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November 7, 2022 | As mortgage interest rates climb to the highest levels in 25 years, the financial services industry has seen a dramatic increase in demand for adjustable-rate mortgages and second-lien mortgages. Second-lien mortgages are a way for home owners to extract capital from the home without selling the house or disturbing an existing first-lien mortgage loan. But not all second liens are the same and these loans present unique risks for borrowers and investors.
Home equity loans and home equity lines of credit (HELOCs) are common examples of second mortgages. Both products are traditionally issued and retained in portfolio by banks or other end investors. Why? Because a second-lien mortgage is not eligible to be sold into a Ginnie Mae or conventional mortgage-backed security (MBS) issued by Fannie Mae or Freddie Mac. As a result, the secondary market or “take out” for the second mortgage is essentially comprised of banks and cash investors and is thus limited.
Some second mortgages are “open-end” loans, which means that you can continue to take cash out up to the maximum credit amount. As the loan balance is paid down, the obligor can draw principal again up to the maximum loan limit. A bank HELOC is an example of an open-ended loan and is essentially a revolving credit line that is secured by a second lien. But is a HELOC really secured?
Other second-lien mortgage loans are “closed-end,” which means you receive the entire loan amount upfront and cannot redraw principal paid after that time. Most home equity products have a maximum maturity, after which the borrower must repay or refinance the loan. Closed-end mortgage loans are far less popular than HELOCs.
The chart below shows used HELOCs, undrawn HELOCs and also used closed-end second lien mortgages. Notice that drawn HELOCs fell from a peak of almost $700 billion in total assets in 2009 to below $300 billion today. Likewise close-end second liens peaked around 2009 and have fallen to below $50 billion today. The portfolio totals for banks are rising again, but only just because the runoff on older loans is running in high single digits annually.
Source: FDIC
The risk to consumers from HELOCs and other home equity products is that these loans typically charge interest based upon a variable rate market index, thus the monthly cost of the loan will rise and fall with market interest rates. Below is an example of the terms for an open-end second lien from loanDepot (LDI):
“loanDepot.com’s home equity line of credit (HELOC) is an open-end product where a minimum draw amount of the greater of seventy-five percent (75%) of the requested line amount (minus the origination fee) will be drawn at the time of origination. No additional draws may be taken for 90 days following the closing date. As you repay the balance on the line, you may make additional draws during the draw period. If you elect to make an additional draw, the interest rate will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. After the draw period ends, you will no longer be able to obtain credit advances and must pay the outstanding balance over 240 months. During the repayment period, payments will be due monthly. Your minimum monthly payment will equal the greater of (a) $100 or (b) 1/240th of your unpaid outstanding balance at the end of the draw period plus all periodic finance charges that accrued on the outstanding balance during the previous month plus other fees, charges, and costs.”
For lenders, the biggest risk from all mortgage loans is interest rate volatility. As interest rates rise and home prices fall, the "equity" in homes also retreats. Or to put it another way, those low-coupon first and second lien mortgages made during the period of quantitative easing (QE) are likely to be underwater by next year. If the first lien loan on a home purchased in 2021 with 20% down at close is underwater next year, what does that say about second liens?
If a borrower defaults on an underwater first mortgage, the second is likely to be worthless and represent a total loss to the lender and/or investor. The nightmare scenario for a lender is that the value of the house falls 20% from peak price levels, wiping out any visible equity in the first lien loan. The borrower then pulls on the unused credit in the second lien home equity loan (which the bank also owns in portfolio) and files bankruptcy. This is a catastrophic loss that can quickly cause a bank to fail.
The first lien mortgage is likely to cause a modest loss to the lender, but the second-lien is basically unsecured and likely to be a total loss to the bank. The way to understand this risk from a Basel capital perspective is exposure at default or EAD, which measures the risk a bank faces from unused but committed bank lines. The chart below shows exposure at default for all US banks on home equity products. EAD shows unused but committed lines vs used lines as a percentage.
Source: FDIC/WGA LLC
So if the home owner has drawn half of the available credit on a HELOC, for example, the exposure at default or EAD is 100%. This means the bank could lose the total used and unused amount of the home equity line in the event of default. Now you know why so many lenders do not allow unused credit lines, especially for consumers.
As one lender quipped to The Institutional Risk Analyst last week, "there are no net worth requirements for consumers." The old rule in the banking industry is that anything about 50% loan-to-value (LTV) for either consumer or commercial loans is 100% risk exposure through the economic cycle.
As the chart above suggests, US banks currently have record credit risk exposure to holders of home equity lines as a percentage of used lines. As the economy slips into recession and the Fed seeks to drive down inflation and, of necessity, home prices, the credit risk on 1-4 family loans will surge. This growing risk is one reason why the Federal Reserve and other prudential regulators are pushing banks to raise capital and sell 1-4 family loans.
Source: FDIC
Banks are not the only lenders to be concerned about volatility in interest rates, home prices and the resultant credit risk. The GSEs, Fannie Mae and Freddie Mac, are furiously demanding that lenders repurchase performing first-lien mortgage loans because of the reality of credit risk implied by the FOMC’s manic interest rate policies. Simply stated, the GSEs do not have sufficient capital to navigate through a prolonged recession and elevated credit costs.
These loans being put-back by the GSEs are performing loans with no apparent defects, but no matter. The GSEs are trying to force lenders to buy them back before falling home prices inevitably push loan default rates higher. Falling loan volumes, and the requirement to redeem the remaining unsecured corporate debt issued by Fannie Mae and Freddie Mac, could force one or both of the GSEs to seek another government rescue.
And the repurchase event may sink many mortgage banks. One reader noted after the original post:
"Borrower equity is irrelevant when you have an immediate 25 point paper loss on the repurchase of a performing, above water, 3% rate mortgage. Hidden tail risk from contingent liabilities is a far bigger and more insidious threat because of the discount required on the balance sheet for those repurchases. The more volume an IMB did, the more they are exposed."
Depending upon how long the FOMC keeps interest rates elevated and how far home prices fall, the GSEs and banks alike face historic levels of risk c/o the FOMC. And has anyone noticed that GSE credit risk transfer (CRT) deals have been trading at a discount of late? Hmm?
Remember, for bank lenders running at 15:1 leverage or the GSEs with infinite leverage and dwindling capital, it’s all about exposure at default on all types of mortgage loans. For consumers, the FOMC’s reckless policies of manipulating market interest rates presents a huge risk of default on a home mortgage that is underwater. And rapidly falling home prices present the first true credit risk to consumers and lenders alike since the 2008 financial crisis.
Doesn't the triple mandate in the Humphrey-Hawkins law that directs FOMC policy say something about "reasonably stable prices?"
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