You have to hand it to the Federal government, they are always working to solve problems that do not exist. Currently there is a new proposal from the federal government (via Freddie Mac) to insure second mortgages/home equity lines of credit similar to first mortgages. Why is the government now getting involved in second mortgages when banks already offer this product? What does this change mean for the mortgage market? Is this a good idea for the real estate industry?
What is in the Freddie Mac proposal
Freddie Mac proposes to purchase certain closed-end second mortgage loans from
primary market lenders who are approved to sell mortgage loans to Freddie Mac
(Sellers). In a closed-end second mortgage loan, the borrower’s funds are fully disbursed
when the loan closes, the borrower repays over a set time schedule, and the mortgage is
recorded in a junior lien position in the land records. Freddie Mac has indicated that the
primary goal of this proposed new product is to provide borrowers a lower cost
alternative to a cash-out refinance in higher interest rate environments
Why is the government getting into second mortgages
What impact will this proposal have on the existing market for Helocs/2nds?
Currently there is a robust market for second mortgages and Home equity lines of credit. Basically every bank offers this product to very well qualified borrowers. Banks are careful with their HELOC lending as they understand the data above and the high risk of second mortgages. Furthermore today most second mortgages are held in a banks portfolio so they are very strict on their underwriting as at the end of the day they hold the bag
What is the risk for insuring second mortgages
I always find it puzzling that our federal government has a knack for rolling out new products at the very top of the market. In this case, residential real estate has peaked or is very close to peaking with the only movement left is down. We will see falling house prices in the near future which will make second mortgages even more risky. Furthermore, the underwriting by Freddie Mac will likely be considerably more generous than the local banks that have to portfolio the loan.
The shear increased number of new second mortgages will increase the number of defaults especially in a declining market. Remember second mortgages are subordinate to the first mortgage so regardless of which one defaults the first mortgage gets paid as suspected first. This will lead in many cases to the elimination of all value in the second mortgage. We saw this in 2008 and will see it again. Below is a proforma explaining in numbers what actually happens.
In this case I assume a 15% drop in value and a default on the first mortgage. As you can see the second mortgage is basically 100% wiped out in this scenario (maybe salvage 7k or so which likely would just be eaten up by attorney fees in a foreclosure). As Freddie Mac gives second mortgages out like candy the downside risk is huge.
Furthermore, I have seen first hand in the last downturn that the number one determination of default is equity, as more borrowers load up on second mortgages as they are easier to get and backed by the government the number of defaults will greatly increase.
4 implications of government insuring second mortgages
There are costs to everything in economics as it is a zero-sum game. It is not like there is a money tree that you shake. Eventually every program must be funded, and someone must take the risk. In this case the federal government and ultimately taxpayers are on the hook. Here are the top five implications of the government insuring second mortgages.
- Moral hazard issue: House becomes a much easier to tap piggy bank: houses are meant to be lived in not as a piggy bank, by increasing second loans, the government is encouraging borrowing on your house like a credit card which will ultimately end badly
- Banks will gladly pass on the risk to taxpayers: More banks will exit from lending on seconds/Helocs as it is much safer and more profitable to pass on these risks just like they do with a conventional first mortgage.
- Lead to more defaults on mortgages: The higher the leverage the higher the probably of default. Equity above any other metric determines whether a lender ultimately gets repaid. As more equity is stripped out of houses, more defaults will occur.
- Taxpayers on the hook for big losses: At the end of the day, just as we saw in 2008, taxpayers bailed out Fannie and Freddie as we are the guarantors of the debt if it goes bad. This proposal will likely add billions more to the federal deficit.
Summary
Freddie Mac/taxpayers insuring second mortgages is a terrible idea that will have long term consequences on the mortgage market. There is a reason that banks are so cautious about second mortgages and charge a premium; there is huge risk of default. As the example above shows, there is almost a 100% probability of a large loss on a second mortgage if the first mortgage defaults. We have seen this in every single real estate cycle and this cycle will be no different. This proposal will lead to billions in losses to taxpayers and a burgeoning federal deficit with very little reward.
The proposal is designed to save borrowers money on second mortgages but at the end of the day all these savings will be for naught as foreclosures increase due to higher leverage. Unfortunately like many of the recent government rules, this will likely pass and ultimately have devastating consequences for both homeowners and taxpayers.
Additional Reading/Resources:
- https://www.bloomberg.com/news/articles/2024-04-17/freddie-mac-seeks-to-back-home-equity-loans-as-refi-costs-rise?srnd=homepage-americas
- https://www.fhfa.gov/SupervisionRegulation/Rules/RuleDocuments/FRE%20Closed-End%20Second%20Liens%20Notice%20for%20Web.pdf
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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