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Subprime Mortgage Credit Derivatives by FRANK J. FABOZZI, THOMAS A. ZIMMERMAN, DOUGLAS J. LUCAS, SHUMIN LI, LAURIE S. GOODMAN

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CHAPTER 3

Second Lien Mortgage Credit

In this chapter, we look at the performance of second lien mortgages (seconds or second lien). When the subprime market imploded in 2006 and 2007, seconds were one of the first sectors to exhibit unusually high defaults. By mid-2006, trading desks were punishing whole loan subprime packages that had a larger than average percentage of seconds. It appears that in a stressful environment, seconds are more vulnerable to the layered risks than are first lien mortgages.

This chapter starts off by comparing historical performances of seconds in closed-end seconds (CES, or standalone seconds) deals versus regular subprime deals that are mostly comprised of first lien mortgages. We then evaluate the recent performances of seconds in the context of the 2006–2007 subprime debacles. Our analyses indicate that the historically bad performance of recent seconds liens shares the same traits of first lien counterparts, which are highlighted by loose underwriting and collateral risk layering.

TWO TYPES OF SECONDS

Second liens occur in nonagency MBS in two forms: either as a small part of a first subprime deal, or in a standalone second deal. For historical reasons, seconds very rarely appear in prime or Alt-A deals, but have long played a role in subprime. In the early days of the “home equity” market (1991–1993), a substantial percentage of the loans were seconds. However, in the modern subprime world (i.e., post-1995), seconds have played only a minor role. ...

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