Why the bank won't let you have a second mortgage

Most banks have long memories and it’s those past experiences, which in all probability resulted in the writing off of a bad debt, that tend to have a strong influence on the executives responsible for writing the banks lending policy.

One such area of contention is the issuing of second mortgages and in most cases the approach by banks is consistent, driven by those past bad experiences.

So while there are sound arguments as to why it might actually be in the banks interest to allow a second mortgage, most credit/risk manager default to a position that will not impact on their security position and it takes some very careful negotiations to convince them to do otherwise. So lets look at the reasons why they have those concerns.

THE BANK DOES NOT THINK THE DEVELOPER HAS ENOUGH MONEY – as the saying goes “If you want it they won’t give it to you and if you don’t want it they throw it at you”. It is true in most regards, that when considering a project a bank wants to be working with a sponsor who has the ability to invest the full equity requirement, also referred to as ‘skin in the game’, and a capacity write a cheque in the event of any unforseen cost overruns.

However, many smart sponsors choose to use Other People’s Money (OPM), usually so that they can get the best return on their funds by investing across multiple opportunities. So it is very important that the financial strength and experience of the sponsor can be demonstrated to the bank even if it is not all to be committed to the project in question.

Utilising second mortgage funding in order to expand the number of projects they can undertake is a smart way for a sponsor to leverage their return on equity provided they can show an ability to meet any unforseen financial pressures along the way. It is critical to give the bank a clear understanding of why the second mortgage funding is being used but also provide statements of position, group cash flows and approved standby arrangements to support the sponsor’s ability to meet their ongoing commitments to the project in question.

THE BANK DOES NOT WANT ANY POTENTIAL IMPEDIMENTS TO IT REALISING ON ITS SECURITY – In the event that things go wrong during a development, the bank will in most instances look to recover its exposure by disposing of the security via a quick sale rather than undertaking a lengthy workout. Even in the case of a development project, banks do not want to ‘take control’ of a project unless absolutely necessary and will usually appoint a receiver or administrator to undertake the exercise of completing the development and sale as soon as practicable with the minimum of additional expenditure.

Their concern is that where there is a second mortgage in place (and dependant on the terms of any priority agreement in place), the potential exists for that mortgagee to frustrate the actions of the bank by arguing that those actions prejudice their security position. Alternatively, while there may be no default or cause for action on the banks part, the second mortgagee may decide to take action under its securities which forces the banks hand to either take its own action in priority to the second mortgage or pay out the second mortgagee in order to gain full control. Both of these scenarios played out during the GFC and previous market corrections, continuing to make all banks hesitant about transactions involving second mortgages.

One way to address these issues is to have a reputable second mortgage provider who the banks are comfortable with and trust not to take any extreme actions during the life of the project. Additionally, the banks will require the second mortgagee to sign a priority agreement which in effect cedes allof its rights to the first mortgagee while its debt exists, effectively preventing the second mortgagee taking any action that the first mortgagee does not want to occur.

DEVELOPERS SKIN IN THE GAME – As previously mentioned, all financiers, be they first or second mortgage providers want to see that the developer has an appropriate amount of their own “risk” money in the project – the view being that the developer will be more likely to act in the right way if they have an appropriate amount of their own cash at risk in the project. The current view is that the developer must be providing at least 10% of the required capital stack in a project.

In the eyes of the banks, this is a different risk to having a capacity to meet your obligations as detailed previously. This is about ensuring that the customer is motivated to act quickly to deal with a problem that requires either financial or physical action when it occurs and their concern is that if the equity at risk is sourced via a second mortgage provider then:

There is less motivation for the sponsor to take the required action and they have no power to require the second mortgagee to act or input further equity.

In fact it is often the case that the second mortgagee is a passive syndicate of investors with limited ability to raise additional funds or make quick decisive decisions which leaves the bank having to deal with the problems associated with the projects but also having to be conscious of not acting in a way which is prejudicial to the interest of those investors which is a complication they do not relish.

In summary, banks tend to view all second mortgages as complicating transactions rather than adding value as their interests are not always aligned with those of the borrower and it is therefore a negotiating exercise that requires a complete understanding of the interests of both sides. At HoldenCAPITAL we are often required to obtain a senior banks consent to a second mortgagee position in order to get the best outcome for our client. We do this by clearly demonstrating the positives that the structure brings to the transaction and how the risks will be dealt with.