Fears about Freddie second lien program overblown, analyst says

Contrary to the fears of opponents, the Freddie Mac second lien purchase proposal will not lead to the extraction of large amounts of borrower home equity, Keefe, Bruyette & Woods analyst Bose George opined.

The program also doesn't qualify as mission creep because the government sponsored enterprises' charters permit the purchase of second lien loans, he said.

In the current environment, cash-out refinancings — the product most impacted by this proposal — are more expensive for borrowers because they would significantly boost the interest rate on their monthly payment.

"Second liens should be better for these borrowers and for Freddie Mac's credit as the combined monthly cash flow for these borrowers should be lower than if they were to do a cash-out refinance," George said. "Some of the opposition to this proposal is based on the expectation that it could result in large amounts ($1-$2 trillion) of equity extraction."

But George was not worried because the program is aimed at prime, if not "super prime," borrowers whose loans with significant equity are already owned by Freddie Mac.

The ratio of home equity loans to total mortgage debt outstanding is at a historic low, George noted.

The $512 billion in outstanding home equity loans as of the fourth quarter of 2023 represents roughly 3.7% of total mortgage debt outstanding, roughly $14 trillion. Of that $512 billion, $400 billion, or 78%, is held by banks.

"As a result, we do not believe that a large percentage of the cohort of borrowers this new rule is trying to serve (borrowers with a first lien guaranteed by the GSEs) is likely to be accessing a home equity product elsewhere," he said.

In comparison, back in 2000, $408 billion in outstanding home equity loans equated to 8% of mortgage debt. George noted home equity lending did peak at $1.1 trillion or 10.2% of mortgage debt outstanding in 2006, but KBW believes this was an artificially inflated number because of piggyback seconds used to help buyers purchase homes during the boom period of the mid-2000s.

On the other hand, Christopher Whalen, the chairman of Whalen Global Advisors who writes a column for National Mortgage News, said his firm sent in a comment letter on the proposal, declaring "We worry that using a government guarantee to lure consumers who cannot do business with a bank is bad policy."

The comment period expired on May 22, with a total of 150 letters submitted, George said.

His report noted the opposition from banks and securitization industry is on the grounds that this program does not fill an unmet need.

The proposal will crowd out private capital and expand the GSEs' footprint; therefore, it should be rejected, the letter from the Structured Finance Agency said.

If the government were to go ahead, the FHFA should establish aggregate limits on program size, establish second lien loan balance limits and limit it only to owner-occupied properties.

"We strongly recommend that the FHFA reject Freddie Mac's proposed new product for the benefit of consumers and the marketplace," said Michael Bright, CEO of the Structured Finance Association, in a press release. "The proposed product simply isn't one that the government should or needs to be involved in."

A report from Kroll Bond Rating Agency noted concern that the private-label securities market will be affected by adverse selection, with the GSEs (it assumes Fannie Mae could also enter this business) taking the best credits as well as being left with the open-end home equity product.

Another group on the capital markets side of the business, the Securities Industry and Financial Markets Association, also weighed in against the proposal.

"In short, SIFMA believes: There is no market failure that the GSEs are best positioned to rectify; The focus of GSE activity should remain closer to their mission; just because they can do something doesn't mean they should; and The proposal lacks adequate detail and analysis to understand the potential size, scale and impacts of the proposed program," its letter, signed by Christopher Killian, managing director, securitization and credit, read.

SIFMA agrees that the GSEs charters let Freddie Mac (along with its counterpart Fannie Mae) purchase second lien mortgages, but added that it is not the best use of their capital and their focus.

The Housing Policy Council, whose president, Ed DeMarco, is the former acting director of the FHFA, also came out in opposition, "based upon our fundamental view that it is not necessary for a GSE to use its special status to offer a product that already is available in the private market.

"In particular, the proposed product would introduce a GSE competitor, with all of its charter advantages, into a market well served by a large number of private sector entities."

The American Bankers Association pointed to the Financial Stability Oversight Council report claiming risks to the nation's financial stability from non-bank mortgage servicers and originators, which are the likely providers of this product given they would now have a secondary market outlet.

"The urgent FSOC concerns outlined in this report — that vulnerabilities could amplify shocks to the mortgage market and pose risks to financial stability — are not at all discussed, nor apparently considered, by FHFA's request for input," the ABA comment, signed by Joseph Pigg, senior vice president, mortgage finance, said.

The ABA also questioned whether it was appropriate to consider this product while Freddie Mac is still in conservatorship and lacks sufficient capital to exit.

Much like the Mortgage Bankers Association, which urged caution about the proposal, the ABA and the U.S. Mortgage Insurers in their own comment letters, also argued that the FHFA needed to provide more information about the specifics of the program.

"After careful consideration, this product should be disapproved, as it does not align with Freddie Mac's statutory mission, creates additional risk, is duplicative of an already active private market, and raises important, unanswered questions," said USMI President Seth Appleton in a press release. "USMI remains committed to housing finance policies that enable low down payment borrowers to affordably and sustainably achieve homeownership, while protecting taxpayers from undue credit risk."

If FHFA were to approve the program, it needs to limit it to borrowers with original loan-to-value ratios of 80% or lower and require a full appraisal of the property. That would mean the borrowers did not have private mortgage insurance as a credit enhancement so a GSE would purchase the loan.

"USMI urges FHFA to consider applying guardrails, including debt-to-income limitations, allowable maximums, and an exclusion for 'piggyback loans,'" the organization said. A piggyback loan is a second mortgage taken out by the borrower in order to avoid the need for PMI; this form of borrowing was cited as one of the causes of the financial crisis.

The regulator also needed to clarify, if the program is approved, whether it would be subject to additional notice and comment periods, USMI said.  

George disagreed with many of those premises.

"Our view is that while banks do provide the product, they are primarily providing it to the high end of the market," the KBW analyst said. "While private label activity has picked up in 2023 and 2024, private label issuance is subject to market conditions and during periods of market volatility, volumes could dry up."

As for the USMI position, George agrees with its point that borrowers whose original mortgage started at an LTV above 80% are a higher risk cohort.

"However, a related concern could be that this could potentially trigger MI cancellations from borrowers who started with an LTV above 80% and now will get an appraisal as part of the process of obtaining a second mortgage and realize they no longer need mortgage insurance," George said.

Not all depository groups oppose the proposition. America's Credit Unions, the new name of the merged Credit Union National Association and the National Association of Federally-insured Credit Unions, came out in support, saying it advances the GSE's public mission.

But it also urged caution. "We wish to stress that it is important consumers use this process thoughtfully and refrain from exposing themselves to delinquency or default by withdrawing the balance of their savings," wrote Amanda Smith, senior regulatory affairs council.

"We further believe that Freddie Mac should tailor its product to interact smoothly with the underwriting process and be scalable to higher amounts," she added. "We also recommend Freddie Mac consider the level of credit risk and the role of loan level pricing adjustments when designing its final product."