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Using 2nd Mortgage to Serve Customers: A-B Structure  
key words: A-B Structure, Loan Pricing, conforming loans, Market Loan Pricing Matrix, 2nd Mortgage  
THC Asset-Liability Management (ALM) Insight  
Issue 6  
Community banks serve their communities by focusing on customers’ needs based on each banks’ core competencies.  
But customers’ needs can be diverse. How can a community bank keep their customers when the loan’s size, LTV, FICO  
or other characteristics exceeds the lending policy? This Insight #6 explains.  
In previous issues, I have discussed the measures of your Risk Capacity, which is then used to enhance profitability by  
applying the Fund Transfer Pricing (FTP) approach. As FTP illustrates, the profitability is driven primarily by your loan  
volume and pricing. My last Insight issue outlined an optimal strategy in selling loans to the Agencies. This issue  
continues this discussion by leveraging participations and 2nd mortgages to keep banks’ customers.  
Overview  
Our bank clients often receive mortgage applications for low FICO score borrowers and/or requests to  
originate high LTV loans. These customers may be turned away due to stringent underwriting standards as  
such loans cannot be kept in the loan portfolio or sold to the Agencies. When high LTV loans are originated,  
the bank will often times require the borrower to purchase expensive mortgage insurance.  
However, banks can split the loan into 1st and 2nd mortgages, called the A-B structure. The bank may:  
a) Keep the 1st mortgage which would meet the usual policy guidelines of the bank. The bank may  
then sell the remaining part of the loan as a 2nd mortgage to other investors.  
b) Sell the 1st mortgage and keep the 2nd mortgage. While the 2nd mortgage is used as credit  
enhancement of the 1st mortgage, community banks tend to have limited distribution of their loans. Fannie  
Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corp), and Federal  
Home Loan Banks (the Government-Sponsored Enterprises) tend to have strict investor guidelines. Capital  
market investors, such as hedge funds, tend to require assets with relatively high yields to compensate for  
credit risk.  
Today, community banks can gain access to a broad pool of potential buyers ranging from community banks,  
credit unions, and portfolio managers. The Loan Pricing Matrix provides a local market intelligence,  
suggesting the rate for different levels of risk (e.g. CLTV and FICO) offered by potential investors. This  
intelligence allows our bank clients to structure their 1st and 2nd loan packages accordingly. For example,  
based on the investor market rate, the bank may adjust the optimal credit enhancement ratio and the 2nd  
mortgage outstanding balance compared to that of the first position loan. (May be helpful to have a specific  
example, just a thought).  
A-B Structure  a Description  
THC models can effectively value 1st and 2nd mortgages, using offer rates as inputs. The bank can work  
with other banks and the loan market to determine the credit enhancement ratio and disseminate the  
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investment opportunities to potential buyers. The bank can identify potential buyers, leveraging  
proprietary database intelligence, which include loan prices, historical loan rate trends, and risk measures.  
The issuing bank and potential buyers can utilize risk analysis reports to meet ALCO requirements. Loan  
transactions between buyers and sellers are straightforward – single loan, 1st mortgage (the “A  
component”), or 2nd mortgage loans (the “B component”).  
Loan Pricing Matrix used in the A-B Structure  
To originate loans that exceed the loan policy limits to customers, ALCO may partner with another lender,  
work with correspondent banks, or with a loan market. In accessing available offer rates of different loan  
types, ALCO should monitor the market offer rates for a specific loan type from multiple sources of loan  
investors including Government-Sponsored Enterprises (GSE), correspondent banks, and investors.  
These rates can be monitored in the Loan Pricing Matrices, which are provided by the THC Loan Central where  
buyers and sellers negotiated loan transactions within the THC Network. An example is given below is based  
on Fannie Mae LLPA pricing of credit risk. As discussed in Insight 5, LLPA pricing of credit exposure may not  
be consistent with capital market pricing. Therefore, ALCO can use the appropriate Loan Pricing Matrix to  
determine the A-B Structure depending on the buyer of the loans. If ALCO is considering selling the A  
component to the Agency, then the Fannie Mae LLPA Loan Pricing Matrix should be used to determine the  
rate of the B component.  
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Source: THC Loan Central  
ALCO and loan officers can use indicative rates to determine the optimal sizes and rates of the 1st mortgage  
and 2nd mortgage, the A-B Structure. A loan valuation model is used to ensure that the combined interest  
cost and principal payments are equal to the loan that the customer initially sought.  
Case 1. Low Credit Borrower  
The numerical example below uses a range of FICO scores to illustrate the risk and return of the 1st and 2nd  
mortgages. A customer comes into the office and applies for a loan. The loan is a 30-year fixed rate 1-4 family  
mortgage. The owner’s property is located in a reasonably priced neighborhood and the customer is a long-  
time resident in the community. The property has recently appraised at $137,500. He is looking to finance  
$110,000, with an LTV just meeting the loan policy guideline. However, for lack of sufficient credit history,  
the FICO sore is below 700.  
The bank considers the borrower a good customer that can develop a long-term relationship and does not  
want the customer to borrow from another bank, two blocks away. The bank is considering originating a 1st  
mortgage with a lower LTV to compensate for the lower FICO score. ALCO would buy a loan with a lower LTV  
to compensate for the lower credit score. The bank can then sell the 2nd mortgage to investors that seek  
higher yields. The rate can be obtained from the Market Loan Pricing Matrix, as explained above.  
The table below illustrates how yields are affected by risk-based pricing of second mortgages, providing  
investors with a higher return opportunity. The 2nd mortgage may be appropriate for investors looking for  
high yielding assets, or the 1st mortgage can be sold at a price acceptable to buyers and sellers. The credit  
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enhancement ratio can be adjusted to fit both the buyer and seller requirements to determine the  
appropriate level efficiently. In the event the FICO score does not correctly reflect the borrower’s credit  
quality, with compensating factors in the borrowers file (i.e., contesting letter as a result of a divorce, identity  
theft, etc.), the bank’s CFO may simulate multiple credit score scenarios, 650, 680 and 690. The CFO may  
subsequently estimate the appropriate loan rate for the 1st and 2nd mortgages.  
The results are provided below  
FICO  
Scores  
690  
650  
680  
Balance  
4.260% 4.040%  
3.640% 3.640%  
5.190% 4.640%  
Borrower’s need  
1st Mortgage  
2nd Mortgage  
$110,000  
$ 66,000  
$ 44,000  
4.680%  
3.640%  
6.240%  
The CFO proceeds to originate the 1st mortgage of $66,000 at 3.64% and the 2nd mortgage of $44,000 at  
4.640% (690 FICO). The 1st mortgage is kept on the balance sheet and the 2nd mortgage is sold to an investor.  
The customer receives a loan of $110,000 in total at an average loan rate of 4.040%. Most important of all,  
the bank keeps the customer.  
Case 2. A Borrower with High LTV  
Example Bank is a $500 million total asset community bank in a 200,000-population town in Iowa. The bank  
has served the community for over 80 years and is an important institution of the community. Today, a long-  
time customer would like to finance an investment property in the amount of $250,000. The appraised value  
is $278,000, and the borrower would like to lock in a rate, as he is concerned with the rising interest rates.  
He is looking for a 30-year fixed rate mortgage loan. The CFO knows the customer well and strongly believes  
that the customer has good credit. However, considering the high LTV ratio along with the significant size,  
ALCO is hesitant to keep such a loan on the balance sheet.  
The CFO then considers two scenarios. The bank can originate a 1st mortgage of $200,000 or $175,000 in  
scenarios 1 and 2, respectively. Based on the market rates and the Loan Pricing Matrix, illustrated above, and  
the A-B Structuring calculation, the 1st mortgage rates would be 5.516% and 5.125% respectively. Given the  
1st Mortgage rate, the 2nd Mortgage rates would be 8.762% and 8.593% for the two scenarios. By lowering  
the LTV, he can sell the 1st mortgage to a correspondent bank, while the bank can keep the 2nd mortgage  
on the balance sheet.  
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Example Bank uses the 2nd mortgage methodology, assisted with a risk-adjusted margin approach, to keep  
the customer and at the same time, receive the yields that compensate for higher credit risk.  
Benefits of the A-B Loan Strategy  
Avoid Turning Customers Away  
This pricing/structuring model can be very useful to banks, particularly if they knew upfront that the 2nd  
mortgage could be sold. Many banks are reluctant to make high LTV loans due to regulatory capital  
requirements and exam scrutiny, as well as the higher default risk. Retaining only the 1st mortgage is  
desirable for risk adverse banks seeking to preserve capital.  
Minimize regulatory risks with current market practices  
Splitting the loan request into a first and a second mortgage to avoid mortgage insurance is a common  
practice in the origination industry. Often a lender will originate a conforming first and a second, sell the first  
to Fannie/Freddie and keep the second on their balance sheet. The borrower would receive two loans. A-B  
Structure simply extends this concept to using a flexible credit enhancement ratio, 2nd mortgage to the  
combined mortgage, such that the bank can retain the 1st mortgage and sell the 2nd mortgage to achieve  
optimality by seeking potential buyers from more diverse investor pool. (long sentence).  
Impose minimal operational changes  
CFOs, chief lending officers and legal counsel often work together in determining optimal product offerings.  
This includes implementing a A-B Structure. Leveraging current ALM risk models and technologies, the bank  
would only have to decide whether they want to service the loan or not.  
Skin in the Game  
One benefit of the bank servicing both the 1st and 2nd liens is that a default on the 2nd may be an early  
warning sign of impending trouble for the 1st mortgage. Arrangements can also be made so that the  
originator shares part of the credit risk.  
Flexible Strategies  
Retaining servicing on a 2nd mortgage that has been sold would require the bank to set up a servicing asset,  
and properly account for the servicing asset over time. Some banks may simply prefer to sell it servicing  
released. The Market Loan Rate Matrix can assist in structuring the transaction with servicing released or  
retained.  
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Transparency  
A bank may ask if the 2nd mortgage could be sold individually as they are originated or if they need to be  
sold as a package of loans. The investor may impose requirements such as minimum loan size and geography  
restrictions as well as posting price levels they are willing to pay. A bank would want to know such  
requirements in advance to avoid being required to hold the 2nd mortgage. The Market Loan Rate Matrix  
can indicate such transactional information, offering transparency for participants.  
Increase Product Offerings  
A-B Structure can be useful for both residential and commercial real estate loans. The model can be extended  
to jumbo loans, which is common in a loan participation.  
Conclusions  
Using 2nd mortgage, banks can expand the offerings of loans to customers by leveraging the GSEs and other  
investors willing to participate. This A-B structure enables ALCO to originate loans and keep customers.  
I welcome your comments.  
Regards,  
Tom Ho PhD  
President  
1-212-732-2878  
About THC  
THC is a financial technology company founded by Dr. Thomas Ho, a former professor at New York  
University, who introduced the first balance sheet valuation (Ho-Lee model 1986) called "option model" by  
regulators and key rate durations (1992), one of the most popular interest rate risk measures.  
THC was selected as the sole provider of the risk reporting to all regulated institutions under a federal bank  
regulator. THC continues to dedicate its research and resources to supporting community banks.  
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