Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products

Abstract

We provide an analytic valuation framework to value second mortgages and first lien mortgages when owners can take out a second lien. We then use the framework to value mortgage-backed securities (MBS) and, in particular, quantify the greater risk associated with MBS backed by first liens that have silent seconds''. Rating securities without accounting for the equity extraction option results in much higher ratings than warranted by expected loss. While the senior tranche’s rating should be A1 rather than Aaa in our benchmark calibration, the big losers from the equity extraction option are the mezzanine tranches who get wiped out.