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

MIT/CRE Senior Lecturer Walter Torous was recently published in Real Estate Economics, the official journal of the American Real Estate and Urban Economics Association. The publication provides an analytic valuation framework to value second lien mortgages and first lien mortgages when homeowners can take out a second lien. The authors 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 their benchmark calibration, the senior tranche rating should be A1 rather than , the big losers from the equity extraction option are the mezzanine tranches that are nearly wiped out.

To read the full paper please click here.