What's a Mezzanine?

Mezzanine is a French word for a balcony, derived from Italian and Latin. It is familiar in architecture when it describes a balcony floor or elevator stop, using up spare space below the high ceilings of the ground floor of a bank or department store. Using this familiar image, it has become a word to describe things which get shoe-horned into the space between two other things, often as an after thought.

The word is used in so many different jargons that multiple meanings lead to abuse and confusion. In the mortgage world, two meanings are particularly important to distinguish. Until recently, a mezzanine mortgage only described a second mortgage (by implication, a first mortgage must pre-exist), in which the security for the loan is not the structure being mortgaged, but the ownership shares of the structure which are held by those who pledge to repay the mezzanine mortgage. Thus, both the first mortgage and the second can foreclose and receive nominal full value independently, rather than standing in sequence with each other to receive the same pledged asset. The legal process of foreclosure is facilitated, even though the recovery may not differ much.

In recent years, however, the term has also been used to describe a second round of tranches in a securitized pool of mortgages. After first slicing away the best grade of mortgages, the residual lesser-grade bundle still contains differing levels of risk, and the top grade of a second sorting process can be skimmed off as enough better than the rest to qualify as value overlooked. When this salvaged subgroup is then insured by a ("monoline") insurance company which itself has a AAA rating, it can be claimed the salvaged bundle has effectively upgraded from, say, AA to AAA. Obviously, the validity of this financial alchemy depends on accurately down-grading the dross left behind. The most important misjudgment in this mezzanine process however was the unexpected undermining of market opinion about the insurance companies standing behind it. Many of them retain a AAA rating, but their stock lost 75% or more of its market value.

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