Most 100% financing packages involve putting together a First Mortgage for 80% of the purchase price and a Second Mortgage for the remaining 20%, what we call a piggy-back transaction.  Those who seek piggy-back Seconds today are going to face much tougher scrutiny. Here's why.

Separating the loans segregates the risk too.  The property value would have to decline 20% for the holder of the First Mortgage to take a loss. That is unlikely as home values in even the weakest areas of the country haven't declined that much. That means that even if a loan was poorly underwritten and even though the borrower was wildly unqualified, the owner of that loan would likely not take a loss in the event of foreclosure.

However, the Seconds would have to absorb most or all of the loss, but let's acknowledge that any holder of a Second would already understand that. They felt that a combination of high yield and the fact that most of them would be paid off in a timely fashion would compensate for that risk. If you owned one such loan, it’s all or nothing, but if you owned 10,000 loans, 85% of them might be perfectly OK and, on balance, you got what you wanted.

But when a lender has to buy back loans in bulk, the only reason is that the loans are already in default. That means that 100% of those loans are risky and it’s conceivable that 80% of them or more would be headed to foreclosure.

If you assume that a market declined 5% and that it took another 5% of the value to fix up the home to re-sell it, and if a 6% sales commission were paid to sell it, you can see that the holder of the Second would only net 4% of the original value, 20% of the face value of the note.  You can also make the assumption that if they were to stick it out, they would also have to keep the First Mortgage current, and that would wipe out that 4% in a heartbeat. In all likelihood the holder of the Second in this situation would just write off his loan in its entirety. 

You might recall that talked about the vultures circling around troubled sub-prime lenders to feast off the carcass.  In a deal just announced and approved by the bankruptcy court, an investment fund just bought $170 million of mortgages from New Century Financial for a paltry $58 million. Many will entail a complete loss, but when you pay 30 cents on the dollar for something, you can bet that they will probably earn a handsome return before the dust settles.

In a related note, you may recall that in an earlier blog – Are You Kidding Me? - April 27, 2007 – I noted that the seven top executives of this sub-prime juggernaut had asked the Bankruptcy Court for $3.5 million in bonuses even though the organization now seems to be worthless as an on-going enterprise. Over 2,000 more workers were laid off and it appears as if they also owe the IRS some $400 million in back taxes. Thus it was to my astonishment and dismay that the Court approved paying the bonuses! 

Maybe I'm in the wrong end of the business.