Second-Lien Debt

What Is Second-Lien Debt?

The term second-lien debt refers to a form of borrowing that occurs once a first lien is put into place. Put simply, if a borrower defaults, any second-lien debt gets paid after the first or original first lienholder is paid off in the event of bankruptcy of asset liquidation. In other words, second-lien is second in line to be fully repaid in the case of the borrower's insolvency. As such, this type of debt has a lower repayment priority than other debt that is senior and ranked higher.

Key Takeaways

  • Second-lien debt refers to loans that are prioritized lower than other, higher-ranking debt in the event of bankruptcy and liquidation of assets.
  • Many second-lien debts are considered senior and are different from unsecured and junior debt.
  • In the event of default or forced liquidation, second lienholders only get paid after first lienholders.
  • Second-lien debt can help a borrower gain access to much-needed financing, but the risks must be weighed, and interest rates are often higher than on the first lien.
  • Junior debt can thus offer investors a higher interest rate than traditional fixed-rate debt, but with greater risk.

Understanding Second-Lien Debt

A lien is a legal claim that is generally established against a piece of collateral by a creditor when a borrower takes out a debt. For instance, a home is used as collateral when someone takes out a mortgage and a vehicle is used as collateral for an automobile loan. If the borrower doesn't meet their financial obligations, the lender (also known as the lienholder) can enforce the lien.

Liens can have different tranches or levels. So the primary lender in a mortgage is the first lienholder. Another bank that grants a second mortgage assumes the role of the second lienholder. As such, a second-lien debt is subordinate to the collateral pledged to secure a loan.

If a default of debt or a forced liquidation takes place, debt holders get paid in the following order:

  • First-lien creditors
  • Second-lien creditors
  • Unsecured creditors
  • All others, including stockholders (if any)

The majority of second-lien debt is considered senior. But as noted above, it does fall second to any other senior ranking debt and is distinct from unsecured forms of credit and junior or subordinated debt. The latter is any debt that's left after all other debts are paid.

A senior lienholder may receive 100% of the loan balance from the sale of any underlying assets. However, the second-lien holder may receive only a fraction of the outstanding loan amount if there isn't enough money left over.

Special Considerations

Due to the subordinated call on pledged collateral, secondary liens carry more risk for lenders and investors than senior debt. As a result of this elevated risk, these loans usually have higher borrowing rates and follow more stringent processes for approval.

For example, if a borrower is in default of a real estate loan with a second mortgage, creditors may foreclose and sell the home. Following the full payment on the balance of the first mortgage, the distribution of any remaining proceeds goes to the lender on the second mortgage.

Investors in subordinated debt must be aware of their position in line to receive full repayment of principal in the case of insolvency of the underlying business.

Risks of Second-Lien Debt

There are many risks associated with holding second-lien debt. And the risks extend to borrowers, lenders, and investors. We've outlined some of the most common ones below.

Borrowers

Borrowers may use secondary liens to access property equity or to add capital to a company's balance sheet. Pledging assets to secure a second lien also poses a risk to the borrower. Should the borrower stop paying the debt, that lender may begin procedures to force the sale of the pledged asset.

For example, if a homeowner has a second mortgage in default, the bank can begin the foreclosure process. Foreclosure is a legal process that allows the lender to take control of the property and begins the process of selling the asset. It happens when a borrower can't make full, scheduled principal and interest payments as outlined in the mortgage contract.

Businesses generally have a wider range of assets to pledge as collateral, including real property, equipment, and their accounts receivables (AR). Much like a second mortgage on a home, a business may be at risk of losing assets to liquidation if the second-lien lender forecloses.

Lenders

The primary risk to lenders is insufficient collateral if default or bankruptcy happens. Second-lien lenders usually assess many of the same factors and financial ratios as first-lien lenders. These financial metrics include:

A borrower's debt-to-income (DTI) ratio is also a very important metric, as it shows the percentage of monthly income dedicated to paying debts. Borrowers with a low risk of default receive favorable credit terms resulting in lower interest rates.

To mitigate risk, second-lien lenders must also determine the amount of equity available in excess of the balance owed on senior debt. Equity is the difference between the market value of the underlying asset less the outstanding loans on that asset.

For example, if a company has an outstanding $1,000,000 first-lien on a building, and the structure has an assessed value of $2,500,000, there is $1,500,000 in equity remaining. The second-lien lender may approve a loan for only a portion of the outstanding equity, say $750,000 or 50%. The first-lien holder may have stipulations on their credit terms that set restrictions about whether the company can take additional debt or a second mortgage on the building.

Lenders also review the market value of the building, the potential for the underlying asset to lose value, and the cost of liquidation. The size of second-liens may be restricted to ensure the cumulative balance of the outstanding debt is significantly less than the value of the underlying collateral.

Covenants are normally included in credit terms by lenders. They place restrictions and outline specific requirements for the borrower. If a business falls behind on payments, loan covenants trigger that might require the sale of assets to pay down the debt.

Investors

Although second-lien debt investors get paid before common stockholders in the event of a company's demise, junior debt has its risks. If the issuing company is insolvent, and through the process of liquidation, there aren't enough assets available to repay both the senior and junior debt, the second lien investors incur the loss.

Junior debt can offer investors a higher interest rate than traditional fixed-rate debt but they need to be aware of the financial viability of the issuing company and the likelihood of being repaid.

Results of Defaulting on Loans

Both businesses and individuals have a credit score that ranks their ability to repay loans. A credit score is a statistical number that evaluates the creditworthiness of a borrower by taking into account the borrower's credit history.

If an individual falls behind in payments or defaults on a loan, their credit score will fall. Low scores make it harder for these borrowers to borrow at a later day and may impact their ability to secure employment, apartments, and items like cell phones.

For a business, negative credit history can mean they will have difficulty finding buyers of future bonds that they may issue without offering an elevated coupon rate. Also, many companies use working capital credit lines for the operation of their business. For example, a company might borrow from a line of credit (LOC) to purchase inventory. Once they receive payment for their finished products, they pay off the LOC and begin the process again for the next sales cycle.

Another result of default for a business is the impact on the company's cash flow. Cash flow is a measure of how much cash a company generates to run its operations and meet its obligations. As a result of higher debt-servicing costs and interest expenses from higher interest rates, the cash flow is reduced.

Example of Second-Lien Debt

Here's a hypothetical example to show how second-lien debt works. Assume Company XYZ has an outstanding loan on one of its truck-producing factories. The loan is approximately $10,000,000 while the property's recent assessment gives it a market value of $22,000,000. As a result, the company has $12,000,000 in available equity ($22,000,000 - $10,000,000).

The outstanding loan of $10,000,000 is senior debt and is the first priority to be paid in the event of default or liquidation of the company. The bank charges 2% interest on the $10,000,000 note in return for being the first lienholder.

The company decides to take out a second mortgage (or incur a second lien) on the property from another bank. However, the second bank will only lend 50% of the remaining equity for second-lien debt. As a result, the company can borrow $6,000,000.

Assume a recession happens, dropping not only the company's income from truck sales but also the value of the property. Should the business not pay its debts, either lender may begin liquidation to satisfy the loan. After liquidation and the payment of the balance from the first, $10,000,000 loan, the company has only $5,000,000 in remaining funds. As a junior debt, the second bank cannot receive the full amount of the second-lien.

How Do Second-Lien Debts Work?

Liens have different levels based on where the lender falls in line. Second-lien debt is often considered senior but the lienholder only gets paid after the first-lien debt is satisfied. For instance, a lender that grants a second mortgage on a consumer's home only gets paid after the lender of the first mortgage. Since the proceeds from the sale of the asset(s) are applied to first-lien debt before anything else, the second-lien debt may not be paid in full.

What Is a Lien?

A lien is a legal claim that is placed on a piece of property and provides the holder a guarantee. Liens are commonly placed on assets such as homes and vehicles when someone takes out a loan. These assets act as collateral where the lien is granted to the lender. If the borrower doesn't pay their loan, the lender can exercise the lien, take legal action to repossess the property, sell it, and use the proceeds to pay off the loan.

What Is a Second Lien Mortgage?

A second lien mortgage is a home loan that occurs after another mortgage—the first one—exists. The lender of a second mortgage becomes the second lienholder against the mortgaged property. If the borrower fails to pay their mortgage and foreclosure takes place, the second lender gets paid only after the first lender receives the balance of the outstanding debt.

Article Sources

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  1. Corporate Finance Institute. "Loan Covenant."

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