Second Lien Debt

Second-lien debt refers to loans that are prioritized lower than other higher-ranked debt in the event of bankruptcy. In other words, second-lien debt is second in line to be fully repaid in the case of the borrower's insolvency. Second-lien debt is also called junior debt since it's paid after all senior debts have been satisfied. Senior debt is the top priority for borrowers and only after all senior debt has been satisfied can second-lien debt be paid.

Second-lien debt has a subordinated claim to collateral pledged to secure a loan. In a forced liquidation, a second lien may receive proceeds from the sale of the assets pledged to secure the loan, but only after senior debt holders have been paid. Due to the subordinated call on pledged collateral, second liens carry more risk for lenders than senior loans. As a result of the elevated risk, these loans usually have higher borrowing rates and more stringent processes for approval than senior debt.

If a borrower defaults on a secured loan, the senior lien holder may receive 100% of the loan balance from the sale of the underlying assets, while the second lien holder may receive only a fraction of the outstanding loan amount.

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

• Second lien debt refers to loans that are prioritized lower than other higher-ranked debt in the event of bankruptcy. In other words, second-lien debt is second in line to be fully repaid in the case of the borrower's insolvency.
• Second lien debt is also called junior debt since it's paid after all senior debts have been satisfied.
• Second-lien debt can help a borrower gain access to much-needed financing, but the risks must be weighed.

The primary risk to lenders posed by second lien mortgages is insufficient collateral in the event of a default or a bankruptcy filing. During the application process, second-lien lenders usually assess many of the same factors and financial ratios as first-lien lenders. The financial metrics include credit scores, earnings, cash flow, and debt-to-income ratios, which shows the percentage of monthly income that goes to paying debts. Typically, borrowers that are perceived to pose a low risk of default can be approved with more favorable credit terms such as lower rate, as compared to high-risk borrowers.

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

For example, if a company has an outstanding first-lien loan on a building whereby the loan is $1,000,000 while the asset is worth $2,500,000, there's $1,500,000 in equity. However, the second-lien lender might only approve a loan for a portion of the outstanding equity such as $750,000 or 50% of the equity. Also, the first-lien holder might have stipulations and restrictions written into its credit terms with the borrower regarding whether the company can take on additional debt or a second mortgage on the building.

Other calculations involved in the lending process include the market value of the building, the potential for the underlying asset to lose value, and the cost of liquidation. It's possible that lenders might restrict the size of second liens to ensure the cumulative balance of the outstanding debt is significantly less than the value of the underlying collateral. mm

Pledging assets to secure a second lien also poses risks to borrowers. Whether the debt is being used to access the equity in a home or to add capital to a company's balance sheet, a lender can initiate a forced sale of the pledged assets in the event of a default on a second lien.

For example, if a homeowner has a second mortgage in default, the bank can begin the foreclosure process. Foreclosure is the legal process by which a lender takes control of a property, evicts the homeowner and sells the home after a homeowner is unable to make full principal and interest payments on his or her mortgage, as stipulated in the mortgage contract.

Businesses generally have a wider range of assets to pledge as collateral, including real property, equipment, or accounts receivable. 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.

If a borrower falls behind in payments or defaults on any type of debt including first-lien or second-lien debt, the borrower's credit score will take a significant hit. A credit score is a statistical number that evaluates the creditworthiness of a borrower by taking into account the borrower's credit history. Lenders use credit scores to evaluate the probability that a borrower will repay a loan. A credit score ranges from 300 to 850, and the higher the score, the better the credit history, and more likely the borrower is to pay back debt. If a borrower's credit score declines due to late payments or default, it'll be significantly more difficult to obtain new debt.

Higher interest rates on debt can accompany a borrower's default on a loan or any perceived risk of default. Even if there's a drop in a borrower's credit score from late payments or too much debt, interest rates can be increased by lenders. Negative credit history can result in a company's business credit cards to experience higher rates as well as other variable-rate debt. Many commercial companies borrow via working capital credit lines, which allows access to ongoing capital so business operations can be funded. For example, a company might borrow from the line of credit to purchase inventory. Once the finished products are sold, and the company is paid by its customers, the company pays off the line of credit, and the process repeats itself in the next sales cycle.

If a company takes on a second-lien loan and falls behind in payments, the company is at risk of higher interest rates on its variable-rate debt including credit cards and variable-rate credit lines but also its outstanding loans. As a result, debt-servicing costs such as interest expense increases due to the higher interest rates, which can reduce a company's cash flow. Cash flow is a measure of how much cash a company generates to run its operations and meet its obligations.

Also, lenders might ask for additional capital to secure their outstanding loans if they believe the company is at risk of default. Companies typically include covenants in their credit terms meaning they place restrictions and outline specific requirements that are needed to be maintained or carried out for the loan to be approved and remain in place. If a business falls behind on payments, covenants in the loan agreement could be triggered that might require the sale of assets to pay down the debt. Second-lien debt can help a borrower gain access to much-needed financing, but the risks must be weighed.

As an example, let's say that Ford Motor Company (F) has an outstanding loan on one of its factories that produces its trucks. The loan is approximately $10,000,000 while the building and the property are worth $22,000,000 according to a recent assessment of its market value.

As a result, Ford has $12,000,000 in equity available (or $22,000,000 - $10,000,000).

The outstanding loan of $10,000,000 issued by Bank Commerce is considered senior debt and is the first priority to be paid in the event of default or liquidation of the company. In return for being first lien holder, Bank Commerce agreed to charge a low interest rate of 2% per year.

Ford looks to take a second mortgage on the property from Bank Eureka, which would represent second-lien debt. However, the bank will only lend 50% of the equity for second lien debt.

As a result, Ford can borrow $6,000,000 as a working capital line that in the event of default will represent second-lien debt. In other words, the $6,000,000 loan will be considered junior debt to the $10,000,000 in senior debt.

Shortly after, Ford faces financial hardship and is unable to pay its debt payments; Bank Commerce begins forced liquidation of the company's assets to satisfy the loan. Also, the market value of the property and building declined and is now only worth $15,000,000 versus the $22,000,000 originally. Bank Commerce is paid the $10,000,000 from the sale of the assets. However, Bank Eureka, which has a $6,000,000 loan outstanding with Ford is only paid $5,000,000 since that's the remaining funds after the liquidation.

Bank Eureka had second-lien debt versus bank Commerce, which had more senior debt meaning Bank Commerce gets paid first and whatever remains goes to satisfy any debts with Bank Eureka.