Where Asset Liability Management and Transactions Meet
a newtwork of opportunties
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
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.
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
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