By the Numbers
Deconstructing faster closed-end second lien speeds
This material is a Marketing Communication and does not constitute Independent Investment Research.
Prepayment speeds on closed-end second lien loans are on the rise and there are a few notable factors driving the increase. More aggressive refinancing of de-levered loans, migration patterns and turnover out of New York and a broad-based increase in speeds on larger second liens look to be the primary drivers. Faster prepayment assumptions look likely to flow through to residual valuations on these deals. And the combination of more conservative equity valuations coupled with higher rates and the drop in loan prices may impair securitization economics.
Prepayments across second liens, and more specifically closed-end second liens (CES), are notably faster than prior observations. Comparing prepayment S-curves constructed using two years of observations from 2023 through 2025 and 2024 through 2026 show that at-the-money speeds on closed-end second liens are roughly 3 CPR faster in the more recent observation (Exhibit 1).
Exhibit 1: At-the-money speeds on CES have increased
Source: Santander US Capital Markets, CoreLogic LP
Both in-and out-of-the-money observations have sped up too. Loans with 75 bp or more of incentive prepay 5 CPR faster in the latter observation. And loans with 100 bp of negative incentive have prepaid 5 CPR faster as well. So, while S-curves remain relatively flat for the cohort, investors should recalibrate baseline assumptions higher to account for the new normal in empirical speeds.
Digging in on the drivers of faster speeds…
Comparing the sets of observations, one stark difference is the disparity in prepayment rates on loans that have seen substantial deleveraging since origination. Looking at a subset of closed-end second liens, whose combined LTVs were at least 80 at origination, prepayment speeds are notably faster in the latter observation on loans with lower mark-to-market cLTVs. Loans that have experienced 10 to 20 points of equity appreciation since origination have seen at-the-money prepayment rates rise from 20 CPR at-the-money to 35 CPR (Exhibit 2).
Based on indicative originator rate sheets, this deleveraging could create anywhere from 150 to 200 bp of rate incentive based on SATO alone, independent of any move in primary mortgage rates. And that type of incentive likely leaves these loans ripe for cross-servicer refinancing. As more large originators expand their second lien origination capacity against the backdrop of relatively moribund first lien originations, this type of SATO-based refinancing looks likely to remain elevated.
Exhibit 2: At-the-money speeds have increased on CES loans with substantial equity
Source: Santander US Capital Markets, CoreLogic LP
New York, New York?
Another driver of faster speeds is a noticeable uptick in at-the-money prepayment rates on New York based loans. At-the-money speeds on NY-based second liens have risen by 5 CPR in more recent observations. While this rise may attributable to refinancing activity, another plausible explanation is the continued and growing migration trend out of New York, and subsequent rising rates of turnover. Higher rates of turnover may be intrastate, as borrowers move out of the city into the suburbs, or out of state to places like Florida and Texas where job opportunities in traditionally New York-centric industries are on the rise. Interestingly, the fastest at-the-money speeds are observed in higher balance second liens, ostensibly to more affluent borrowers with greater mobility (Exhibits 3&4).
Exhibit 3 & 4: At-the-money speeds rise on NY-based second liens
Source: Santander US Capital Markets, CoreLogic LP
These drivers, along with others, have pushed broad-based prepayments across the sector higher. Cutting the cohort by loan size, then looking at the delta in prepayment rates across the two observation datasets for each degree of moneyness shows that second liens with modestly larger balances are experiencing the biggest increase in prepayment rates (Exhibit 5). At-the-money speeds on second liens with original balances between $100,000 and $200,000 have risen by 3 CPR with even faster speeds when those loans are both 100 bp in- and out-of-the-money. The relative increase in prepayments on larger loans may be explained in part or whole by growing cross servicer refinancing activity, where fixed costs in re-underwriting the borrower are higher for a new originator, driving their focus to higher balance loans.
Exhibit 5: Comparing changes in prepayments by second lien balance
Source: Santander US Capital Markets, CoreLogic LP
Implications for valuation
Investors in the investment grade portion of the debt stack are likely fairly agnostic to these faster speeds given those bonds are par priced at issuance and faster speeds, to the positive, will build credit enhancement as the current pay ‘AAA’ bonds are paid down. Investors farther down the debt stack likely welcome these faster speeds as growing levels of credit enhancement should tighten spreads on these longer spread duration bonds as they become candidates for potential upgrades. The most meaningful impact to valuations will be felt by the equity or residual classes of these deals. The equity classes of these deals are comprised of the remaining interest cash flow generated by the net WAC of the collateral remaining after the interest on the debt has been paid. And this interest is subordinated at the bottom of the capital structure to insulate debt holders against future principal losses or interest shortfalls. As a result, these cash flows are effectively credit sensitive, interest-only instruments, and small changes to both assumed and empirical prepayments can have material impacts on their rates of return. As equity investors restrike their prepayment expectations on these cash flows higher, their values will decline, likely impairing economics for sponsors to some extent.
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