Friday, July 27, 2018

How To Approach A Defaulting Second Mortgage


Default happens, hopefully not often, but it is a fact of lending. Upon default, however, a holder of a second mortgage must find an objective, value-driven manner in which to evaluate its options. Unfortunately, in many instances second position lienholders opt for one of two extreme approaches—accepting a nominal amount in exchange for the release of the lien or demanding an unreasonably high sum for satisfaction of the lien. Both approaches are harmful for different reasons. Despite such prevalent behavior, with proper management, a defaulting second mortgage can provide a lienholder with a number of options.


So, You Agreed To Be Second

Financing a second mortgage is making a conscious decision to maintain an interest in a property that is subject to the interests of the first lienholder. The most cogent concern of a second lender is that upon default of the first mortgage, all of the second lienholder's interest can be extinguished. Such subordination is not only a concern at default, but an ongoing concern, as any changes to the property or its rights that the second position lender would like to make may possibly trigger a default in the first mortgage. 

Upon default, the relationship between the first and second lienholders undergoes a slight alteration. To understand this shift, it is probably most beneficial to think of a second position lien as converting into an option or right of first refusal upon default. When either mortgage is in default, the second lien holder has to assess whether it wishes to incur the cost of litigation, in the case of the second lien’s default, or satisfaction, in the case of a default on the first mortgage. In the same manner, the money lent for the second lien can similarly be seen as the cost of the option, which bears interest for the lender. Viewing its lien from this property rights perspective will enable the second lien holder to conduct an objective risk-weighted cost-benefit analysis of the second mortgage.

Which Approach Should Be Taken Upon Default?

When it comes to defaulting second mortgages, objectivity is essential. Accepting a nominal payoff leads to lost profits. Alternatively, overly aggressive demands for a payoff will lead to either foreclosure of the first lien position and extinguishment or a longer period of nonpayment, followed by ownership of the property subject to the first mortgage. An active approach is necessary to avoid entering either situation unwillingly. Second lien holders should assess the value of the property and determine if the remaining equity after satisfaction of the first lien and additional litigation/acquisition costs makes the exercising of the lien holder’s rights worth the cost of doing so. In addition to this course of action, it is important for the second lienholder to understand the secondary market pricing for performing second mortgages, defaulting mortgages and the typical payoff discount for defaulting second mortgage in the property’s local area. The state of title of property is also an important determining factor. Armed, with this information, a second position lienholder can make an informed decision on how it will proceed upon default.

Unfortunately, second lienholders and their authorized agents are not always optimally informed at the time of default, leading to frequent instances of idiosyncratic behavior. That said, I thought it prudent to provide my take on how to approach the default of a second position mortgage. Please feel free to provide your prospective on the matter below.