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

We provide an analytic valuation framework to value second lien mortgages and first lien mortgages when homeowners can take out a second lien. We 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 MBS without accounting for homeowners' equity extraction option results in much higher ratings than warranted by expected loss. While in our benchmark calibration, the senior tranche rating should be A1 rather than _Aaa, the big losers from the equity extraction option are the mezzanine tranches that are nearly wiped out.