Is there a ticking time bomb in the housing market?
During the housing boom, origination of second mortgages surged to historic levels as homeowners sought to take cash out of appreciating homes or finance a home purchase without private mortgage insurance. A large percent of these second mortgages are now poised to reset over the next several years, which will increase monthly payments for many homeowners.
A panel of experts recently convened by the Urban Institute’s Housing Finance Policy Center examined these outstanding second liens. One expert explained that the pending resets are not likely to trigger another significant round of defaults and foreclosures. Another looked closely at the performance of second liens, comparing them to first liens for the same borrowers. A third looked at the behavior of first liens with and without different types of second liens.
The volume of outstanding second mortgages peaked in 2007, at the height of the housing boom, at just over $1.1 trillion. Piggyback loans--second liens that accompany a first lien at signing, also known as “simultaneous seconds”--were a staple of the time, with as many as 45 percent of purchasers in coastal and bubble areas using a piggyback loan to subsidize the down payment on a first mortgage, hoping to eliminate the need for mortgage insurance. These second liens took the form of both home equity lines-of-credit (HELOCs) and closed-end seconds. Second liens taken out after the purchase of a home, or “subsequent second liens,” were also popular from 2005 to 2007 as a way to withdraw equity from a home; most of these took the form of HELOCs.
Since 2007, second liens outstanding have plummeted from $1.1 billion to about $700 million, with prepayments and defaults far outweighing new originations. Total second lien debt, which had surpassed student loan debt and auto debt combined, is now smaller than either. Furthermore, the composition of second mortgages has changed, with closed-end products shrinking more rapidly.
CoreLogic data indicates that HELOCS comprise 84 percent of current outstanding second liens. As CoreLogic’s Sam Khater noted, most HELOCs are interest-only loans with a 10-year reset period. Essentially, the borrower pays the interest only for ten years; at the end of year ten (month 120), the borrower begins paying principal as well, so monthly payments spike. Does this mean the housing market is in for rough times again?
In Khater’s opinion, that’s not likely. While many fear that the 10-year reset could cause a spike in foreclosures, Khater showed that while delinquencies can be expected to spike by 300-700 percent, four factors mean a surge in defaults is unlikely.
- The 25 percent of HELOCs that are were originally taken out as first liens , will be more resilient, as the LTV on the property is apt to be lower;
- Prepayments on HELOCs will likely also spike at the ten-year mark as borrowers anticipating the payment shock pay off or refinance the entire loan;
- We know from past performance that when HELOCs reset, the absolute delinquency rate generally rises to only about six percent, and the balances affected are quite small;
- The economy is improving and negative equity is down, so performance post-reset is likely to improve in the years ahead.
Donghoon Lee of the Federal Reserve Bank of New York, drawing on data a from a paper written with Chris Mayer and Joseph Tracy, echoed this point, showing that while delinquency rates on home equity loans spiked after 2007, these loans tend to perform better than either first liens or closed-end seconds. Lee then compared the performance of first and second liens when both liens are taken out by the same borrower. Using borrowers who had only a first mortgage and a closed-end second, the first and the closed-end second performed very similarly. When looking at borrowers who only had first mortgages and a HELOC, Lee found that the HELOC performs marginally better. He believes this is because the balance on the second lien is so much smaller than the first.
FHFA’s Andrew Leventis’s paper found that if one simply compares first mortgages with piggybacked second liens to those without, mortgages with piggy-backed second liens defaulted more often. Of GSE mortgages with piggyback second liens, those with closed-end seconds performed worse than those with HELOCs. However, he found that if the mortgages with a second lien are compared to a single larger first mortgage with the same amount of equity and the same monthly payment, the presence of the piggyback second has no material effect on outcomes. The results are different for subsequent seconds. Loans with subsequent second liens performed better than other loans from 1996-2002 and again from 2008 on, most likely the result of a signaling effect (only borrowers with strong first-lien performance were able to get subsequent seconds). For loans originated in the 2003-2006 period—the height of the housing boom—Leventis’s results indicated a fundamentally different phenomenon, however; loans with subsequent seconds actually performed worse than other mortgages during that period.
Moderator Leonard Carl Kiefer of Freddie Mac echoed many of these points in his final remarks. While second liens are a significant part of the market, nearly $700 billion as of Q2 2014, external factors, like when the loan was originated and how much total debt the household has, are more important markers of success than the simple fact that a loan is a second lien. As Dr. Lee succinctly noted, ultimately this is “a story about a borrower’s ability to prioritize payments.”
Illustration by Tim Meko, Urban Institute.