage lenders to secure their loans with first liens on rural real estate that borrowers lease as long as such borrowers have sufficient legal and equitable interest in the land. Since 1972, FCA regulations have designated leases as suitable collateral for System mortgages. As Congress intended, these leases grant the tenants substantial legal and equitable rights and interest in the land by enabling them to: (1) build a home on the property, (2) encumber the property with mortgages, and (3) sell the home and transfer the lease to another member of the tribe. These loans are for shorter terms than the leases, which preserve the association's first lien in the property, as the law requires, and is prudent from a safety and soundness perspective.

From a historical perspective, FCS associations have had a mixed experience in lending on tribal reservations. Associations can avoid potential problems by developing proper underwriting standards for this type of lending. In developing underwriting standards for these loans, FCS associations should take applicable tribal law into account, and understand the process and procedures of tribal courts in the event that foreclosure proceedings become necessary. System associations that plan to rely on loan guarantees from the tribal authority, or grant the tribe a right of first refusal to repay the loan if the borrower defaults, should assess counterparty risk as part of the loan underwriting process.