Second Lien Loans

People often think of second lien loans in terms of a second mortgage on a home. The difference between what a person owes on his residence and the amount at which the house is appraised (its market value) is known as equity. Homeowners can tap into this equity by taking out a second loan on the house. In a similar, though more complex way, a company has both tangible and intangible assets. The tangible assets are physical items such as buildings, manufacturing equipment, computer networks, and vehicles. Even office desks and chairs are tangible assets. In contrast, intangible assets include such things as a company's trade secrets and intellectual property. Manufacturing formulas, client lists, copyrights, patents, and trademarks are examples of intangible assets. A company's board of directors may choose to seek second lien loans when their tangible and intangible assets are already serving as collateral for primary debts.

For homeowners who have significant equity in their homes, second lien loans are a way to get cash without the high closing costs of refinancing the first mortgage. The application process is not that lengthy and loan approval is usually fairly quick. The cash can be used for home improvement projects, to consolidate other debt such as credit cards and car payments, or for any other purpose. The homeowner can even use the money to take a dream around-the-world vacation. One benefit of borrowing against the equity in one's home is that the interest is usually tax deductible. The interest paid on other types of debt is hardly ever tax deductible. Even with that benefit, conservative financial experts advise against tapping into home equity for unnecessary purchases, such as that dream vacation.

The downfall of a home equity loan is that the person's primary residence is put at risk. If the payments are not made, the lender can foreclose on the home. Poor financial decision puts a family at risk. When property values were skyrocketing, many families tapped into the increasing equity by applying for second lien loans. Now that property values have dropped, some people owe more on their combined first and second mortgages than the house is worth on the market. The Proverbs writer warned those who stray far from wisdom: "depart not from the words of my mouth. . . . Lest strangers be filled with thy wealth; and thy labours be in the house of a stranger" (Proverbs 5:7b, 10). No matter the value, payments still have to be made so that the house isn't taken away. This upside-down situation also makes it difficult for families to sell their properties since, in most areas of the country, the surplus of housing inventory benefits buyers.

Boards of directors tread a similar line between the benefits and drawbacks of second lien loans. According to industry experts, the vast majority of a company's assets will be used as collateral for first or primary funding. But once the company's debt reaches that point, it becomes difficult to obtain the more favorable rates of primary funding. The primary lenders are concerned that companies with high debt will not be able to make the necessary payments. In making the tough decisions required to restructure a troubled company, the board members may turn to secondary lenders. They may need cash to rebuild operations, to pay off other debt that has come due, or to make dividend payments to stockholders. The lenders also encounter risk when they approve loans based on leftover collateral. Should the company fold, the primary lenders have first dibs on the assets or the proceeds from the sale of the assets. The secondary lender comes next, before unsecured bondholders, trade creditors (such as suppliers), and even stockholders. Because of the risk that most if not all of the company's assets, in case of bankruptcy, will end up with primary lenders, the secondary lenders charge higher interest rates.

To protect their own interests, most senior lenders prohibit borrowers from seeking second lien loans without approval. A separate document, known as an intercreditor agreement or subordination agreement, is made between the two lending institutions. The agreement defines the legal rights for each one and includes language regarding the disposition of assets in case of bankruptcy. For homeowners, the primary mortgage holder will be first in line for the proceeds from the sale of a foreclosed home. The home equity lender will receive payment only if the house sells for more than what was owed to the primary mortgage holder. The homeowner may end up with nothing or in the unenviable position of still owing money to one or both of the creditors.

The popularity of second lien loans for businesses grew significantly in recent years from about a half-billion dollar industry in the year 2002 to approximately $30 billion in 2006. But company boards have learned to be wary. The lenders often turned out to be hedge fund, private equity fund, and distressed debt managers. The motive of some lenders wasn't to receive payment on the debt but to gain control of the company. A provision is some loan agreements required payment to be made in equity (part ownership in the company). By gaining a 51% ownership, the lender could replace the board members and effectively take over the business. There may be good and valid reasons for individuals and boards of directors to apply for second lien loans. But, as in all financial dealings, they have a duty, respectively, to other family members and stockholders to review all provisions very carefully before signing on the dotted line.

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