A Second Look at Second Liens

For the first time in a while, second liens have come to the forefront of mortgage industry conversation. To a large degree, this is natural because of the unprecedented rise in home prices that we have experienced since the Covid shock. These seconds can be so-called “piggyback” loans that are used to keep the first lien under the conforming loan limit at origination, or they may be “closed seconds” that are used by consumers to extract equity from gains in home price valuations. This product may be superior to the other traditional form of equity extraction, cash-out refinancings, as this vehicle requires that the entirety of the original mortgage be refinanced, not just the extraction amount, often from a much lower level. Finally, while not strictly a loan, Home Equity Lines of Credit (HELOCs) are also popular for this purpose.
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Below find the share of second liens, by both loan count and by the original loan amount from HMDA[1]:

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The shares look remarkably like those in place just prior to the Global Financial Crisis. In fact, the magnitude of second liens in 2023 exceeded that of the prior peak in 2006 (23.7% vs 22.6% by loan count and 8.2% vs 6.7% by value). We can also break it further by the type of open or closed-end, but unfortunately, HMDA provides this information only back to 2018 :

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It’s interesting to note that the capacity for new credit availability from second-lien HELOCs is greater than that from closed seconds each year over the 2018-2023 interval. Moreover, the share of closed-end first-lien loans fell from 92.3% to 72.5% by loan count and from 97.0% to 89.3% by volume over the 2020-2023 period.

Given the similarity in shares of second liens at the present time to the GFC, it’s natural to ask whether seconds pose risks of a similar magnitude to the earlier period. This is a complex question, and a detailed answer is beyond the scope of this note. The key research piece addressing this issue during the GFC was written by Donghoon Lee, Christopher Mayer, and Joseph Tracy and published by the New York Federal Reserve in 2012 called “A New Look at Second Liens” (which we will call LMT)[2]. The analysis is based on a 5% sample of loans from a credit bureau. This data set has the advantage that the LOC data goes back to the GFC period. To summarize the conclusions from LMT:

• Second liens were originated to higher-quality borrowers than the average first lien borrowers, with the biggest increase among borrowers who apparently have the financial resources to pay.
• Within the category of second liens, home equity lines of credit (HELOCs) appear to be the best credit quality, with relatively few piggyback originations, higher quality borrowers at origination, and a smaller percent originated near the peak of the housing boom.
• The default rate on a second lien is generally similar to that of the first lien on the same home, although about 20 to 30 percent of borrowers will pay the second lien for more than a year while remaining seriously delinquent on their first mortgage.
• The relatively low delinquency rates for HELOCs have remained flat in recent quarters (as of 2012) even as delinquency rates have fallen for most other types of credit. Such performance could signal that problems are not over for some lenders with large portfolios of HELOCs on their balance sheet.

To answer the question, we need to take into account how the economic and market environment has evolved over the past two decades. We looked at many factors, but one that jumped out immediately was the distribution of second liens by lender type:

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It’s always good to be surprised. The bank share of seconds in 2023 at 42.3% is quite close to the 44.8% share recorded in 2004. In between those dates, however, the share reached as high as 66% in 2007. Over the same period, the credit union share increased over fourfold, most recently reported at 41.5%, just 0.8% below the bank share.
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We can perform a similar calculation over a shorter time period for second-lien HELOCs:

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In this case, the bank share dropped by almost 20 points to 49.3% over the 2018-2023 period, while the credit union share rose by just over 15% to 41.6%, very close to their share of first liens.
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Before we move on, we recall that our GSE disclosure data contains a flag (assigned by ourselves) for loans with second liens, so-called “piggyback loans”. We can then run our Cohort Analyzer to sort purchase mortgages by seller type with this flag:

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The share of loans delivered to the GSEs with piggybacked seconds began to pick up from about 1.5% in mid-2022 when mortgage rates cleared the 5.5% hurdle, reaching 4.4% by late 2023. So far this year, the overall share has been decreasing. However, there are notable differences in the shares of different lender groups. Credit unions have seen a fourfold increase in their share this year, while the other two groups, especially nonbanks, have pulled back on their second mortgage lending. This is a nice confirmation of our previous findings from a distinct data source.

Conclusion

So where do we stand on the question of whether the similarity in share of seconds now and in 2006 imply similar levels of risk. Looking at the LMT paper, we conclude “could be”. There are a couple of mitigating factors now that distinguish present circumstances from those of two decades ago. First, credit conditions are generally tighter now than then. Second, house prices are so far holding their value. In a recent note, we discussed how recent broad trends in delinquencies across asset classes are tied in part to the economic incentives to service various types of debt[3]. As of today, mortgage holders have a lot of incentive to service this debt.

In the end the surprise reaction of market participants to “mortgage winter” conditions of unaffordable house prices and high interest rates is not so much the ensuing lower volume of activity but its composition. There is broad sentiment that loan performance of mortgages produced by credit unions exceeds that of other lender segments based on their superior customer knowledge. But at the present time credit unions face many challenges regarding the asset sides of their balance sheets as do banks that were not an issue in 2006. In this case the question perhaps shifts from “should we be worried about accumulating mortgage debt burdens” to “should we be worried about credit unions”?

Looking forward, a new wrinkle is the recent announcement by FHFA regarding their approval of Freddie Mac’s pilot program for purchases of second liens[4]. The policy purpose of this proposal is to support liquidity of a product that broadens access to credit for many borrowers. There are many questions surrounding the implementation of such a program. There are also deeper questions about the role of the public vs private sectors in this product, as well what a prudent level is for the share of second liens starting from their record high current levels.

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[1] Note: The category “Not secured by a lien” is excluded from the chart, which accounts for 1-2% of the total loan count or 0.05-0.15% of the total loan amount before 2018. It has been retired since then.
[2] https://www.newyorkfed.org/research/staff_reports/sr569.html
​[3] https://www.recursionco.com/blog/the-big-picture-view-on-delinquencies
[4]https://www.fhfa.gov/news/news-release/fhfa-announces-conditional-approval-of-freddie-mac-pilot-to-purchase-second-mortgages