Second Liens and the Leverage Option
This Article demonstrates that the housing bubble was driven by second mortgages to a much greater extent than previously appreciated. A unique feature of American law allows homeowners to take out second mortgages, without the consent or even knowledge of the first mortgage lender. The result is an underpricing and overextension of credit as first mortgage lenders cannot control or properly price for the risks created by second mortgages.
Homeowners’ unilateral right to encumber their properties with additional mortgage loans creates what we term the “leverage option” that is embedded in American mortgages. The leverage option is an unintended consequence of a federal law enacted to deal with seller financing arrangements that prevailed during the inflationary economy of the 1970s. The leverage option was of little importance until the housing bubble in the 2000s, as homeowners massively increased their leverage using second mortgages, often unbeknownst to first mortgage lenders, who were unable to price for the risk created by second mortgages on their collateral or for the risk of a credit-fueled asset price bubble.
This Article demonstrates the problems that the leverage option causes for lenders, for homeowners (who pay for it, regardless of whether they want it), for regulators, and for the economy at large. We propose a discrete legal change that will convert the leverage option from being a mandatory, embedded option to a bargained-for, unembedded option that will enable efficient pricing and force the information about total mortgage market leverage that is necessary for macroprudential financial stability regulation.
Adam J. Levitin
Professor of Law, Georgetown University Law Center. This article has benefitted from a presentation at the Georgetown Law faculty workshop as well as from comments from John Brooks, Natania Locke, Michelle Kelly-Louw, and David Vladeck, and from research assistance by Mabel Shaw.
Susan M. Wachter
Sussman Professor of Real Estate and Professor of Finance, The Wharton School, University of Pennsylvania. Dr. Wachter acknowledges assistance from the Research Sponsors Program of the Zell/Lurie Real Estate Center at The Wharton School of the University of Pennsylvania.