Paying 88 on a seasoned second when the first has 22 years left

Question

Looking at a pool of seasoned performing seconds, and the pricing convention in it is bothering me. The tape prices them around 88 to 92 of unpaid balance, which for a note at 9.5% coupon with 22 years remaining gets you into the low teens on yield if it pays to term. Fine. But the first lien on most of these has a longer remaining term than the second, and on three of them the combined loan to value sits near 95 based on an AVM the seller ran themselves.

My problem is what the collateral actually protects. If the borrower stops paying the second and keeps paying the first, my remedy is to foreclose subject to a first I would then have to keep current, on a property where there's no equity cushion. So am I really buying secured paper, or am I buying unsecured cash flow with a lien attached for decoration? What do people underwrite the second-lien discount against if not recovery value?

Rena Expert · Accepted Answer

On a second at 95 combined loan to value, recovery value is close to zero and you should price it that way. What you're buying is payment behavior, and the lien matters mostly because it gives the borrower a reason to keep paying rather than because it gets you paid out of a sale.

That changes what the diligence has to look at. Pay history on the second is table stakes, but the useful signal is whether the first is current, because a borrower who stops paying the first will take your position out from under you when the senior lienholder forecloses in a market where the sale doesn't cover both. Order a credit report where the borrower's authorization permits it, and check whether there's an escrow shortfall or a tax delinquency building on the property. Tax liens generally prime both mortgages, and priority rules vary by state, so confirm how your state treats them before you assume you're second in line rather than third.

The AVM the seller ran is not a valuation. It's a marketing number. If the price difference between 88 and 82 matters to you, it should be worth a drive-by broker price opinion at a couple hundred dollars a file, and on a pool of any size the seller may let you sample.

One thing your framing skips: an underwater second is exactly the paper that gets written down or stripped in a borrower bankruptcy, depending on the chapter and how the court treats a wholly unsecured junior lien. That's a legal question specific to the filing and the jurisdiction, and you'd want counsel who does creditor work rather than a general answer. But it's the tail risk on this pool, and it doesn't show up anywhere in a pay history that looks clean.

dpatel_re · Answer

The thing I'd want from the seller before quoting is the actual pay string, twelve to twenty-four months, not a "current" flag. Current means the borrower paid this month. A note that has been thirty days late eight times in two years and then cured is not the same asset as one that has never missed, and both show as performing on a tape. Sellers know this and the tape header rarely says which you're getting.

aaron_fitz10 · Answer

Naive question from the sidelines, but if the second is really unsecured cash flow at that combined loan to value, why is anyone paying 88? Consumer unsecured at 9.5% with that risk profile would trade far cheaper. Is the market pricing off the coupon and the word "mortgage" instead of the recovery math?

Paying 88 on a seasoned second when the first has 22 years left

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