Philadelphia Reflections

What's a Mezzanine Loan?

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A French word for a balcony, mezzanine is derived from Italian and Latin. In architecture it describes an indoor balcony floor or elevator stop, using up spare space below the high ceiling but above the ground floor of a bank or department store. Evoking this familiar image, mezzanine has become a word to describe things which get shoe-horned into the vertical space between two other things, often as an afterthought.

In the mortgage world, the meaning you want to be careful about is a loan sandwiched between the owner's equity and the first mortgage, potentially leaving it unclear whether the "mezz" is equity or mortgage, but in fact often a warning the property buyer had to borrow to make his down payment. Persuasion efforts at the time of investor re-purchase of a mezzanine loan are apt to focus on the rich double-digit income which would result from everything going well with the loan, falling back on a cheap acquisition price for the real estate in case of a foreclosure. However, mezzanine loans are a comparatively new product, and the full range of consequences are not common knowledge. In the first place, the 2008 wave of foreclosures was not anticipated, so the risk of rich double-digit interest payments was badly underpriced. Even more important, the mezzanine loan seems somehow senior to the first mortgage, but that is meaningful only if the amount recovered from the foreclosure significantly covers the residual of the first mortgage. Even if the total acquisition cost after the foreclosure is a bargain, the big problem in 2009 has proven to be the freezing up of the financial system, with the effect that no one can be certain what the final house value will be, and consequently what the value of the mezzanine loan should be. The resulting bad name that mezzanine financing acquired in this uproar has further frozen the market with fear.

There are other definitions of a mezzanine loan in use, so the first message to investors is to make certain what meaning the term intends in a particular case. If the interest rate was underpriced, the principle of the loan was overpriced. The market will only clear when all parties reach an agreement about the degree of overpricing of the asset, the degree to which the foreclosure recovery fails to cover the first mortgage, and the risk premium needed to cover the uncertainties. Mortgage professionals will eventually puzzle all this out, but until then the existing mezzanine loans will be yet another major obstacle to the recovery of the impaired financial system.

It may or may not be helpful to understand another way of describing this puzzle. A mezzanine mortgage describes 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 held by those who pledge to repay the mezzanine mortgage. Thus, both the first mortgage and this second one can foreclose and receive nominal full value independently, rather than standing in sequence with each other to receive the same pledged asset. In this somewhat legalistic view, the mezzanine is not senior to the first mortgage, but independent of it, holding the owner's equity as security rather than the house. 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. This is the view that emerges from trying to price a layer in the middle by disregarding the bottom of the heap which is hopelessly lost, as well as the top of the heap which is safe and sound. After first slicing away the best grade of mortgages, the residual middle-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 retained a AAA rating, while their stock lost 75% or more of its market value.

Language moves fast on Wall Street, particularly when a new concept needs to be packaged in a sales environment. Within a few months, mezzanine financing in common parlance quickly came to mean Alt-A. And Alt-A came to be defined as a mortgage or a package of mortgages in which the borrower was neither asked his income nor asked to prove it if the matter was challenged. That may not be exactly accurate when referring to any particular security, or package of securitized debt. But in common parlance, Alt-A was the term used when someone described mortgages where the lender knew very little about the borrower.

Having a general sense of the uncertainties, the general reader may perceive why this issue freezes up the market, and someday may be ornamental to explaining it all to one's grandchildren. But that's about all; most people become glassy-eyed, and start to run away.

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Originally published: Thursday, February 14, 2008; most-recently modified: Friday, June 07, 2019