Last week, the Federal Housing Finance Agency (FHFA) approved Freddie Mac’s second-lien program, which offers borrowers a cheaper alternative to cash-out refinancing. We were pleased to see the approval, but the pilot comes with unnecessarily stringent restrictions.
The program will allow borrowers to take out a second mortgage up to an 80 percent loan-to-value (LTV) ratio by allowing borrowers with a low-interest-rate Freddie Mac mortgage to keep their existing mortgage and add a second without refinancing the first. This could lead to lower monthly payments and thus reduce default risk.
The pilot will proceed with a volume limitation of up to $2.5 billion, a pilot duration of 18 months, a maximum loan amount of $78,277, and a 24-month minimum seasoning requirement for the first mortgage. Eligibility will be limited to primary residences. The pilot will help the FHFA determine whether to make the program permanent, make it permanent with restrictions, or disband it. The reevaluation point will be the sooner of 18 months or when the volume reaches the $2.5 billion cap. We anticipate the latter will come first, and the reevaluation will occur well before 18 months has elapsed.
The surprise in this announcement was the low volume limitation. In her statement, FHFA director Sandra Thompson said the low volume cap was, in part, to mitigate concerns about “crowding out” private capital. Evidence suggests these concerns are overblown. The Freddie Mac program will provide a standardized product, which the private market does not, ultimately expanding both markets. We view the low volume cap as a hinderance to developing this product.
Private market second-lien debt is a small share of the total mortgage market
The data show that the private market provides a limited volume of second liens, composed mostly of home equity lines of credit (HELOCs). HELOCs are different from Freddie Mac’s second-lien offering because HELOCs, which are aimed primarily at borrowers with high credit scores, allow a borrower to draw on their line of credit at any time. In contrast, the Freddie Mac product is a closed-end, fully amortizing loan with a maturity up to 20 years.
There is $512 billion in total home equity loans outstanding—a small fraction of total mortgage debt outstanding ($13.1 trillion), total home equity ($31.8 trillion), and the total value of the residential mortgage market ($44.8 trillion). Looking at total home equity as a share of these other funding flows, the number has declined steadily since the financial crisis.
Within the second-lien debt market, depository institutions hold $446 billion on their balance sheets, including $365 billion in funded HELOCs and $81 billion in closed-end second mortgages. This is almost all loans on depository balance sheets, and very little is securitized product. The remaining balance, $66 billion, is held by nondepository investors, both outright and in securitizations, with most held in nonsecuritized form. All these numbers show an increase since 2021, but the amounts are still much lower than in the aftermath of the financial crisis and are on par with the early 2000s, a period with a smaller mortgage market.
The second-lien securitization market has grown tremendously over the past few years, but the activity level remains low even relative to second-lien debt, which is itself a small number. Second-lien securitizations, which include closed-end second mortgages, HELOCs, and home equity investments, totaled $1.7 billion in 2022 and $5.4 billion in 2023. For the first quarter of 2024, origination activity hit $2.7 billion, putting it well ahead of the 2023 pace and potentially on pace for more than $10 billion in securitizations by year end. But even $10 billion a year is small relative to the overall market.
What are the implications of the FHFA approval?
The program will likely increase awareness of second-lien mortgages, which will benefit borrowers, the private market, and Freddie Mac.
Once Freddie Mac borrowers are aware of this product, they can choose between the more flexible private market product or the standardized Freddie Mac product (for those who have a Freddie Mac first mortgage). Some Freddie Mac borrowers who would have otherwise selected a private market second mortgage might move to a standard Freddie Mac second mortgage, but this loss would be more than offset by the overall expansion of the borrower base for second liens.
Our fear is that the low volume cap will affect some lenders’ willingness to offer the product. Partially mitigating this, the FHFA will reevaluate sooner if volume reaches the cap before the 18-month pilot expiration. Importantly, this product offers a powerful avenue to make borrowers aware of the alternative opportunity to tap into their home equity in a high-interest-rate environment instead of using more expensive cash-out refinances.
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