Second-Liens and the Leverage Option

Abstract

The finance literature has long recognized the existence of embedded put options within mortgage contracts, such as a prepayment option and a walk-away default option. This Article identifies a previously unrecognized option embedded in residential mortgages: a mortgagor’s unilateral option to increase total leverage on the collateral property through junior liens irrespective of existing mortgagees’ wishes. We term this the “leverage option.”

We show how the leverage option was created as an unintended consequence of a federal law enacted to deal with seller financing arrangements that prevailed during the inflationary economy of the 1970s. The leverage option was of little importance until the housing bubble in the 2000s, as homeowners massively increased their leverage using second-lien mortgages.

We demonstrate the problems that the leverage option causes for lenders, for homeowners (who pay for it, regardless of whether they want it), for regulators, and for the economy at large. We propose a discrete legal change that will convert the leverage option from being a mandatory embedded option to a bargained-for, unembedded option that will enable efficient pricing and force the information about total mortgage market leverage that is necessary for both effective market oversight.

Keywords: second-lien, junior mortgage, leverage, loan-to-value, LTV, CLTV, embedded option

JEL Classification: G21