« Deflate Gate and Bankruptcy Reform | Main | The Art of Valuation »

Second-Liens and the Leverage Option

posted by Adam Levitin

Susan Wachter and I have a new (short!) paper up on SSRN. It's called Second-Liens and the Leverage Option, and is about the curious absence of negative pledge clauses in US home mortgages, which enabled enormous amounts of second-lien leverage (much more than anyone realized) during the housing bubble. We have a very simple, narrowly tailored legislative fix that should make additional mortgage leverage via junior liens a bargained-for matter between the borrower and the senior lienholder(s), rather than an absolute right of the borrower. 

Abstract is below the break:

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.    

Comments

The comments to this entry are closed.

Contributors

Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.

News Feed

Categories

Bankr-L

  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.

OTHER STUFF

Powered by TypePad