Second-Lien Debt

What Is Second-Lien Debt?

Second-lien debt is borrowing that occurs after a first lien is already in place. It subsequently refers to the ranking of the debt in the event of a bankruptcy and liquidation as coming after first-lien debt is fully repaid. Another term for this type of debt security is junior or subordinated debt.

These debts have a lower priority of repayment than do other, senior, or higher-ranked debt. In other words, second-lien is second in line to be fully repaid in the case of the borrower's insolvency. Only after all senior debt, such as loans and bonds, have been satisfied can second-lien debt be paid. Investors in subordinate debt therefore must be aware of their position in line to receive full repayment of principal in the case of insolvency of the underlying business.

Second-Lien Debt Explained

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

If a borrower defaults on a secured loan, the senior lien holder may receive 100% of the loan balance from the sale of underlying assets. However, 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 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.

Second-Lien Lender Risks

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. These financial metrics include credit scores, earnings, and cash flow. Lenders also review a borrower's debt-to-income ratio, which shows the percentage of monthly income dedicated to paying debts. Typically, 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. In this case, the second-lien lender may approve a loan for only a portion of the outstanding equity, say $750,000 — 50%. Further, the first-lien holder may have stipulations on their credit terms that set restrictions regarding if the company can take additional debt or a second mortgage on the building.

Other calculations a lender reviews during the lending process include the market value of the building, the potential for the underlying asset to lose value, and the cost of liquidation. Lenders may 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.

Lenders typically include covenants in credit terms. These covenants 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.

Second Lien Investor Risks

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 will incur the loss.

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

Second Lien Borrower Risks

Junior debt may be in the form of loans from a bank or through the sale of bonds to investors. 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.

Regardless of the reasons for the second loan, should the borrower fall behind in payment on 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 where a lender takes control of the property and begins the process of selling the asset. Foreclosure happens when a borrower cannot 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 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.

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 cellphones.

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 cost and interest expenses from higher interest rates, the cash flow is reduced.

Real World Example

As an example, let's say that Ford Motor Company (F) has an outstanding loan on one of its factories that produce 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, 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. In return for being first lien holder, the bank charges 2% interest on the $10,000,000 note.

Ford looks to take a second mortgage — in essence, 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, Ford 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.