Lenders Could Use Second Mortgages to Counteract Marketplace Entrants

The second mortgage is on its way back, and some lenders could have an advantage in the competition for the piggyback loan business.

Second mortgages fell out of favor in the wake of the financial crisis, but second liens have been making a comeback since at least 2014. As conditions for the loans have strengthened over the last year, with home prices increasing and negative home equity rates decreasing, originators that do both consumer and mortgage loans could have the upper hand in tapping that market.

"They're used to dealing with a lot of rules about the dos and don'ts of originating," said Larry Penn, chief executive of Ellington Financial, speaking Wednesday at an investor conference in New York. Originators can also have an advantage because of their relationships with homeowners, Penn said, and a lot of the consumer loan products that are hot right now, such as home improvement loans and debt consolidation, make sense for homeowners.

For originators, the resurgence of second mortgages could be arriving at an opportune time. Since the financial crisis, online marketplace lenders — also known as peer-to-peer or platform lenders — have emerged and grown rapidly by offering consumer loans. Those loans have been attractive to consumers and investors alike: Ellington Financial has diversified in recent years and now 22% of its long credit assets are consumer debt.

"Consumer credit risk is good risk to take right now," said Mark Tecotzky, Ellington’s co-chief investment officer, comparing consumer debt to corporate debt. He attributed Ellington's positive outlook on consumer debt risk to the impact of post-crisis regulations, which have forced consumers to pay down debts and borrow less. Meanwhile, he said there has been "tremendous growth in corporate debt," and corporate loans have featured weaker covenants, making that debt more risky for investors.

Now, marketplace lenders are ramping up their offerings in the mortgage market. In May, marketplace lender Social Finance's mortgage subsidiary, SoFi Lending Corp., gained Fannie Mae approval as a seller/servicer, having offered non-qualified mortgage jumbo loans since October 2014.

Diving into second mortgages could serve as a way for originators to claw back some of the ground lost to consumer lenders. According to Tecotzky, the foundation for a second-mortgage renaissance is starting to take shape.

Tecotzky pointed to the rise in home prices as one factor predicating the resurgence in piggyback mortgages. Home prices are less than 4% below their 2006 peak and have risen more than 1% in the past year, according to the most recent Home Price Index from Black Knight Financial Services.

The negative equity situation is also improving. Black Knight reported in April that the negative equity rate was at 6.5% at the end of 2015 versus 9.4% one year earlier. And much of that negative equity concentrated in the lowest-price tier, representing the bottom 20% of homes by price.

From the borrower's perspective, a second mortgage can make more fiscal sense than a consumer loan, Tecotzky said.

"It's inherently more efficient for the borrower to get the tax deduction that you get on a second lien that you don't have on a consumer loan," Tecotzky said. "That should translate into a lower rate. And for a consumer that should be a benefit to them."

Of course, not every lender is likely to take advantage of the opportunities presented by second mortgages. Banks will be less likely to participate in the market, partly because of potential reputational risk, Penn said, "and the nonbanks like us should be able to fill the void there."