Monday, August 7, 2006

Securitizing Piggyback (Second-Mortgage) Loans

There's been a lot of talk about the risks associated with 2nd-lien (also called "piggyback", or 2nd mortgage) loans. For the unitiated, what people traditionally think of as a mortgage is usually a "1st lien" loan, or 1st mortgage. This means that in the event of a default, or if the home is sold, the mortgage holder is first in line to get paid.

Up until a few years ago, most houses were financed strictly by 1st-lien (i.e. 1st mortgage) loans. Most first-mortgages require either that the borrower make a 20% down payment, or (alternately) takes out private mortgage insurance (PMI) that will cover the lender in case the proceeds from the sale don't cover the first mortgage amount.

Recently, however, home buyers have started financing some (and in many cases, almost all) of the 20% down payment with a 2nd mortgage (also known as a "2nd lien" loan). These loans have significantly higher risk of default than 1st-lien loans for a number of reasons: first, in the event of a default, they're last in line. The 2nd-lienholder doesn't receive any money until the 1st mortgage holder is paid in full. Second, homebuyers who use 2nd mortgages as part of their financing tend to be less financially secure than those who don't (after all, that's why many of them use a 2nd-lien loan - they can't come up with the 20% equity required). Finally, these loans tend to have higher "prepayment risk" than first-lien loans since, given a choice, borrowers usually pay them off more quickly due to their higher interest rates.

When these loans first gained popularity, banks held them in their portfolios. Now, the securitize them. In other words, they pool a number of these loans together into a portfolio and then write new securities whose payoffs are based on the cash flows to the portfolio.

The process of securitization benefits the capital markets immensely. It allows lenders to "sell off" the risk (and returns) associated with these loans, and frees up their capital to make more loans. Borrowers in turn benefit because banks are more willing to make these loans: since they're not stuck bearing the risk from holding them in portfolio, they're willing to provide them at more favorable terms to borrowers. Finally, investors benefit because the new securities created allow them access to the risk-return tradeoff associated with these instruments.

To more about some recent developments in the securitized piggyback loan market, you can read this WSJ article (online subscription required) titled Piggyback Loans are a Risky Business.

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